1. society
2. work
3. unemployment

Deutsche Bank
Markets Research
Global
Rates
Credit
Date
26 October 2014
Francis Yared
Global Fixed Income Weekly
Strategist
(+44) 020 754-54017
[email protected]
Dominic Konstam
Research Analyst
(+1) 212 250-9753
[email protected]

The data this week has reduced some of the tail risk on global inflation and
growth in Europe without being decisive enough to resolve the stand-off
between the market and the ECB

The ECB will need to expand its asset purchase programme to reach its
balance sheet objective. However, given the lower yield levels and tighter
spreads. the marginal benefit on credit conditions of more easing is
diminishing

The latest data and risky asset performance should support a mild upward
drift in core yields, with risks emanating from further pressure out of
Europe

Positioning is becoming favourable to a stabilization in commodity prices

We maintain a low risk in Europe, but the relatively elevated level of vol
offers attractive opportunities to capture a slightly higher range in rates in
the US and the UK
Table of contents
Bond Market Strategy
Page 02
US Overview
Page 07
Treasuries
Page 19
Derivatives
Page 27
Agencies
Page 31
Mortgages
Page 34
US Credit Strategy
Page 50
Euroland Strategy
Page 55
Covered Bond and Agency
Update
Page 64
UK Strategy
Page 67
Japan Strategy
Page 70
Dollar Bloc Strategy
Page 74
Global Inflation Update
Page 80
Inflation Linked
Page 83
Contact
Page 87
________________________________________________________________________________________________________________
Deutsche Bank AG/London
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.
26 October 2014
Global Fixed Income Weekly
Europe
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Bond Market Strategy
Francis Yared
Strategist
(+44) 020 754-54017
[email protected]
Abhishek Singhania
Strategist
(+44) 207 547-4458
[email protected]

The data this week has reduced some of the tail risk on global inflation and
growth in Europe without being decisive enough to resolve the stand-off
between the market and the ECB
Jerome Saragoussi
Research Analyst
The ECB will need to expand its asset purchase programme to reach its
balance sheet objective. However, given the lower yield levels and tighter
spreads. the marginal benefit on credit conditions of more easing is
diminishing
(+1) 212 250-3529
The latest data and risky asset performance should support a mild upward
drift in core yields, with risks emanating from further pressure out of
Europe
Strategist

Positioning is becoming favourable to a stabilization in commodity prices
Markus Heider

We maintain a low risk in Europe, but the relatively elevated level of vol
offers attractive opportunities to capture a slightly higher range in rates in
the US and the UK
Strategist


[email protected]
George Saravelos
(+44) 20 754-79118
[email protected]
(+44) 20 754-52167
[email protected]
Stalemate
The market is primarily focused on three macro drivers: weak growth in
Europe, low inflation globally and the ECB’s policy response. On the data front
(US CPI and the European PMI), the releases this week were better than a
downbeat consensus. The current trend in US core inflation is around 1.7-1.8%
YoY and is likely to stay in this range in H1 2015, before drifting towards 2%
later in the year. In Europe, the latest PMIs are consistent with ~0.2% QoQ
growth. This is half way in between the ~0.3% implied by the lending
survey/fiscal impulse and a recent consensus/market pricing which was more
in line with 0.1% or less. On the ECB side, the covered bond purchase
programme is in its early days, but the start has been relatively cautious. More
recent ECB speak suggests that the ECB is considering widening its asset
purchase programme to meet its balance sheet targets. Overall, tail risks on
the growth/inflation side have been reduced. On the other hand, the ECB and
the market are likely to continue to gauge each other as the data was not
decisive enough to break the stalemate ahead of the next ECB meeting.
The focus next week is likely to turn to the ECB’s release of the AQR results,
the FOMC meeting and the Eurozone CPI. With respect to the AQR, DB’s
equity analysts do not expect any required capital raise for the banks under
their coverage. The market consensus seems to be broadly in line with this
view as the overall capital requirements are expected to be limited. The
Eurozone HICP (DBe: 0.4%) has the potential to be more of a market moving
event, especially core inflation (DBe: a weak 0.9%). Finally, the most recent
FOMC speakers have tended to reiterate the “around mid 2015” message for
lift-off. The risky asset performance and most recent data would suggest that
the FOMC could make only marginal changes relative to their overall message.
From a market perspective, the short positions in core rates are likely to have
been materially reduced following last week’s volatility. The front-end is pricing
a first hike in November vs. the most recent Fedspeak which would be more
consistent with a hike in Q3. The relatively subdued progress in some of the
Page 2
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
key indicators of labor market slack (Quits, Hires and Part time) and inflation
(as discussed above) would argue in favour of September over June at the
moment. Finally, the yield curve remains too flat for the level of rates. Overall,
this would argue for a mild parallel shift upward of the US curve, with risks
mostly emanating from further pressure out of Europe (e.g. a weaker than
expected CPI). In Europe, after having exited last week both the long in Italy
and the hedges against further stresses, we keep risk low, with only a long in
the front-end of the euro curve and in weaker covered bonds. As discussed
last week, we remain strategically constructive on the periphery, but the shortterm positioning imbalance may weigh on the market for now. From an RV
perspective, we find it attractive to monetize the high level of rates vol and sell
1Y expiry 3Y2Y mid-curve strangles 2.50%/3.50% which would capture a
positive payoff as long as the terminal FF rate is between 2.05% and 3.75%.
Similarly, payer flies on GBP3M10Y (ATMF/25bp/50bp) provide a 5:1 leverage
and captures a 2.4-2.85% range (2.85% being the upper bound observed this
year).
ECB: in search of the least bad solution
Even relative hawks such as Nowotny describe the ECB’s objective of
increasing the size of its balance sheet as being legitimate. The question is
how will the ECB achieve this and how effective will it be. The CBPPs purchase
programme started more aggressively than its predecessors, but not (yet)
aggressively enough to deliver a sizable balance sheet increase. As Luc Coene
recognized in an interview with l’Echo, this leaves the ECB faced with the
choice of either buying the currently targeted assets at a very high price or
extending the scope of the asset purchase programme, for instance to
corporate bonds. Our prior has been that the ECB will try the former up to a
certain point, and then, unless there is a more noticeable improvement in the
data, shift to the latter and ultimately launch a wider asset purchase
programme.
According to the ECB, repo eligible non-financial corporate debt amounts to
EUR1.4trn and repo eligible unsecured bank debt would amount to EUR2.2trn.
Given that the ECB lends on a secured basis in its repo operations, it would be
somewhat inconsistent to purchase unsecure bank debt. Focusing on the nonfinancial corporate debt, the actual amount that the ECB could target is likely
to be smaller (EUR ~580bn) if one considers only euro denominated bonds
issued by euro area residents, with more than one year maturity and liquid
enough to be included in indices. Ultimately, the purchase of corporate bonds
is likely to face the same constraints as the purchase of covered bonds, and if
macro conditions do indeed require the ECB to increase its balance sheet by
the touted EUR1trn, it is likely that government bonds will also need to be
incorporated.
The marginal benefit of buying corporate bonds from a credit easing
perspective is likely to be limited. First, IG spreads are relatively tight and
corporate that have access to the bond market are by definition those which
are not credit constrained. Second, banks own a relatively small amount of
corporate bonds. Thus the primary benefit from further ECB easing would
come primarily via the FX and portfolio channels. This is pretty much what
most ECB speakers have already acknowledged, by focusing more on the size
of the balance sheet than its composition. Of course, the more credit risk the
ECB assumes the more credit easing would be felt, but the ECB seems to still
be reluctant to go much lower the credit spectrum.
EUR iBoxx IG non-financial market
value outstanding by countries
(Eurozone only, EUR bn)
France
200
Netherlands
165
Germany
56
Luxembourg
23
Belgium
16
Austria
8
Finland
6
Italy
57
Spain
42
Ireland
8
Slovakia
1
Portugal
1
Total
583
Core
473
Periphery
110
Source: Deutsche Bank
More generally, lower interest rates and the tighter the spreads the less
beneficial monetary policy becomes, especially from a credit easing
perspective. It does not mean that more easing may not be required or
Deutsche Bank AG/London
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26 October 2014
Global Fixed Income Weekly
necessary, but rather that other drivers of policy are likely to be more effective.
In the current environment, the pecking order is likely to be (a) structural
reforms, (b) regulatory easing, (c) targeted fiscal easing and (d) monetary
policy easing. The ABS purchase programme provides a simple example of the
above. The ECB is trying to lean against regulation which is making it more
onerous to issue or hold ABS. As the ECB and the BoE recognized in their joint
proposal, it may be easier to adapt the regulation than try to overcompensate
via monetary policy which is bound to create distortions.
To further illustrate the declining efficiency of monetary policy, we compare
below the impact of the LTRO announced in 2011, and the most recent TLTRO.
The benefit of the LTROs can be measured by its impact on the profits of the
banking system. This is can be broadly captured by the difference between the
cost of unsecured bank debt and the equivalent cost of the ECB’s financing. To
simplify the calculations, we will use instead the sovereign bond yield with the
appropriate maturity.
We calculate the benefit for the periphery via the vLTRO as the difference
between the 3Y Italian bond yield (averaged over Dec-11 to Feb-12) and 1%
(the ECB refi rate when the vLTRO was initially conducted) on 70% of the total
vLTRO take up over 3 years. This amounts to EUR 83bn or 2.7% of the
combined GDP of Italy, Spain, Ireland, Greece and Portugal. For the TLTRO the
benefit is calculated as the average 4Y Italian bond yield (from Jun-14 to date)
less 0.15% (funding cost at the TLTRO) on 70% of the estimated EUR 400bn
TLTRO take up (across all 8 TLTROs) over 4 years. The benefit to the periphery
by this estimation is much smaller at EUR 10bn or 0.3% of GDP.
For the core/semi-core countries the benefit of both the vLTROs and the
TLTROs estimated by using French bond yield instead of Italian bond yields is
much smaller at around EUR 1bn which is negligible compared to the GDP of
these economies (see table below).
Declining efficiency of ECB monetary policy easing
Fo r periphery
Spread between Italian bo nd yield
and ECB funding
A mo unt bo rro wed (EUR bn)
B enefit (EUR bn)
B enefit as % o f GDP
2.7%
Dec-11to Feb-12
3.90%
713
83
Jun-14 to date
0.85%
280
10
0.3%
Spread between French bo nd
yield and ECB funding
A mo unt bo rro wed (EUR bn)
B enefit (EUR bn)
B enefit as % o f GDP
0.13%
305
1
0.0%
120
1
0.0%
Fo r co re/semi-co re
Dec-11to Feb-12
Jun-14 to date
0.14%
Source: Deutsche Bank, ECB, Bloomberg Finance LP
US inflation update
In the US, inflation and wage dynamics rather than growth are the key binding
constraint for monetary policy. The latest US Core CPI at 0.14% MoM SA went
back to a normal trend (compatible with the current annual pace of 1.7%)
slightly above low expectations. Simultaneously, flows and positioning in the
commodity complex are supportive of some stabilization in commodity prices.
Core inflation: Although we did not get a large payback in September for the
peculiar softness of the August report, core CPI returned to a normal trend
around 0.14% MoM SA. The report was broadly encouraging with (1)
continuous strength in rent inflation (~0.27% MoM SA for Shelter CPI), in line
with our leading indicators based on encouraging private surveys of rent
inflation historically low vacancy rates, and the recovery in house prices over
the past 12 months (2) some normalization of the pace core goods inflation
supported by the past recovery of pipeline inflation (see chart 1 below) and
Page 4
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
imported inflation or core capital and consumer goods (3) a stabilization of
core services prices after an unusually large drop in July and August.
The persistent source of softness in the September report has been inflation for
medical care services. However this softness is more likely to be a supply story
(i.e. Obamacare, de-regulation, and the ability of US consumers to choose in a
transparent way the cheapest providers of healthcare services) rather than a
demand story. At the margin, given the lower weighting of shelter inflation in
the core PCE basket and the higher weighting of healthcare inflation, there is a
slight downside risk to Sep core PCE but healthcare inflation as measured by
the BEA (to compute core PCE) has been more resilient with limited correlation
relative to the BLS measure (they have different scopes).
All in all a bottom up and top down analysis of core inflation continues to
suggest a stabilization in a 1.7-1.8% range until mid 2015 before gradually
increasing towards 2% by the end of 2015.
Core goods inflation bottoming out
5.0%
Core goods inflation (lhs)
Core Import prices YoY (18M lead)
Core PPI YoY (rhs, scaled, 12m lead)
4.0%
Core CPI forecasts imply 1.7-1.8 range until mid 2015
5.5%
3.0%
US core CPI YoY
Forecast
4.5%
2.5%
3.5%
3.0%
2.5%
2.0%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
1.5%
1.0%
-1.5%
-2.0%
-2.5%
-3.0%
-3.5%
0.5%
05
06
07
08
09
10
11
12
13
14
15
02 03 04 05 06 07 08 09 10 11 12 13 14 15 16
Source: Deutsche Bank
Source: Deutsche Bank
Commodities: Beyond the supply/demand picture that has likely contributed to
the correction in commodity prices and in crude oil prices, flows and
positioning prove to be useful indicators of market turns and future market
direction.
Speculative positioning -First looking at speculative positioning data from CFTC
on crude oil WTI futures, we find good empirical evidence of a contrarian
relationship between the change in net speculative positioning and the
subsequent performance of crude oil (see chart below). Net speculative
positioning in crude oil futures increased sharply in H1 2014, reaching a peak
in mid June. This large net increase in net long spec positioning was sending a
strong bearish signal on crude oil prices. The correction observed since July
broadly reflects what was implied by the increase in net long spec positions
until June. The correction over the past four months has taken place with an
abrupt liquidation of net long positions, so that the 6M change in positioning is
currently sending a contrarian message of a rebound of crude oil futures prices
over the next couple of quarters.
Flows: Similarly, a look at the net inflows into Commodity/Materials mutual
funds (data from EPFR) shows that the asset class benefited from remarkably
large inflows in June and early July, sending a contrarian signal about the
subsequent quarterly change in industrial metal prices. The correction
experienced between August and October also broadly reflects the expected
underperformance implied by past inflows. The correction took place with very
Deutsche Bank AG/London
Page 5
26 October 2014
Global Fixed Income Weekly
large net outflows away from commodity funds, so that these large outflows
now send a bullish signal on the asset class in the coming quarter.
Positioning and mutual fund flows are only one of many drivers of asset prices.
Nonetheless, from this perspective, it can be argued that these factors are now
favourable for at least a stabilization in commodity prices, with associated
implications for global inflation.
Destruction of net spec long position sends bullish signal
Large outflows away from commodity funds in the past
on crude oil in the next couple of quarters
quarter sends bullish signal on industrial metals
0.35
0.30
6M change in spec positioning in WTI Crude Oil
Subsequent 6M change in Crude oil TWI (rhs, inv)
-70%
25%
-60%
20%
0.25
-50%
0.20
-40%
0.15
0.10
15%
-40%
1M MA of weekly net inflows in
Commodities/Materials funds (as % of AUM)
-30%
Subsequent 3M change in LMEX
-20%
-30%
10%
-20%
5%
-10%
0%
0%
-10%
0.05
0%
0.00
10%
-0.05
20%
-5%
10%
-10%
-0.10
30%
-0.15
40%
-15%
50%
-20%
Jun-11
-0.20
Sep-09 Jun-10
Source: Deutsche Bank, CFTC
Page 6
Mar-11 Dec-11 Sep-12 Jun-13
Mar-14
20%
30%
Feb-12
Oct-12
Jun-13
Feb-14
Oct-14
Source: Deutsche Bank, EPFR
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
United States
Rates
Gov. Bonds & Swaps
Rates Volatility
US Overview





The recovery in risk asset pricing and stickiness of rates and rates vol
suggest that the markets are simultaneously comfortable with the
economic outlook being sufficiently robust and the Fed remaining
sufficiently supportive. Central bank failure to accommodate risk is a key
risk for equity and credit valuations.
This likely means the Fed needs to recognize stalled progress on inflation
while remaining optimistic that it will be met in time. We expect the Fed to
complete the taper, or at least leave only a $5 billion purchase of
Treasuries. We think "considerable period" is likely to stay for now.
The decline in the euro has greatly outpaced relative changes in central
bank balance sheets. Unless the euro reverses course, it will take a year of
balance sheet expansion at 47 billion/month for the ECB to catch up. We
expect risk markets to react poorly to any reversal of this sort.
Investor positioning is cleaner all round, although probably less so among
real money managers, who have remained short in overall duration but
have had an overweight credit.
Equities may well be able to sustain their gains under an accommodative
Fed and rising inflation expectations, but it is pretty clear that earnings
alone should not be the sole driver of valuations, nor just nominal yields
without reference to the mix.
Dominic Konstam
Research Analyst
(+1) 212 250-9753
[email protected]
Aleksandar Kocic
Research Analyst
(+1) 212 250-0376
[email protected]
Alex Li
Research Analyst
(+1) 212 250-5483
[email protected]
Stuart Sparks
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]
Carry or scary?
Is it a range trade for risk assets and rates or is it a complete rejection of the
risk-off flash crash/rally two weeks ago? Risk assets in several cases seem to
be in full recovery mode: US/European equities and high yield; although high
grade cash credit appears to be lagging. In volatility space the VIX is down to
around 16% from the 26% peak although 3m10y rate vol is still elevated
around 81 but down from 93 bps. 10s are back at 2.30 bps with 5s over
1.50bps and the 2s5s10s fly has 5 still very cheap at +32bp, albeit off the
September closing highs around 49 bp. EDZ7 is 97.55 off the highs of 97.82
but still well above the September lows of below 97. EDZ5 is more impressive
at 99.22 off a little from the 99.3 high on 15 October but well above the
September low of 98.76 i.e. two hikes have been priced out of late December
2015/early 2016 and late 2016/2017 although a third hike that was priced out
in the latter has been put back.
Net if there is an ongoing return to full “risk-on”, it seems so far to be not fully
endorsed by rates, partly in the vol space but especially in front end rate
expectations. The conclusion is that the market seems to be comfortable with
some combination of the economic outlook being sufficiently robust in tandem
with the Fed expected to be sufficiently supportive. This therefore is consistent
with the view we expressed last week that the markets are hostage to policy
makers delivering on accommodation in the form of ECB meeting balance
sheet targets and the Fed being prepared to underwrite a delay in tightening.
By contrast if policymakers fail to deliver, especially in the context of
disappointing data, risk assets are vulnerable, albeit perhaps temporarily
through the channel of front end disappointment.
Deutsche Bank AG/London
Page 7
26 October 2014
Global Fixed Income Weekly
For investors with a proclivity towards risk, a good hedge may therefore be
now found in being short Eurodollars in the red pack or perhaps steepeners
versus greens or greens versus blues. The hedge itself might well make money
if stocks continue to rise. But it is also a hedge that could work well if the Fed
is repriced for more and early tightening but at the expense of further risk
asset appreciation. What we think may be a more naïve approach is to just
assume that stocks can keep rallying and the Fed can raise rates sooner and
more aggressively. That presumes that normalization is straightforward; the
impact of rising rates is a positive for risk assets. While historically this has
often been the case, as we’ve argued before, that is much more likely in a
higher volatility environment when risk premia are already embedded in risk
assets. Until risk premia return, the danger this time is that rising rates stall
and partially reverse risk asset performance. Of course currently one can’t
distinguish between investors repricing more Fed now as either a hedge for
risk on or as a complement to risk-on positions. What appear to be similar
strategies are indeed very different in their rationale.
Having said all of that we suspect that risk assets will remain vulnerable to
policy disappointments and are reluctant to see a sustained rise in Treasury
yields quite yet. While our forecast for year end is 2.35 percent, we think there
is a decent chance that the market retests 2 percent before it moves to 2 ½
percent. Near term aside from the data itself the three looming events are AQR
results/stress tests for European banks released Sunday October 26, FOMC on
October 28/29 and the ECB on November 6th.
On AQR there seems to be a strong conviction that it will be a nonevent. All
but a handful of the banks that our analyst team covers are expected to pass
the stress test. We think the market should probably think of four tiers of
potential reaction however. At one extreme there is a stress test pass with
favorable AQR results so that the impact on tier 1 capital is muted from the
markets’ eye. This presumes some industry standard for CET1 capital e.g. 10
percent so that relative to capital in place in 2013 and any raised in 2014, any
particular bank is deemed well capitalized. The second tier might be a stress
test but a harsher AQR that leaves some banks below the “industry” standard,
even though passing the actual stress test itself. This might pressure financials
to raise more capital or reduce risk assets more and would be mildly risk off. A
third tier might be a failure of the stress test but only on the capital in place in
2013 but subsequent capital raising implies no further action needed. In all
probability banks would still be below the industry standard and given the
stress test failure would still be in need of a capital raise in addition to further
asset deleveraging. Finally the fourth tier is an outright failure of the stress test
and falling into the category of needing to raise capital within a 9 month
window. As a guide our European Banks strategy team expect for their
coverage universe Euro 95 billion in AQR related provisions with no capital
increases required (CET1 still above 8 percent) and an additional Euro 43 bn hit
from the stress test but thanks to capital raises in 2014 again with no need for
balance sheet strengthening (CET1 above 5.5 percent).
There is greater uncertainty around the Fed than the AQR, it would appear.
Given the relative robustness around the front end especially 2015 Eurodollars,
the market appears to be discounting heavily the previous FOMC minutes and
the Fischer speech as well other rhetoric from Governors including Dudley and
Tarullo. We think the Presidents themselves have been somewhat less
consistent with Bullard’s flip flop and doves Williams and Rosengren being
more evenhanded. We suspect that FOMC members in general were
somewhat surprised by the violence of the risk-off trade and are wary of
sounding too concerned about falling or low inflation and global growth for
fear that that in itself can undermine the recovery. The analogy is shouting fire
in a crowded theater, when there may not be one. Ideally one wants to
Page 8
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
indicate that there may be small fire but it is under control and meanwhile
enjoy the show!
Drawing that fine line probably means that the Fed has to recognize stalled
progress on the inflation front but optimism that it will meet its long term
objective; it probably recognizes explicit global growth weakness but does not
expect that to undermine the US recovery – and anyway stands ready to
maintain a highly accommodative monetary stance as needed; it probably
retains ‘considerable period’ in that light; but it nevertheless does complete the
taper or at the very least only leave $5 billion in purchase of Treasuries. Below
we reproduce the last statement and highlight the nature of the possible
changes that the market might be expecting. Overall we think that if the Fed is
particularly dovish, it is consistent with a steeper yield curve with more risk on
– bullish to neutral for 5s but more bullish for reds and green Eurodollars, as
initially without weak data the market will interpret this as “delayed hikes but
then catch up once they do go”-- this is the “hockey stick” problem for 5s or
optimal control issue and one (good) argument why 5s stay cheap on the curve,
i.e. they just cannot compress meaningfully to a locked down 2 year note. To
be really bullish 5s, we need risk-off and weaker data. Very much a plausible
tail risk along the lines of a corporate profits recession but not the obvious
issue for the coming week. If the Fed is hawkish and let’s say barely changes
the statement outside what it has to do, the market reaction itself will be very
telling. But we think the bias would be for risky assets to fare poorly on
potentially earlier Fed hikes absent any data strength and presumably on the
back of a stronger dollar and more exported disinflation to the US. Even
though October 15 was a big risk-off event, the decline in breakevens started
several months ago on the back of USD strength. In turn that could mean at
least something bullish in rates but given the cheapness of 5s and the
“inevitability” of Fed acquiescence more a parallel shift in rates than bull
flattening.
DXY versus 10 yr BEIs
88
87
86
85
84
83
82
81
80
79
78
10/23/2013
1.7
DXY
1.8
10 yr breaks rhs inv.
1.9
2
2.1
2.2
2.3
4/23/2014
2.4
10/23/2014
Source: Haver and Deutsche Bank
Release Date: September 17, 2014 [new release date October 29th ]
h
Information received since the Federal Open Market Committee met in July
suggests that economic activity is expanding at a moderate pace. [The beige
book was a little more downbeat – modest increasing versus moderate and one
mixed. So this could be softened although the Fed doesn’t want to downplay
growth we think]. On balance, labor market conditions improved somewhat
Deutsche Bank AG/London
Page 9
26 October 2014
Global Fixed Income Weekly
further; however, the unemployment rate is little changed and a range of labor
market indicators suggests that there remains significant underutilization of
labor resources [LMCI won’t be released until Nov 10, but the last one was
clearly disappointing so even if they recognize still lower unemployment, hard
to see this really changing]. Household spending appears to be rising
moderately and business fixed investment is advancing, while the recovery in
the housing sector remains slow. [Retail sales were disappointing but the oil
“tax” drop will help. Investment and housing seem to be steady] Fiscal policy is
restraining economic growth, although the extent of restraint is diminishing.
Inflation has been running below the Committee's longer-run objective.
Longer-term inflation expectations have remained stable. [unchanged]
Consistent with its statutory mandate, the Committee seeks to foster maximum
employment and price stability. The Committee expects that, with appropriate
policy accommodation, economic activity will expand at a moderate pace, with
labor market indicators and inflation moving toward levels the Committee
judges consistent with its dual mandate. The Committee sees the risks to the
outlook for economic activity and the labor market as nearly balanced [here
there could be a reference to global growth risks being monitored] and judges
that the likelihood of inflation running persistently below 2 percent has
diminished somewhat since early this year. [this could also be modified – it may
not have diminished and/or Fed could suggest that policy will remain
appropriate to ensure inflation rises towards its objective].
The Committee currently judges that there is sufficient underlying strength in
the broader economy to support ongoing improvement in labor market
conditions. In light of the cumulative progress toward maximum employment
and the improvement in the outlook for labor market conditions since the
inception of the current asset purchase program, the Committee decided to
make a further measured reduction in the pace of its asset purchases.
Beginning in October, the Committee will add to its holdings of agency
mortgage-backed securities at a pace of $5 billion per month rather than $10
billion per month, and will add to its holdings of longer-term Treasury securities
at a pace of $10 billion per month rather than $15 billion per month. [here the
Fed can either now ditch all net new purchase commitments or just move to a
$5 billion purchase of Treasuries. We think it is unlikely that they maintain the
current level of taper given the partial recovery in risk assets]. The Committee is
maintaining its existing policy of reinvesting principal payments from its
holdings of agency debt and agency mortgage-backed securities in agency
mortgage-backed securities and of rolling over maturing Treasury securities at
auction. The Committee's sizable and still-increasing holdings of longer-term
securities should maintain downward pressure on longer-term interest rates,
support mortgage markets, and help to make broader financial conditions more
accommodative, which in turn should promote a stronger economic recovery
and help to ensure that inflation, over time, is at the rate most consistent with
the Committee's dual mandate.
The Committee will closely monitor incoming information on economic and
financial developments in coming months and will continue its purchases of
Treasury and agency mortgage-backed securities, and employ its other policy
tools as appropriate, until the outlook for the labor market has improved
substantially in a context of price stability. If incoming information broadly
supports the Committee's expectation of ongoing improvement in labor market
conditions and inflation moving back toward its longer-run objective, the
Committee will end its current program of asset purchases at its next meeting.
[This may well not be necessary]. However, asset purchases are not on a preset
course, and the Committee's decisions about their pace will remain contingent
on the Committee's outlook for the labor market and inflation as well as its
assessment of the likely efficacy and costs of such purchases.[Modified as
necessary but more importantly emphasis could be made on being prepared to
start it up again depending on the outlook for the labor market and inflation].
Page 10
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
To support continued progress toward maximum employment and price
stability, the Committee today reaffirmed its view that a highly accommodative
stance of monetary policy remains appropriate. In determining how long to
maintain the current 0 to 1/4 percent target range for the federal funds rate, the
Committee will assess progress--both realized and expected--toward its
objectives of maximum employment and 2 percent inflation. This assessment
will take into account a wide range of information, including measures of labor
market conditions, indicators of inflation pressures and inflation expectations,
and readings on financial developments. The Committee continues to
anticipate, based on its assessment of these factors, that it likely will 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 continues to run below the Committee's 2 percent longerrun goal, and provided that longer-term inflation expectations remain well
anchored. [Modified subject to asset purchase program ending; but we think
considerable language is retained].
When the Committee decides to begin to remove policy accommodation, it will
likely take a balanced approach consistent with its longer-run goals of
maximum employment and inflation of 2 percent. The Committee currently
anticipates that, even after employment and inflation are near mandateconsistent levels, economic conditions may, for some time, warrant keeping
the target federal funds rate below levels the Committee views as normal in the
longer run.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair;
William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Narayana
Kocherlakota; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.
Voting against the action were Richard W. Fisher and Charles I. Plosser.
President Fisher believed that the continued strengthening of the real economy,
improved outlook for labor utilization and for general price stability, and
continued signs of financial market excess, will likely warrant an earlier
reduction in monetary accommodation than is suggested by the Committee's
stated forward guidance. President Plosser objected to the guidance indicating
that it likely will be appropriate to maintain the current target range for the
federal funds rate for "a considerable time after the asset purchase program
ends," because such language is time dependent and does not reflect the
considerable economic progress that has been made toward the Committee's
goals.
Article of Faith?
Since the crisis year over year changes in EURUSD have corresponded closely
to year over year changes in the ratio of the Fed’s balance sheet to the ECB’s
balance sheet. When the Fed’s balance sheet grows relative to the ECB’s, the
dollar weakens, and vice versa. The recent depreciation of the euro implies a
significant increase in the size of the ECB’s balance sheet relative to the Fed’s.
If EURUSD declines at a constant y/y rate going forward, it would still require
just over a year for the relative balance sheet growth to “catch up” if the ECB
balance sheet grows at 47.5 billion/month and the Fed’s is unchanged. This is
the problem with the recent trend in euro-dollar, it appears to have become
more an article of faith that the ECB will successfully grow its balance sheet in
a consistent fashion beginning in the very near future. The chart presumes
that the vLTROs mature, and then that the balance sheet grows €1 trillion in
equal increments over two years. Even then trying out the two series requires
at worst a constant rate of decline of the euro, if not a reversal of its
depreciation. The point being that EURUSD’s decline has been extremely
aggressive and has far outrun the fundamentals requisite to achieve it.
Deutsche Bank AG/London
Page 11
26 October 2014
Global Fixed Income Weekly
Y/y change in EURUSD (including change implied by current forwards), y/y
change in ratio of Fed balance sheet to ECB balance sheet. Presumes
maturity of vLTROs and then prorated growth of ECB by €1 trillion over 2
years.
80%
Y/y Ccy (rhs)
20%
15%
60%
10%
40%
5%
20%
0%
0%
-5%
-20%
-10%
-40%
-15%
-60%
-20%
Currency y/y
Y/Y Ratio
Oct-09
Mar-10
Aug-10
Jan-11
Jun-11
Nov-11
Apr-12
Sep-12
Feb-13
Jul-13
Dec-13
May-14
Oct-14
Mar-15
Aug-15
Jan-16
Jun-16
Change in ratio of balance sheets
100%
Source: Deutsche Bank
From this perspective it is not difficult to foresee one potential path back to
risk-off markets. The ECB jawbones the EUR lower, as it has of late by
reiterating the likely divergence of central bank policy. However as the
stronger dollar and declining domestic inflation leads the Fed to rethink the
pace of its policy normalization, the onus shifts to the ECB to actually do
something. As always this is the thorny bit in Europe as the members of the
zone debate asset purchases and alternative policy tools. The appearance of
gridlock leads markets to price the worst case scenario, and as a result risk
assets underperform – here meaning specifically the periphery. The move in
EURUSD thus far has followed the script and investors are essentially knocking
on the ECB’s door shouting ‘trick or treat!’
Some Random Economic Charts
A lot of investors have expressed frustration recently with Fed officials for
crying wolf over global economic woes. We have interpreted the Fed slightly
more kindly in the spirit that these global woes and especially a stronger dollar
expose the weaknesses of the US recovery. The main problem with the US
recovery is the lack of productivity. This is consistent with but not necessarily
proof of the “secular stagnation” hypothesis. Productivity may be weak due to
a hangover from the financial crisis as regards animal spirits. It may reflect an
abundance of labor supply at low wages in conjunction with constrained final
demand. The low productivity problem may be rectified in time. Secular
stagnation itself would require a persistent weakness in structural demand that
reinforces a persistent lack of animal spirits (supply equals demand, supply
creates its own demand or demand creates its own supply). Thoughts we have
also had around the debate is whether equities are too cheap relative to fixed
capital and investment won’t pick up until Tobin’s Q is soaring. Now that can
really work people up the wrong way. Some think equities are already very
overvalued; others think Tobin’s Q cannot possibly be measured properly in a
digital world. Another issue is just to accept that we have been blinded by late
1990s TMT mania and that outside that period productivity is a little lower than
trend but not by too much – maybe 50 bps or so. It’s not necessarily secular
stagnation except when you also add in low labor force growth from ageing
demographics (demand creates its own supply). And we need to grow
Page 12
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
accustomed to a risk free rate in nominal terms that is maybe somewhere
between 2 and 3 percent. Perhaps though what we can all agree with, is that if
there was a repeat of the late 1990s – robotics, 3D printing - then we could
have at least for one or two cycles a rising real equilibrium interest rate as
businesses were obliged to invest to apply new technologies. These Luddite
style inventions are the essence of Schumpeterian creative destruction and
underpin waves of economic progress. Kuznets had them at 25 years and
indeed the late 1990s would suggest something next around the end of this
decade. Be that as it may, for now we observe our capital labor ratio indicator
for productivity does have productivity strengthening but only to around 2
percent by end 2015 as long as investment grows at 10 percent year over year;
but this seems quite plausible given, say, the Philadelphia survey showing still
elevated projections for capex. There may be not a lot of optimism but it is too
early to be too pessimistic.
Capital labor ratio predicts a modest rise in productivity
Nonresidential investment vs. Philly capex expectations
during 2015 on 10% yoy investment growth
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
19901
capital (net) labor ratio yoy, leads 4qtrs
productivity rhs
20001
Source: Haver and Deutsche Bank
20101
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
-0.5
20
30
15
20
10
10
5
0
-5
-10
0
Nonres investment
Phil Fed capex expns rhs
-15
-20
19921 19954 19993 20032 20071 20104
-10
-20
-30
Source: Haver and Deutsche Bank
That said there is a problem with low productivity potential in a cyclical sense.
And this is where we have a little more sympathy with the Fed. Productivity
typically drives profits. When it doesn’t profits need to be supported by higher
prices at the expense of lower wages. Which makes sense in economic theory
as workers get paid their (lack of) productivity in terms of a (low) real wage.
The last time we had a really extended period of low productivity were the
early 1990s. And profits then were supported by higher pricing and low wages.
As wages rose though productivity also rose, so that pricing could be
squeezed. This, if you like, was partly “engineered” by Fed tightening
(Greenspan’s opportunistic disinflation) and partly a reflection of the
application of TMT and investment. This time may not be different. But it
hasn’t started yet. The problem is that pricing is already low and we know
wages are necessarily low to support what are still elevated albeit stagnant
profits. When Yellen cries about income inequality she doesn’t appear to
appreciate the whole picture. Higher wages now will likely come at the
expense of profits - unless they are paid for by higher productivity. There is no
virtuous circle where companies can front run a profit decline by paying higher
wages and expecting demand for their product to go up. That’s why Keynes
was right. So when Europe falls foul and expects to depreciate its way to
growth as a substitute for fiscal ease and possibly even “credible” QE (viz
above discussion) it is quite reasonable for the more savvy Fed members to
highlight the risks of falling prices in the current phase of our recovery. And
even more reasonable for the markets to worry about risk assets that rely on a
healthy profits story. To emphasize the US recovery is not a bad one but if
Deutsche Bank AG/London
Page 13
26 October 2014
Global Fixed Income Weekly
anything goes wrong it is not because of household leverage. It is not about
corporate leverage initially but it is about a corporate profits recession that
would stall economic progress for a little while. Just enough for a mild rise in
unemployment and just enough for stocks and credit to cheapen significantly
subject to the Fed’s response.
Goods prices (high vol CPI index) yoy vs. model with
Productivity contribution to Profits
current USD level- projected into 2015
4.0
0.3
3.5
0.25
3.0
0.2
2.5
profit change
prody contribution
0.15
2.0
0.1
1.5
0.05
1.0
0
0.5
-0.05
(0.5)
high vol cpi
(1.0)
2007-Mar
2010-Mar
fitted
2013-Mar
Source: Haver and Deutsche Bank
-0.1
-0.15
19611
19761
19911
20061
Source: Haver and Deutsche Bank
Cleaner positioning all around
Investor positioning is cleaner all round, although probably less so among real
money managers, who have remained short in overall duration but have had
an overweight credit.
The duration exposure among bond fund managers hasn’t shifted significantly,
based on survey data, although it has become less short over the past couple
of months. The top 20 bond fund total returns suggest a heavy exposure to
credit and an underweight to duration. In the massive Treasury market rally
and credit spread widening in mid-October, all funds in our sample
underperformed the index in total returns. There has been some reversal in the
relative total return performance given the stability this week.
The rolling beta of the first principal component on funds’ excess returns over
the index suggests that credit exposure is dominant. We believe real money
investors have some staying power despite their underweight in duration. On a
year-to-date (YTD) basis, their total return performance remains decent. The
YTD weighted average return on our top 20 bond funds stands at 5.44%,
slightly ahead of the index YTD return of 5.38%. That said, given the heavy
credit exposure, bond fund performance could be vulnerable in a high volatility
and spread widening scenario, in our view.
Page 14
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Bond fund total returns in mid October, when bonds
Bond fund total returns year-to-date
rallied
0.80
8.00
10/9/14 to 10/16/14
0.60
6.00
Total return (%)
0.20
0.00
-0.20
-0.40
-0.60
5.00
4.00
3.00
2.00
1.00
-1.00
0.00
1
2
3
4
5
6
7
8
9
Weighted
10
Index
11
12
13
14
15
16
17
18
19
20
-0.80
Index
1
2
3
4
5
6
7
8
9
10
11
12
Weighted
13
14
15
16
17
18
19
20
Total return (%)
12/31/13 to 10/23/14
7.00
0.40
Performance ranking, sorted by return
Performance ranking, sorted by return
Source: Bloomberg Finance LP and Deutsche Bank
Source: Bloomberg Finance LP and Deutsche Bank
Early this year we highlighted the under-investment in Treasuries by foreign
official institutions. That underinvestment seems to be in a process of
correcting. Our metric of foreign under/over-investment (changes in reserves
relative to changes in Treasury holdings) went from about +1.5% in late 2013
to about -1% lately. The latest TIC data showed foreign investors bought $26
billion Treasury notes and bonds in August, above the year-to-date monthly
average of $17 billion.
In the COT data last week, spec investors cut their short positions in
Eurodollars as the market priced a delay in rate hikes. That reduction coincided
with the collapse in open interest during the week of October 10. Spec
investors’ net positions in Treasury futures were about neutral.
Source: Haver and Deutsche Bank
Deutsche Bank AG/London
Foreign net purchases of Treasury notes and bonds
140,000
3.8
3.3
2.8
2.3
1.8
1.3
Net Purchases of Treasury Notes/Bonds
120,000
Monthly, $ Millions
Foreign investments in Treasuries relative to reserves
5
underinvestment in USTs+3 mths
4
10 yr yield
3
2
1
0
-1
-2
-3
-4
-5
2009-Jul
2011-Jul
2013-Jul
100,000
All Foreign
80,000
60,000
40,000
20,000
0
-20,000
-40,000
-60,000
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Jan-14
Source: US Treasury
Page 15
26 October 2014
Global Fixed Income Weekly
Spec net positions in Treasury futures
500K
Spec net positions in Eurodollars futures
TY contract equivalents (ex. ED): -27K
1500K
UST 10Y cash equivalents (ex. ED): -2.5bn
1000K
300K
Net Position (contracts)
TY Contracts Equivalents
400K
200K
100K
0K
0K
-500K
-1000K
-100K
-1500K
-200K
-300K
-400K
Oct-10
500K
-2000K
Oct-11
Oct-12
Source: CFTC and Deutsche Bank
Oct-13
Oct-14
-2500K
Oct-08
Net Position: -916K
1 Week Ago :-1297K
4 Weeks Ago: -1800K
TY contract equivalents: -283K
Oct-09
Oct-10
Oct-11
Oct-12
Oct-13
Oct-14
Source: CFTC and Deutsche Bank
Equities versus bonds
Is the equity market cheap or not? There certainly seem to be many metrics
that equity strategists use to suggest it is – including low bond yields, a high
level of (expected) earnings, buyback potential, etc. Our view is first of all,
there is a legitimate debate around the appropriate metrics but based on
correlation analysis since the 1960s and trend earnings, equities are only really
cheap in bond yields are low for the “right” reasons, i.e. real yields stay very
low and breakevens are elevated. Otherwise equities are in danger of looking a
little expensive. Much focus is on the Shiller CAPE measure, which as we
show below is almost identical to the cumulative trend earnings PE measure
that we typically employ. Basically actual earnings are way above trend. So if
there is any concern as per the above discussion around profits being in
danger of excessive and premature dollar strength, then the equity market can
quickly look “expensive”. In addition it is noted that the distribution of PEs
based on the adjusted earnings is a bell distribution to yields so that low yields
are usually associated with much lower valuations. This captures the 1960s
but also the 2000s period. But what is different now, and we think thanks to
QE, the correlation has changed whereby lower nominal yields have not
“required” lower PEs but instead have allowed for higher PEs but only because
of the better low real yields/higher breakeven mix that has not existed before.
If this correlation continues it is very important that nominal yields normalize
over time led by higher breakevens rather than higher real yields or at least real
yields can’t rise at the expense of breakevens – which is exactly what has
happened recently or at least in September. That we think is the Achilles heel
of stocks. So equities may well be able to sustain their gains under an
accommodative Fed and rising inflation expectations but it is pretty clear that
earnings alone should not be the sole driver of valuations nor just nominal
yields without reference to the mix.
Page 16
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
CAPE and detrended earnings SPX PE
6
5
detrended
earnings PE
30
Nominals
BEIs
reals
Pes
25
4
20
3
Shiller CAPE
2
15
1
10
0
-1
19781 19871 19961 20051 20141
Source: Haver and Deutsche Bank
-2
2007-Jan
2007-Jul
2008-Jan
2008-Jul
2009-Jan
2009-Jul
2010-Jan
2010-Jul
2011-Jan
2011-Jul
2012-Jan
2012-Jul
2013-Jan
2013-Jul
2014-Jan
2014-Jul
50
45
40
35
30
25
20
15
10
5
0
19511 19601 19691
PEs vs. yields
5
0
Source: Haver and Deutsche Bank
Detrended PEs vs. nominal yields by bucket
Rolling betas of earnings yield to yields
5
12
4
average earnings
yield
10
3
2
8
1
6
0
-1
4
-2
2
-3
-4
0
-5
1955-Apr 1967-Oct 1980-Apr 1992-Oct 2005-Apr
1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10
Source: Haver and Deutsche Bank
beta to nominals
beta to reals
beta to beis
Source: Haver and Deutsche Bank
Midterm election’s impact on financial markets
The upcoming midterm election on November 4 might give bond market bulls
a reason to be cheerful. Using 10y yields going back to 1970, we find that
bond markets have rallied following the date of the election 8 out of 11 times.
The exceptions were 1978, 2002 (more on these dates later), and 2010, when
the Fed’s announcement of QE2 came one day after the election and bond
yields surged in tandem with stock prices. Excluding 2010 from our data
sample, the average 10y yield decline was 20bp one month after the election
date.
A plausible explanation for the post-election rally is that past midterm elections
have more often than not resulted in a political gridlock, which weighted on
the investor sentiment. Only twice since 1970 had an election produced an
outcome with both the House and the Senate being controlled by the same
party as the president – in 1978 during the Carter administration, and in 2002
when George H. Bush was president. As noted above, yields climbed after the
Deutsche Bank AG/London
Page 17
26 October 2014
Global Fixed Income Weekly
election in those years. Conditioning on election outcomes, 10y yields declined
an average 27bp one month after an election that ended in a gridlock, and rose
an average 5bp in one that ended without.
The stock market has also ended up higher post election, with the S&P 500
index posting an average 1.2% gain in one month’s time (1.1% gain in a
gridlock, and 1.4% without). What’s notable is that stock prices had tended to
rise strongly into the election date but had flattened out after the election, a
reaction that would be consistent with less optimistic investor sentiment and
lower bond yields.
Change in 10y yields relative to midterm election
Change in S&P 500 index relative to midterm election
10%
60
Change in S&P 500 index
Change in 10y yields (bp)
40
20
0
-20
-40
-60
No Gridlock
Gridlock
Average (excl. 2010)
-80
-100
-25
-20
-15
-10
-5
Page 18
0%
-5%
No Gridlock
Gridlock
Average (excl. 2010)
-10%
-15%
0
5
10
15
Trading days relative to midterm election
Source: Haver Analytics and Deutsche Bank
5%
20
25
-25
-20
-15
-10
-5
0
5
10
15
20
25
Trading days relative to midterm election
Source: Haver Analytics and Deutsche Bank
Deutsche Bank AG/London
26 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

We like selling the rich classic bond futures versus off-the-run bonds in the
2026 to 2028 sector, which have cheapened lately and appear attractive on
our fair value models.

We update our market positioning metrics. Overall positioning is more
balanced all round, although probably less so among real money managers,
who have remained short in overall duration but have had an overweight
credit.

Spec investors cut their short positions in Eurodollars as the market priced
a delay in rate hikes. That reduction coincided with the collapse in open
interest during the violent Treasury market rally last week.
2026-2028 bonds are cheap, while classic bond futures are
rich
We like selling the rich classic bond futures versus off-the-run bonds in the
2026 to 2028 sector, which have cheapened lately and appear attractive on our
fair value models.
First, the 2026 to 2028 off-the-run bonds have cheapened significantly over the
past few weeks. The 2/2026 to the 5/2030 spread, for example, was about
+29bp two months ago, and has narrowed to about +24bp lately. Meanwhile,
the 8/2028 to the 5/2030 spread compressed from +7.5bp around mid
September to the current +5.6bp. The 2026 to 2028 sector has wide spreads to
our spline model, with high t-statistics.
Treasury fair value spline model t-statistics
Source: Deutsche Bank
Deutsche Bank AG/London
Page 19
26 October 2014
Global Fixed Income Weekly
The 2/2026 to the 5/2030 spread is at an extreme tight
The 8/2028 to the 5/2030 spread is at an extreme tight
level
level
38
10
36
9
34
32
8
30
7
28
26
24
6
T6 2/15/2026 Govt to T6.25 5/15/2030 Govt
5
T5.5 8/15/2028 Govt to T6.25 5/15/2030 Govt
22
20
10/1/12
4/1/13
10/1/13
4/1/14
Source: Bloomberg Finance LP and Deutsche Bank
10/1/14
4
10/1/12
4/1/13
10/1/13
4/1/14
10/1/14
Source: Bloomberg Finance LP and Deutsche Bank
Second, the classic bond futures have outperformed 10s and 30s. Whether
regressed on rate levels or yield curve, the 10s-US-30s spread looks tight. It
would make sense for investors to shorten from 2030s to the cheaper 2026 to
2028 off-the-run bonds, given the recent shift in relative value.
Classic bond futures are rich to 10s and 30s
Source: Deutsche Bank
Page 20
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
10s-US-30s spread versus 10s-30s curve
Source: Deutsche Bank
10s-US-30s spread versus ten-year yield
Source: Deutsche Bank
More Balanced Positioning
Investor positioning is cleaner all round, although probably less so among real
money managers, who have remained short in overall duration but have had
an overweight credit. The duration exposure among bond fund managers
hasn’t shifted significantly, based on survey data, although it has become less
short over the past couple of months. The top 20 bond fund total returns
suggest a heavy exposure to credit and an underweight to duration. In the
massive Treasury market rally and credit spread widening mid October, all
funds in our sample underperformed the index in total returns. There has been
some reversal in the relative total return performance given the stability this
week.
Bond fund total returns in mid October, when bonds
Bond fund total returns over the past week
rallied
0.80
0.60
Total return (%)
0.80
0.20
0.00
-0.20
-0.40
-0.60
0.40
0.20
0.00
-0.20
-0.40
-1.00
-0.60
Performance ranking, sorted by return
Deutsche Bank AG/London
1
2
3
4
5
6
7
8
9
10
Weighted
11
12
13
14
15
16
17
18
19
20
Index
-0.80
Source: Bloomberg Finance LP and Deutsche Bank
10/16/14 to 10/23/14
1.00
0.40
Index
1
2
3
4
5
6
7
8
9
10
11
12
Weighted
13
14
15
16
17
18
19
20
Total return (%)
1.20
10/9/14 to 10/16/14
0.60
Performance ranking, sorted by return
Source: Bloomberg Finance LP and Deutsche Bank
Page 21
26 October 2014
Global Fixed Income Weekly
The rolling beta of the first principal component on funds’ excess returns over
the index suggests that credit exposure is dominant. We believe real money
investors have some staying power despite their underweight in duration. On a
year-to-date (YTD) basis, their total return performance remains decent. The
YTD weighted average return on our top 20 bond funds stands at 5.44%,
slightly ahead of the index YTD return of 5.38%. That said, given the heavy
credit exposure, bond fund performance could be vulnerable in a high volatility
and spread widening scenario, in our view.
Early this year we highlighted the under-investment in Treasuries by foreign
official institutions. That underinvestment seems to be in a process of
correcting. Our metric of foreign under/over-investment (changes in reserves
relative to changes in Treasury holdings) went from about +1.5% in late 2013
to about -1% lately. The latest TIC data showed foreign investors bought $26
billion Treasury notes and bonds in August, above the year-to-date monthly
average of $17 billion.
In the COT data last week, spec investors cut their short positions in
Eurodollars as the market priced a delay in rate hikes. That reduction coincided
with the collapse in open interest during the week of October 10. Spec
investors’ net positions in Treasury futures were about neutral. Spec are net
long the ultra long bond futures.
Spec net positions in ultra-long bond futures
30K
1500K
1 Week Ago :28K
4 Weeks Ago: 19K
20K
1000K
TY contract equivalents: 83K
Net Position (contracts)
Net Position (contracts)
Spec net positions in Eurodollars futures
Net Position: 26K
10K
0K
-10K
500K
0K
-500K
-1000K
-20K
-1500K
-30K
-40K
Oct-12
-2000K
Feb-13
Jun-13
Oct-13
Feb-14
Jun-14
Oct-14
Source: CFTC and Deutsche Bank
-2500K
Oct-08
Net Position: -916K
1 Week Ago :-1297K
4 Weeks Ago: -1800K
TY contract equivalents: -283K
Oct-09
Oct-10
Oct-11
Oct-12
Oct-13
Oct-14
Source: CFTC and Deutsche Bank
Auction preview: 2s, 5s, 7s, and 2-year FRNs
Treasury is set to offer $93 billion of securities worth about $47 billion in tenyear equivalents through two-, five-, and seven-year note auctions next week.
Additionally, it will also offer $15 billion of new two-year floating rate notes
(FRN) maturing in October 2016. The auctions will settle on Friday, October 31
against an estimated $77 billion of coupon Treasuries maturing on the same
day.
The combined customer participation in September set of auctions fell below
average to 58.2% from 61.7% in August. The indirect bidder takedown was
solid at 46.7%, as compared to the average 40%, for the third straight month.
However, direct bidder takedown fell to 11.5%, the lowest since June 2013,
from 14.2% in August, and compares with the 18.7% average over the last
twelve months.
Page 22
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
2-year floating rate note (FRN)
The combined buyside participation has risen consistently since March, and
was a record 59% in September. Indirect bidders took down 54.4% of the
supply, the highest in the auctions so far, taking their average participation to
45.6%. Direct bidders takedown improved to 4.6% from 3.3% in the previous
two auctions as well, but was still below the average 5.6%. The allotment
share to foreign and international investors subsided to 30.6% from the record
42.6% in August. The share allotted to investment fund investors fell to almost
nil in September, and the combined share allotted to the two investor classes
dropped to 31.2%, the lowest in the last five months. Additionally, 23% of the
supply was allotted to investors classified as “Other.” The bid-to-cover ratio of
the auction improved to 4.45 from 4.38 in August, but was still below the
average 4.73. Each of the nine auctions held so far has stopped through by an
average 0.3 bps.
2-year note
The indirect bidder participation was strong for the second straight month, and
recorded a six-month high of 40.9% in September (average is 29.2). Direct
bidder participation increased to 16.1% from 12.1% in August, but was below
its twelve-month average 21.8% for the third consecutive month. The
combined buyside takedown of 57% was the highest since March, and
compares with the average 50.6%. The allotment share to foreign and
international investors beat the average 14.8% for the second consecutive
month, and was at a three-year high of 24.7% in September. Investment funds
allotment share declined to 26.7% from 28.4% in August, but was in line with
its twelve-month average. The last two auctions of the note recorded strong
bidding, and the bid-to-cover ratio of 3.56 in September was the highest in the
last seven months. The last twelve auctions have stopped through by an
average 0.3bp.
2-year note auction statistics
Size
($bn)
1yr Avg
$31.0
Primary
Dealers
49.0%
Direct Indirect
Bidders Bidders
21.8%
29.2%
Cover
Ratio
Stop-out 1PM WI
Yield
Bid
3.42
BP Tail
-0.3
Sep-14
$ 29.0
43.0%
16.1%
40.9%
3.56
0.589
0.593
-0.4
Aug-14
$ 29.0
48.0%
12.1%
39.8%
3.48
0.530
0.530
0.0
Jul-14
$ 29.0
58.7%
14.3%
27.0%
3.22
0.544
0.542
0.2
Jun-14
$ 30.0
53.6%
23.3%
23.1%
3.23
0.511
0.513
-0.2
May-14 $ 31.0
55.9%
25.2%
18.9%
3.52
0.392
0.391
0.1
Apr-14
$ 32.0
57.7%
19.0%
23.4%
3.35
0.447
0.448
-0.1
Mar-14
$ 32.0
37.5%
21.5%
40.9%
3.20
0.469
0.477
-0.8
Feb-14
$ 32.0
46.4%
19.3%
34.3%
3.60
0.340
0.343
-0.3
Jan-14
$ 32.0
49.2%
22.4%
28.5%
3.30
0.380
0.385
-0.5
Dec-13
$ 32.0
48.2%
30.2%
21.5%
3.77
0.345
0.352
-0.7
Nov-13
$ 32.0
50.3%
27.3%
22.5%
3.54
0.300
0.303
-0.3
Oct-13
$ 32.0
40.0%
31.0%
29.0%
3.32
0.323
0.325
-0.2
Source: US Treasury and Deutsche Bank
5-year note
Indirect bidder takedown has been strong over the past five months, and
averaged 50.8% over the period as compared to its one-year average 47.2%.
However, direct bidder participation was soft for the second straight month,
and the 8.8% takedown in September compares with the average 13.5%.
Overall, the combined customer participation fell to 59% from 63.6% in August,
the lowest in the last eight months. Investment funds were allotted 41.3% of
the supply, as compared to 40.7% in August and 37.4% average. Foreign and
Deutsche Bank AG/London
Page 23
26 October 2014
Global Fixed Income Weekly
international investor share fell to 14.1% from 18.6% in the previous month,
but was close to its one-year average. The last auction had a weak bid-to-cover
ratio of 2.56, compared to the average of 2.72 in the last year. The auction
tailed by 0.8bp.
5-year note auction statistics
Size
($bn)
1yr Avg
$35.0
Primary
Dealers
39.5%
Direct Indirect
Bidders Bidders
13.7%
46.8%
Cover
Ratio
Stop-out 1PM WI
Yield
Bid
2.73
BP Tail
0.3
Sep-14
$ 35.0
41.0%
8.8%
50.3%
2.56
1.800
1.792
0.8
Aug-14
$ 35.0
36.4%
10.8%
52.7%
2.81
1.646
1.644
0.2
Jul-14
$ 35.0
25.9%
25.9%
48.2%
2.81
1.720
1.729
-0.9
Jun-14
$ 35.0
38.2%
9.3%
52.5%
2.74
1.670
1.668
0.2
May-14 $ 35.0
39.1%
10.5%
50.4%
2.73
1.513
1.505
0.8
Apr-14
$ 35.0
36.5%
18.6%
44.9%
2.79
1.732
1.723
0.9
Mar-14
$ 35.0
25.9%
23.1%
50.9%
2.99
1.715
1.726
-1.1
Feb-14
$ 35.0
40.2%
9.2%
50.7%
2.98
1.530
1.538
-0.8
Jan-14
$ 35.0
44.7%
10.7%
44.6%
2.59
1.572
1.568
0.5
Dec-13
$ 35.0
62.4%
11.8%
25.8%
2.42
1.600
1.576
2.4
Nov-13
$ 35.0
39.2%
10.8%
50.0%
2.61
1.340
1.336
0.4
Oct-13
$ 35.0
41.9%
12.2%
45.9%
2.65
1.300
1.298
0.2
Source: US Treasury and Deutsche Bank
7-year note
The combined customer participation fell below its average to 58.3% from
69.3% in August. Indirect bidders took down 48.3% of the supply, solidly
above their average 43.1% for the third consecutive month. But direct bidder
participation fell by a half of its average to just 10% in September, and
remained soft for the fourth straight month. Investment funds were allotted
42.2% of the supply as compared to 49.3% in the previous month. Foreign and
international investor share too dropped to just 12.4% from 16.7% in August
and compares with its average 15.4%. The bid-to-cover ratio was soft at 2.48
as compared to 2.56 average, and three of the last four auctions tailed by more
than 1bp.
7-year note auction statistics
Size
($bn)
Primary
Dealers
Direct Indirect
Bidders Bidders
Cover
Ratio
1yr Avg
$ 29.0
36.2%
20.6%
43.1%
2.56
Stop-out 1PM WI
Yield
Bid
BP Tail
0.3
Sep-14
$ 29.0
41.7%
10.0%
48.3%
2.48
2.235
2.225
1.0
Aug-14
$ 29.0
30.7%
20.4%
48.8%
2.57
2.045
2.047
-0.2
Jul-14
$ 29.0
37.4%
15.2%
47.4%
2.58
2.250
2.238
1.2
Jun-14
$ 29.0
42.7%
16.7%
40.6%
2.44
2.152
2.139
1.3
May-14
$ 29.0
35.6%
24.1%
40.4%
2.60
2.010
2.008
0.2
Apr-14
$ 29.0
31.0%
19.1%
49.9%
2.60
2.317
2.321
-0.4
Mar-14
$ 29.0
26.0%
32.6%
41.4%
2.59
2.258
2.267
-0.9
Feb-14
$ 29.0
34.3%
24.6%
41.1%
2.72
2.105
2.108
-0.3
Jan-14
$ 29.0
32.3%
19.9%
47.8%
2.65
2.190
2.192
-0.2
Dec-13
$ 29.0
41.2%
17.1%
41.7%
2.45
2.385
2.368
1.7
Nov-13
$ 29.0
49.8%
16.1%
34.1%
2.36
2.106
2.095
1.1
Oct-13
$ 29.0
33.8%
23.9%
42.3%
2.66
1.870
1.873
-0.3
Source: US Treasury and Deutsche Bank
Page 24
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Allotments update
The allotments data for the October second re-opening auctions were released
on last Wednesday. The investment funds were allotted 33% of the combined
supply as compared to their 35.1% share in September and their twelve-month
average allotment share of 33.6%. The foreign and international investors were
at 17.8%, below their 23.1% share in the previous month, but in line with their
one-year average.
Three-year note
Allotment shares to foreign and international investors, though slightly below
than in previous two auctions, remained strong at 23.4% and compares with
its trailing one-year average of 19.5%. Investment fund investor allotment
share of 24.5% was in line to its average, and the combined share to the two
investor classes increased to 48% from 47.2% in the previous month, solidly
above the average 44.1%.
Ten-year note
The foreign and international investor allotment share fell to 12.5% in October,
the lowest since April 2013. Allotment shares to this investor class had
averaged 22.2% in the previous three auctions of the note. Investment funds’
share dropped to 33.3% from 41.6% in September as well, and compares with
their one-year average 38.4%. Consequently, the combined share to the two
investor class fell to 45.8%, the lowest since May 2013.
30-year bond
The allotment share to investment funds remained strong for the fifth straight
month at 50.1% and compares with its average of 44.8%. The share allotted to
foreign and international investors bounced back to 14.8%, the same as in
August, from 12.7% in September. The combined share allotted to the two
investor classes increased slightly from 64.3% to 64.9% and compares to its
average 57.4%.
Fed buyback
October Fed purchases conclude next week with a single buyback operation
on Monday. The duration removal is approximately $0.95 billion in notional or
$2.13 billion in ten-year equivalents. Detailed Fed buyback schedule for the
month of November will be announced on Friday, October 31, following the
conclusion of the Fed policy meeting on Thursday.
Fed buyback schedule for Oct 27
Date
Operation
type
27-Oct
Treasury
Maturity range
2/15/2036
Total
8/15/2044
Expected
Avg.
par ($bn) Duration
Avg.
DV01
10yr Equiv Sub/cover
($bn)
(Last 4 avg)
0.95
17.0
19.55
2.13
0.95
17.0
19.55
2.13
4.48
Source: Deutsche Bank, New York Fed.
Deutsche Bank AG/London
Page 25
26 October 2014
Global Fixed Income Weekly
Three-year note auction allotments
Settle Date
1 Yr Avg
10/15/2014
9/15/2014
8/15/2014
7/15/2014
6/16/2014
5/15/2014
4/15/2014
3/17/2014
2/18/2014
1/15/2014
12/16/2013
11/15/2013
Total
(less Fed)
$bn
29
27
27
27
27
28
29
30
30
30
30
30
30
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%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
16.0
13.9
14.2
13.2
15.4
16.9
15.1
16.3
18.2
14.9
19.2
16.8
17.4
55%
51%
52%
49%
57%
60%
52%
54%
61%
50%
64%
56%
58%
Investment
Funds
$bn
Foreign and
International
$bn
$bn
%*
$bn
7.1
6.6
6.0
6.9
6.6
6.2
7.7
8.1
7.3
6.9
6.1
9.4
6.9
5.6
6.3
6.8
6.8
4.7
4.8
6.0
5.4
4.2
8.1
4.7
3.7
5.6
0.1
0.1
0.1
0.2
0.3
0.2
0.2
0.2
0.3
0.1
0.1
0.1
0.1
0.5%
0.5%
0.4%
0.7%
1.1%
0.7%
0.6%
0.6%
0.9%
0.4%
0.2%
0.2%
0.2%
24.5%
24.6%
22.1%
25.4%
24.4%
22.0%
26.7%
27.0%
24.4%
22.9%
20.4%
31.4%
22.9%
Other
19.5%
23.4%
25.1%
25.1%
17.5%
17.0%
20.7%
18.0%
14.0%
26.9%
15.5%
12.3%
18.8%
* Percentage as of total less Fed SOMA
Source: US Treasury and Deutsche Bank
Ten-year note auction allotments
Settle Date
1 Yr Avg
10/15/2014
9/15/2014
8/15/2014
7/15/2014
6/16/2014
5/15/2014
4/15/2014
3/17/2014
2/18/2014
1/15/2014
12/16/2013
11/15/2013
Total
(less Fed)
$bn
22
21
21
24
21
21
24
21
21
24
21
21
24
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%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
9.3
11.1
7.8
10.1
10.5
10.1
7.7
9.1
6.8
9.0
9.6
9.8
9.6
42%
53%
37%
42%
50%
48%
32%
43%
32%
37%
46%
46%
40%
Investment
Funds
$bn
%
Foreign and
International
$bn
%
$bn
%
8.5
7.0
8.7
7.5
6.4
7.4
12.4
9.2
9.9
8.6
8.1
6.7
9.7
4.2
2.6
4.4
6.3
4.0
3.4
3.9
2.7
4.2
6.3
3.2
4.5
4.7
0.1
0.3
0.1
0.0
0.0
0.1
0.0
0.0
0.1
0.1
0.2
0.1
0.1
0.4%
1.3%
0.3%
0.2%
0.1%
0.6%
0.2%
0.1%
0.3%
0.5%
0.8%
0.5%
0.5%
38.4%
33.3%
41.6%
31.3%
30.5%
35.1%
51.6%
43.8%
47.2%
36.0%
38.4%
31.7%
40.2%
Other
18.8%
12.5%
20.9%
26.3%
19.2%
16.2%
16.3%
12.7%
20.1%
26.1%
15.1%
21.4%
19.4%
* Percentage as of total less Fed SOMA
Source: US Treasury and Deutsche Bank
30-year bond auction allotments
Settle Date
1 Yr Avg
10/15/2014
9/15/2014
8/15/2014
7/15/2014
6/16/2014
5/15/2014
4/15/2014
3/17/2014
2/18/2014
1/15/2014
12/16/2013
11/15/2013
Total
(less Fed)
$bn
14
13
13
16
13
13
16
13
13
16
13
13
16
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%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
5.9
4.5
4.6
5.1
5.0
3.6
8.7
5.6
6.6
7.0
5.7
6.1
8.6
42%
35%
35%
32%
39%
28%
54%
43%
51%
44%
44%
47%
54%
Investment
Funds
$bn
Foreign and
International
$bn
$bn
%*
$bn
6.2
6.5
6.7
8.5
6.6
7.0
5.9
5.8
5.0
6.6
5.8
4.5
5.8
1.7
1.9
1.6
2.4
1.3
2.3
1.3
1.6
1.3
2.3
1.5
2.1
1.5
0.1
0.0
0.0
0.1
0.1
0.0
0.1
0.0
0.1
0.1
0.0
0.3
0.1
0.6%
0.3%
0.3%
0.4%
0.5%
0.3%
0.4%
0.3%
0.8%
0.3%
0.3%
2.5%
0.4%
44.8%
50.1%
51.6%
53.1%
51.0%
54.1%
37.1%
44.6%
38.6%
41.5%
44.6%
35.0%
36.3%
Other
12.6%
14.8%
12.7%
14.8%
9.7%
17.8%
8.1%
12.3%
9.7%
14.1%
11.5%
16.0%
9.3%
* Percentage as of total less Fed SOMA
Source: US Treasury and Deutsche Bank
Page 26
Deutsche Bank AG/London
26 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

We see ahead of us a temporally fragmented landscape with bimodal
outcomes in both the short and the long run. Any particular trend that
might make itself evident in the near term could create conditions that
would lead to its subsequent reversal. Long term, there are worries about
global growth and the effectiveness of existing policy tools. Near term, the
main dilemma concerns the articulation of the dialogue between policy
makers’ actions and the data.

A near-term hawkish Fed means a push for higher rates, most likely bad
for risk, with another correction in risky assets, compression of breakevens,
stronger USD and general disinflationary pressures, which would be an
impediment to growth in the long term. The initial rates selloff could mean
a need for lower yields in the future. A dovish Fed, on the other hand,
would be better for risk and generally supportive for long-term growth.
Keeping rates low initially could bring back expectations of Fed hikes
according to schedule, sometime in the second half of 2015.

We capture the current dichotomy in the market through two pathdependent trades, vanilla vs. mid-curve payer calendars and exotic up and
out payers:

Buy $100mn 1Y5Y ATMF Receivers 163.5 cents vs. sell $100mn 6M 6M5Y
MC ATMF Receivers 120.5cents, net premium: 43cents

Buy $100mn 1Y5Y 2.415% (25bp OTM) payers subject to KO If 5s >
2.415% in the first 6M, offer 47c, a 59% discount to vanilla at 114c

The event risk is likely to remain high, and the market could be swinging
between risk-on and risk-off mode within an extended range with some
bias towards the risk-off. This applies even more to risky assets than to
rates. There will be some carry play and vol selling, but the landscape is
perceived as more risky.

Risky assets are likely to remain more volatile and vulnerable to data than
rates. At the same time, rates vol – although not likely to decline to Q2
lows – could see some correction lower. The aftertaste of the massive
intraday whipsaw should encourage opportunistic buying of the dip. If we
see another replay of Oct-15 – and we believe there is a decent chance
that we will – equity and (possibly) credit vol should outperform. We would
use rates gamma to finance long vol positions in risky assets.
The fragmented event horizon: From carry to scary
An event is the effect that seems to exceed its causes. It is the disclosure of
the horizon of meaning that determines how we perceive and relate to reality.
There are essentially only three types of events: a change in the way reality
appears to us (transcendental), a shattering transformation of reality
(ontological), and both of these at the same time. Oct-15 is a proper example
of a transcendental event1 – it represents a coalescence of several factors that
1
A typical example of an ontological event is a devastating natural disaster like an earthquake. The 2008
financial crisis has been both a change of reality itself and our perception of it.
Deutsche Bank AG/London
Page 27
26 October 2014
Global Fixed Income Weekly
outlined the contours of the new perspectives on the economic recovery.
Doubts about both the short- and the long-term prospects of the economy
have resurfaced again, but there has not been any comment from the policy
makers that would sway the market either way. Bifurcation of the long-term
horizon has opened a new set of contingencies that are likely to drive the
markets for the remainder of the year and possibly in the early months of 2015.
As a consequence, there does not appear to be a clear consensus about the
market’s direction. In many ways, Oct-15 was an important date for the market.
In terms of market confidence and the general view on risk, we have traversed
to the “other” side. Positioning has cleared, but there was a price to pay and
there is an aversion to repeating the same mistake. Perhaps the most eloquent
summary of the underlying change in sentiment across Oct-15 is condensed in
the attitude towards the 1X2 receiver spreads. This is the trade we have been
recommending for some time and we continue to like now. Up to two weeks
ago, this positive carry trade was largely ignored because it did not align with
the consensus view. Currently, it is being rejected because selling of the low
strike receivers has become a scary proposition.
It is back to data again, but the question is really what data and to what extent.
Long term, there are worries about global growth and the effectiveness of
existing policy tools, leading ultimately to the big one: is recovery possible at
all, and under what conditions? Near term, the main dilemma concerns the
articulation of the dialogue between policy makers’ actions and the data. The
presence of the long-term risks is what will most likely tone down possible
hawkish edges in Fed rhetoric. Event risk will be high and the market could
swing between risk-on and risk-off mode within an extended range, with some
bias towards the risk-off. This applies even more to risky assets than to rates.
We are facing a temporally fragmented landscape with bimodal outcomes in
both the short and the long run. Any particular trend that might make itself
evident in the near term could create conditions that would lead to its
subsequent reversal. Near term we have two possibilities: hawkish or dovish
Fed. A hawkish mode means a push for higher rates, most likely bad for risk,
with possibly another correction in risky assets, compression of breakevens,
stronger USD and general disinflationary pressures, which would be an
impediment to growth in the long term. The initial rates selloff could mean a
need for lower yields in the future.
Even in the context of solid data, a near-term dovish Fed and low rates would
be better for risk and generally supportive for long term growth. Keeping rates
low initially could bring back expectations of Fed hikes according to schedule,
sometime in the second half of 2015, with appropriate repricing of the curve.
At these levels of vol, rates and risky asset prices, the current market
configuration appears unstable and is likely to decay into one of two different
equilibria, but the final destination will be path-dependent and conditioned on
how the short term is played out. Given that rates positioning has been more
or less cleared, and that data dependence is stronger than before Oct-15, vol
could move lower, but not much more. There will be some carry play and vol
selling, but the landscape is perceived as riskier. In terms of getting more
maneuvering space and injecting some risk premia into the market, the Fed’s
position should be more comfortable now, and we see a low likelihood of the
Fed wanting to tamper with it.
Risky assets are likely to remain more vulnerable to data than rates, and
therefore more volatile. At the same time, rates vol – although not likely to
decline to Q2 lows – could see some correction lower. It is still trading at
elevated levels. The aftertaste of the massive intraday whipsaw should
encourage opportunistic buying of the dip. If we see another replay of Oct-15 –
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Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
and we believe there is a decent chance that we will – equity and (possibly)
credit vol should outperform. We would use the current dychotomy to finance
long vol positions with rates gamma.
Dealing with negative carry commitmentophobia: Two
path-dependent trades
In the absence of conviction, which seems to be the main casualty of the past
week’s vol spike, we are likely to see resistance towards committing to
negative carry expressions of any particular theme. Given the absence of a Fed
reaction to the mid-October events, the base case (for now) remains centered
on the Fed staying its course. However, the market could be less enthusiastic
about positioning along those lines before we see further data that supports
this view. In the absence of such confirmation, Fed expectations are likely to
remain low in the near term, but over a longer time horizon, around Q2:2015,
rates could begin to rise again. This rates path, low in the first 6M followed by
a subsequent rise, could be used to structure carry-friendly bearish trades. We
consider two possible implementations in terms of vanilla and exotics.
Vanilla vs. mid-curve
Conceptually, here, we are sellers of short-term and buyers of longer-term
payers. In its most straightforward implementation, this is a vanilla vs. midcurve payer calendar – financing a 1Y5Y payer with 6M 6M5Y mid-curve
payers:

Buy $100mn 1Y5Y ATMF Receivers 163.5 cents vs. sell $100mn 6M 6M5Y
MC ATMF Receivers 120.5cents, net premium: 43cents
This is a positive carry version of a synthetic forward vol trade. It is short
gamma and is vulnerable to transient vol spikes in the first 6M from a mark-tomarket perspective, with theoretically unlimited downside in a rally. Its ageing
and P&L profile under different rates scenarios is shown in Fig 1.
Figure 1: P&L profile of the payer calendar over different time horizons
1
Today
0.8
In 3m
0.6
in 6m
0.4
0.2
0
-0.2
-0.4
-25
0
25
50
75
100
Source: Deutsche Bank
The trade is an articulation of the mean reversion inherent in the current
bifurcating landscape. If rates rally in the first six months, the residual position
is $100mn payers; if they sell off initially, in six months the position is $100mn
receivers. To illustrate this feature, we consider a snapshot of the market six
Deutsche Bank AG/London
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26 October 2014
Global Fixed Income Weekly
months from inception under two scenarios: 1) rally and 2) sell-off in the first
six months (Table).
Long leg
Scenario in 6M
Short leg
Net position
Rates rally
6M5Y receivers
pay on 6M5Y swaps
$100mn 6M5Y payers
Rates selloff
6M5Y receivers
Expires OTM
$100mn 6M5Y receivers
If rates initially rally beyond the forwards, the mid-curve receivers will be
exercised at expiry (option to receive on 6M5Y forward swaps means that the
owner of the short receiver position will be paying on swaps). Hence, if rates
rally in the first six months, the net position is long $100mn 6M10Y receivers
plus pay $100mn on 6M5Y swaps. But receiver + (pay on swaps) is the same
as a payer swaption (using put/call parity). Similarly, the resulting position after
initial selloff in the first six months (mid-curve is OTM and is not exercised)
becomes a long $100mn receiver swaption.
Up and out payers
In the exotics space, the path-dependence of the Fed-sensitive sector of the
curve – e.g., 5s stay low in the first six months and begin to rise thereafter –
can be articulated almost literally through up and out payers with window
barrier:

Buy $100mn 1Y5Y 2.415% (25bp OTM) payers subject to KO If 5s >
2.415% in the first 6M, offer 47c, a 59% discount to vanilla at 114c
The trade has a positive carry of +24c in the first three months. The
discounting is a function of both serial correlations and relatively high 5y
gamma. Fig 2 shows the history of the 5Y swaps rate in the context of the
trade parameters (forwards, strike and barrier).
Figure 2: 5Y swaps rate in the context of the trade
3.50
5s
barrier
3.00
2.50
2.00
1.50
1.00
0.50
09
10
11
12
13
14
15
Source: Deutsche Bank
With 5Y spot at 1.635% and 6M5Y vol at 83bp, there is a cushion of almost
80bp (=1.4 sigma) on 5s. This is within the bounds of our rates forecast, which
is consistent with 5s at 1.60% for the end of 2014, or 6M5Y forwards at
1.865%. The trade has limited downside with maximum losses equal to the
options premium.
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Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
United States
Rates
Gov. Bonds & Swaps
Credit
Sovereigns
Steven Zeng, CFA
Research Analyst
(+1) 212 250-9373
[email protected]
Agencies

Risk/reward favors buying short maturity agencies. Following last week’s
volatility surge, the 2y sector has become cheap relative to history
compared to the 5y and 10y sectors. Additionally, the rise in 2y spread
volatility has lagged the rise of volatility in 2y rates.

The breakeven spread-to-volatility ratio (a return/risk measure) of the 2y
sector is now higher than the ratios of 5y and 10y, a rare occurrence given
the range of these ratios over the past year.

Agency market’s MTD excess return through Thursday 10/23 is -0.16%,
the worst of this year, according to the Deutsche Bank US Agencies Index.
Year to date, agencies still outperforms Treasuries, thanks to the gains
posted in March and April.

Higher rates volatility has given rise to cheaper callable agencies. For
example, a 3nc6m 1x callable currently yields ~15bp over a 3y agency
bullet and ~30bp over a 3y Treasury note. The pickup in yield for callables
is now the highest of this year.
Safety in the front-end
We recommend agency investors trading these volatile markets rotate into 2y
paper to minimize exposure to rising volatility and to take advantage of the
cheapness of the sector. Below we discuss several metrics that support this
rationale.
The rise in 2y spread volatility has lagged in the context of rise in rates volatility
Volatility has risen in all maturities on the yield curve, and naturally volatility in
agency spreads has followed suit. Yet, shorter maturity spreads have so far
offered the most resistance to rising in tandem with rates vol. As illustrated in
Figure 1, in swaps, realized volatility in 2y rates has risen to 190% of its 1-year
average, while volatility in 2y agency spreads is only around 150% of the
average. Similarly, on a percentile basis, volatility in 2y swaps is currently
100% of its 1-year range (highest during this period), while volatility in 2y
spreads is in the 85% percentile. For investors, the 2y sector’s lower sensitivity
to volatility in rates could mean lower spread risk relative to the other points on
the curve.
Deutsche Bank AG/London
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26 October 2014
Global Fixed Income Weekly
Figure 1: Spread volatility is least sensitive to rates
Figure 2: Par agency spreads (vs. matched Treasuries)
volatility in the 2y
60
Realized volatility as a % of 1-year
average
200%
Swap rates
180%
Agency spreads
50
160%
bp
10y
5y
2y
40
140%
120%
30
100%
20
80%
10
60%
0
40%
20%
-10
0%
2Y
5Y
10Y
Note: Realized volatility calculated as the standard deviation of daily changes over a 21-day period.
Agency spreads are generic par yields over Treasuries as implied by the Deutsche Bank spline model.
Source: Deutsche Bank
Source: Deutsche Bank
2y sector has cheapened the most after last week’s volatility surge
Relative to their own histories, 2y paper now offers more value for investors
than the 5y or 10y sectors. On DB’s spline model, 2y spread is now 4.5bp wide
to its 1-year average and the widest over this period, compared to 1.9bp wide
for the 5y and 0.4bp wide for the 10y. On a percentile basis, 2y spread is 99%
(all-time wide), while both 5y and 10y are just middling in their historical
ranges. Shortening from the 5y to the 2y, an investor gives up 12bp of yield
pick-up (over matched Treasuries), about 3bp less than the average during the
past 12 months.
2y has the most attractive return/risk profile
The ratio of breakeven spread to spread volatility, a measure of return/risk, is
more attractive in the 2y sector than the 5y and 10y sectors. We define the
breakeven spread as the yield differential between an agency paper and its
matched Treasury note, normalized by duration. The spread/vol ratio for the 2y
is current 0.34, compared to 0.29 for the 5y and 0.30 for the 10y (see Figure 3).
Indeed, this is quite unusual in the context of history. As Figure 3 shows, the
range of the 2y spread/vol ratio has historically been lower compared to the
longer maturities. This is likely due to the tightness of the 2y, which was
trading in a low single digit spread as recently as August. The recent
cheapening, however, combined with a limited rise in spread vol in this sector
(see points 1 and 2 above) has made it possible for the 2y spread/vol ratio to
rise above the ratios of 5y and 10y. In short, risk/reward now favors buying
short maturity agencies.
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Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Figure 3: Breakeven spread-to-spread volatility ratio is
Figure 4: Best roll-down on the agency curve is in the 2y-
highest in the 2y sector
3y sector
0.90
0.80
Treasury
Current
0.70
3m Rolldown (bp)
12
1y range
Agency
10
0.60
8
0.50
6
0.40
0.34
0.30
0.30
0.29
0.20
4
2
0.10
0
0.00
2Y
5Y
10Y
Source: Deutsche Bank
1
2
3
4
Years to Maturity
5
6
7
Source: Deutsche Bank
Damage assessment, TRACE count, cheapened callables
The volatility surge that began last week has turned October into a month to
forget for spread product investors. Agency market’s MTD excess return
through Thursday 10/23 is -0.16%, the worst of this year, according to the
Deutsche Bank US Agencies Index. Year to date, agencies still outperforms
Treasuries, thanks to the gains posted in March and April (see Figure 5).
October’s TRACE count has totaled $90 billion through this Thursday, running
slightly ahead of the $82 billion during the same period last month. Increased
trading volume is good news for dealers and investors alike, as secondary
bid/ask spreads tighten and making it cheaper to trade these products.
The concern is if market volatility is allowed to rise unrestrained. Volatility
spikes force dealers to withdraw their balance sheet, and trading volume suffer
as a result. Figure 6 illustrates this relationship. We removed the noise from
both data series to get a clearer representation. Note that periods of rising
volatility typically coincide with falling trading activities, and vice versa.
Higher rates volatility has given rise to cheaper callable agencies. For example,
a 3nc6m 1x callable currently yields ~15bp over a 3y agency bullet and ~30bp
over a 3y Treasury note. The pickup in yield for callables is now the highest of
this year (see Figure 7).
Figure 5: US Agency market
performance
0.25%
0.21%
0.14%
0.15%
0.05%
Figure 6: Volatility trend vs. trading
volume trend
0.04%
0.07%
0.09%
0.09%
5.0
120
13,000
4.0
115
12,000
3.0
110
11,000
2.0
105
10,000
100
9,000
95
8,000
90
7,000
-3.0
(0.16%) -4.0
85
6,000
80
5,000
-5.0
75
4,000
1.0
0.02%
0.0
(0.05%)
-1.0
(0.03%)
-2.0
(0.15%)
(0.14%)
(0.25%)
US Agency market excess return
Change in spread (bp, right axis)
Source: Deutsche Bank
Deutsche Bank AG/London
Volatility (bp, left axis)
TRACE count ($mil, right axis)
Note: Hodrick-Prescott filter used to obtain trend components
Source: Deutsche Bank
Figure 7: 6m2y vol vs. yield pickup
of 3nc6m callable over 3y bullet
70
25
65
20
60
15
55
10
50
5
45
40
Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14
6m2y swaption vol (bp, left axis)
0
5nc6m vs. 3y bullet (bp, right axis)
Source: Deutsche Bank
Page 33
26 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 22 in The Outlook in MBS and Securitized
Products.
Short the prepayment option
Every MBS investor writes a prepayment option against a very specific rate,
and it’s not the intraday Treasury or swap rates that fell and largely retraced
42 bp extremes last week. It’s also not the par MBS rate. Investors write
prepayment options on the rate that a borrower can actually get from a
mortgage lender. And last week highlighted the stickiness of the primary
mortgage lending rate but also signaled that there may be more life to that rate
than we’ve seen in recent years. Holders of newer 30-year 3.5% and 4.0%
pools, particularly those with higher WACs and large balances, need to keep a
close eye on their prepayment risk.
Behind usually slow-moving mortgage rates
Most indicators of primary rates on 30-year mortgages slipped below 4.0% last
week after hovering above that mark the week before. Nevertheless, the
average US 30-year mortgage rate, as reported by Bankrate.com, moved in a
range between 4.15% and 3.93%—a 22 bp swing. Closing 10-year Treasury
rates over that same stretch ranged between 2.42% and 2.14% with 10-year
swap rates between 2.58% and 2.30%—a 28 bp range for each. The range in
the primary rate was smaller, but not by much.
Steven Abrahams
Research Analyst
(+1) 212 250-3125
[email protected]
Christopher Helwig
Research Analyst
(+1) 212 250-3033
[email protected]
Ian Carow
Research Analyst
(+1) 212 250-9370
[email protected]
Jeff Ryu
Research Analyst
(+1) 212 250-3984
[email protected]
Volatility in the primary mortgage rate usually runs below levels in traded
benchmarks (Figure 1). Over different stretches within the last year, for
instance, the volatility of the primary mortgage rate has run between 65% and
70% of the 10-year Treasury and between 70% and 80% of the 10-year swap.
Mortgage rates simply move more slowly.
10-Week
UST 10Y
26-Week
USSW 10Y
US 30Y Second Mtg
15
17
21
23
17
17
21
24
21
22
28
Standard deviation of rate (bp)
31
Figure 1: Volatility in primary mortgage rates runs below other benchmarks
52-Week
US 30Y Primary Mtg
Note: 52-week annualized volatility based on weekly levels. US 30Y secondary rate measured by the Fannie Mae
30-year par MBS rate. US 30Y primary mortgage rate measured by the Bankrate.com average.
Source: Bloomberg Finance LP
Page 34
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Primary mortgage rates tend to lag in part because secondary mortgage rates
often widen as rates drop and tighten as rates rise. The wider spreads usually
reflect a rise in implied volatility as rates fall as well as expectations of rising
gross supply. The tighter spreads arguably reflect just the reverse. The net
effect is to make secondary mortgage rates less volatile than Treasury or swap
benchmarks.
The primary mortgage rate in recent years has tended to lag even the slow
moves in secondary rates as originators have used the primary rate to manage
demand on the mortgage origination pipeline. Mortgage originators since 2008
have had to move loan underwriting and quality control from the back to the
front of the lending process to lower the risk of later having to buy back flawed
loans from Fannie Mae and Freddie Mac. The days of starting the process with
a pop-up call center are largely over. That has made originators operationally
less flexible, and the primary rate helps match the flow of applications against
the capacity to process them.
A rise in originator capacity
A recent rise in originator capacity, however, may have started to tie mortgage
rates a little more closely to broader benchmarks than typical in recent years.
Employment in mortgage lending—both at lenders and brokers—has risen
since May of this year (Figure 2). And although employment is still below the
recent peak of July 2013, it is off the bottom. It is hard to know if the new
employees include front- or back-office personnel, and how that translates into
productivity. But more is likely better than less.
The rise in employment also likely reflects the improving economics of
mortgage lending. After hitting a post-2008 low in the first quarter of this year,
the margins in mortgage originations, according to the quarterly Mortgage
Bankers Association survey, rebounded sharply in the second quarter (Figure 3).
Originators made a 46 bp profit on each loan made in the second quarter, just
below the 54 bp average since the start of the survey. The MBA suggested that
the low margins of preceding quarters may have reflected costs for compliance
with the new underwriting rules of the Consumer Financial Protection Bureau.
Those costs may now be behind the industry.
Figure 2: A recent slight rise in mortgage lending
employment
Figure 3: Improving economics for mortgage lenders
Net production income (bp)
310
290
270
120
107 107
87
82
72
71
55
50 49
66
54
49
75
59
20
17 15
9
-8
Source: Bureau of Labor Statistics via Haver Analytics
Deutsche Bank AG/London
3Q13
1Q13
3Q12
1Q12
3Q11
1Q11
Jul-14
3Q10
Jan-14
1Q10
Jul-13
3Q09
Jan-13
1Q09
Jul-12
3Q08
250
230
Jan-12
46
38
33
32
1Q14
Employees (000s)
330
Source: MBA Quarterly Mortgage Bankers Performance Report
Page 35
26 October 2014
Global Fixed Income Weekly
The surprisingly broad moves in primary mortgage rates last week suggest that
the market is continuing to move away from the days of late 2011 and 2012
when a handful of originators controlled 60% of the market and used the
primary rate to manage capacity. Wells Fargo continues to hold an outsized
16% share of originations, but that’s less than half the share it held a few years
ago (Figure 4). Nonbank lenders have become much more competitive.
0.9%
1.0%
1.0%
1.1%
1.2%
1.2%
1.3%
1.4%
1.6%
1.8%
1.8%
2.0%
2.2%
2.7%
2.8%
2.9%
4.6%
4.6%
7.2%
16.1%
Share 2Q14 mortgage lending
Figure 4: Share of 2Q14 mortgage originations
Source: Inside Mortgage Finance
All of this may help explain the relatively broad moves last week in the primary
rate. A more competitive market, especially one with improving capacity, could
move primary rates more in line with other benchmarks. If 10-year Treasury
and swap rates happen to revisit their levels of last week and stay there,
primary mortgage rates could quickly follow. A primary rate of 3.85% would
give new refinancing incentives of 50 bp or more to $590 billion of agency
MBS, mostly in 30-year 3.5% and 4.0% pools.
With hedge-adjusted carry favoring higher coupons, as detailed by Ian Carow
in Perusing pass-throughs, owners of TBA 30-year 3.5% and 4.0% pools should
weigh moving up-in-coupon, down-in-coupon or into specified pools within
those coupons that offer some protection against the negative convexity of
TBA. Since loan-balance 3.5% pools underperformed last week while loanbalance 4.0%s moved in line with model pricing, loan-balance pools in the
lower coupon look like a good safe harbor.
***
Long on ideas, short on details for expanding mortgage credit
Although MBS investors may have to weigh risk from lower rates, a quick
loosening of agency mortgage credit and a subsequent rise in prepayments
does not look like it’s in the cards for now.
Federal Housing Finance Agency Director Mel Watt laid out a set of ideas on
Monday at the MBA Annual Convention to address originator concerns about
having to buy back loans from Fannie Mae and Freddie Mac. The enterprises
had implemented new rules a few years ago that aimed to provide buy back
relief after three years. These rules included numerous exemptions, however,
that still gave the GSEs the right to pursue a buy back after the 3-year sunset.
Those exemptions have led many originators to limit lending to borrowers with
high LTVs, low credit scores or other features that signal risk of delinquency or
default. Originators have hesitated to take on repurchase risk for these kinds of
loans under current exemptions.
Page 36
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Watt on Monday proposed changes that would limit buy backs to cases
showing a pattern of significant flaws in underwriting. In Leaving Las Vegas –
with little detail, Chris Helwig lays out the particulars.
Discussions with originators after Watt’s speech nevertheless indicated that
although the broad approach seemed helpful, Fannie Mae and Freddie Mac’s
ability to pursue buy backs even under the new proposals seemed to change
originators’ current reluctance to underwrite risky borrowers. Although
originators may loosen their approach eventually, nothing seems imminent.
Watt also proposed extending Fannie Mae and Freddie Mac credit above the
current limit of 95 LTV to borrowers with 97 LTV. As Chris Helwig also outlines,
that looks most likely to simply take borrowers with high FICO scores out of
the current FHA pool. That may eventually pose incremental risk to some
Ginnie Mae pools that include better borrowers. But details from FHFA on
lending to higher-LTV borrowers are still pending.
***
The view in rates
Rates globally continue to reflect the risk of slow growth or possible deflation
in Europe, with even Germany showing signs of economic weakness. German
expectations of economic performance lately have flashed signs of pessimism,
new German manufacturing orders have decreased and German
manufacturing output year-over-year has started to decline.
A report Tuesday from Reuters that the ECB might buy corporate bonds signals,
if true, understandable concern at the central bank about its ability to move the
EU economy through ABS. Although there is nominally 1 trillion euro of
covered bonds and ABS eligible for purchase, it’s not clear that current owners
could easily take it off their balance sheets. The reported ECB interest could
also signal ongoing concern about the ECB’s ability to buy sovereign debt
since there’s considerable opposition on the ECB’s Governing Council. Buying
corporate debt, however, could pose challenges of its own since it amounts to
direct lending to specific companies. Decisions about which countries, which
companies and at what levels could be extremely complex—both economically
and politically.
Despite issues in Europe, the Fed still seems set to end QE this month and
raise policy rates late next year or possibly in early 2016. That should continue
putting pressure on the front end of the yield curve.
The view in spread markets
A snapshot of relative value in pass-throughs shows both some familiar
themes as well as some new opportunities created by recent market volatility.
Our core positions:

Remain overweight MBS against rates with a flatter curve, carry and
sufficient demand likely to sustain good MBS performance

NEW: Own 15-year 3.0%s against 30-year 3.5%s on supply technicals,
hedge-adjusted carry and recent increases in demand from accounts
traditionally active in short duration—namely banks and REITs

Hold higher coupon TBA 30-year 4.5%s and 5.0%s on hedge-adjusted
carry against underweights in TBA 30-year 3.5% and 4.0% pools

NEW: While 4.0% call protected stories repriced fully with the recent
market move, 3.5% loan balance pools look undervalued

NEW: Consider HLB LTV MHA paper for call protection in 3.5%–4.5%
coupons over CQ or CR stories, as latter look more fully priced
Deutsche Bank AG/London
Page 37
26 October 2014
Global Fixed Income Weekly
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%. This kind of home price appreciation, although
lower than recent years, is still well above the likely sustainable average. By
2018, annual appreciation should slip below 5%.
Perusing pass-throughs
A snapshot or relative value in pass-throughs shows both some familiar
themes as well as some new opportunities created by recent market volatility.
In the current environment we recommend:

Remain overweight MBS basis on flatter curve and demand continuing to
outpace supply

Long 15-year 3.0%s vs. 30-year 3.5%s on supply technical, hedge-adjusted
carry and recent increases in demand from accounts traditionally active in
short duration—banks and REITs

Hold higher coupon TBA 30-year 4.5%s and 5.0%s on hedge-adjusted
carry

While 4.0% call protected stories repriced fully with the rate move, 3.5%
loan balance pools look undervalued

Consider HLB LTV MHA paper for call protection in 3.5%–4.5% coupons
over CQ/CR stories, as latter look more fully priced relative to recent move
Ian Carow
Research Analyst
(+1) 212 250-9370
[email protected]
Checking in on net supply and demand at third quarter-end
Year-to-date net issuance of $51 billion in net fixed-rate MBS has been easily
absorbed by $57 billion in Fed and bank buying in the third quarter alone.
While new issuance picked up, to the tune of $39 billion in the third quarter,
some things remained the same. The bulk of new supply continued to come in
the 30-year sector, led by Ginnie II, while 15-year MBS outstanding continued
to shrink (Figure 5).
Figure 5: Net supply continues to run negative in 15-year; GN30 leads pack
40.8
27.4
14.9
-13.0
GN30
FH30
FN30
FN15
-9.0
-15.4
FH15
AllOthers
Note: Amounts in billions of dollars.
Source: Deutsche Bank, CPRCDR
While less transparent than the supply side, demand appears to have remained
strong with some buyer bases surprising to the upside.

The Fed and US banks combined to add $57 billion in Q3—a slightly faster
pace at banks than we had previously expected
Page 38
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly

Through August, the latest available reporting, the GSEs actually added
around $3 billion, reversing a long trend of declines

Foreign portfolios may have added marginally, to the tune of $6 billion net

Newly available numbers for the second quarter also show that mortgage
REITs added about $16 billion
A look out over TBA
On a hedge adjusted basis, MBS continue to perform well. FNCL 3.5%s have
outperformed swaps by 19/32 since July. FNCI 3.0%s have outperformed their
hedges by 11/32s over the same period.
We first look at hedge-adjusted carry as a guide to relative value across the
coupon stack (Figure 6 and Figure 7).
Figure 6: FNCL coupon stack hedge-adjusted carry
Figure 7: FNCI coupon stack hedge-adjusted carry
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
FNCL 3.0
FNCL 3.5
Source: Deutsche Bank, YieldBook
FNCL 4.0
FNCL 4.5
FNCL 5.0
FNCI 2.5
FNCI 3.0
FNCI 3.5
FNCI 4.0
FNCI 4.5
Source: Deutsche Bank, YieldBook
In 30-year TBA, hedge-adjusted carry continues to favor FNCL 4.5%s and
5.0%s despite a flatter curve and higher volatility, as those rolls have remained
persistently special. Lower coupons have begun to benefit slightly from a
flatter curve, however, particularly FNCL 4.0%s, while 3.5%s and lower still
have negative carry after hedging out rate risk.
The picture across the 15-year stack is one of uniformity—except for FNCI
4.0%s, which trail—FNCI 2.5%s through 4.5%s all carry right around 1/32 per
month after hedging out duration, convexity and vega.
Within 30-year then, higher coupons deliver the best carry return per unit of
risk, though that return is dependent upon continued specialness in higher
coupon dollar rolls. However, 15-year rolls are not nearly as special, but in all
coupons 3.5% and lower provide better risk adjusted carry than 30-year.Given
the fact that 15s do not rely on the specialness of the dollar roll for their hedge
adjusted performance we continue to favor 15s over 30s.
A scan of specified pools
Call protected stories in specified pools have repriced dramatically over the
past week as a result of the spike in volatility, rally and mild softening in TBA
dollar rolls. Loan balance and high-LTV 4.0% pools in particular have raced
ahead of the pack, with pay-ups appreciating nearly 20/32s over a very short
time period.
Deutsche Bank AG/London
Page 39
26 October 2014
Global Fixed Income Weekly
In the scatter below, we compare the change in actual pay-up from the
beginning of the month against the change in theoretical fair value pay-up
based on equal OAS to TBA (Figure 8).
Figure 8: Call protection revalued higher, but not stories all equally
25
LLB 4
MLB 4
CQ 4
20
CR 4
15
Act pay-up chg. (32s)
HLB 5
LLB 5
MLB 4.5 MHA100 4
CR 3.5
MHA95 4
MLB 5 HLB 4
10
HLB 4.5
MHA90 4
MLB 5.5
5
CR 4.5
CQ 3.5
LLB 5.5
CQ 4.5
MHA100 4.5
33 WALA 3.5
30 WALA 3.5 PostHarp 5.5MHA90 3.5 MHA90 4.5
PostHarp 5
16 WALA 3
MHA100
3.5
50 WALA 4
MHA95 3.5
Seas 5 MHA90 3
36 WALA 3.5
CQ 3
CR 3
18 WALA 3
47 WALA 3.5
MHA95 3 MHA100 3
HLB 3.5
Seas 6.0
Seas 5.5
0
CK 4
-5
LLB 4.5
MLB 3.5
CK 3.5
LLB 3.5
HLB 3
-10
MLB 3
-15
CT 4.5
-20
-15
-10
-5
0
LLB 3
CT 4
5
10
15
20
25
30
Theoretical pay-up chg (32s)
Note: All levels indicative, as of COB: 10-2-14 to COB: 10-15-14.
Source: Deutsche Bank
Not surprisingly, traditional call protection stories were valued higher by both
investors and the model, while traditional extension protection stories repriced
lower. Looking a little more closely at the relationship between actual moves
and theoretical pay-up we find that:

Some of the largest disparities between theoretical move and actual came
in 3.5% loan balance stories, where the model projected increased value,
but actual moves were down around 5/32s

Call protection in 4.5% LTV stories—CQ, CR and MHA—had some of the
largest disparities between theoretical and expected, suggesting it may
also be rather undervalued after the dramatic moves of last week

Most 4.0% call-protection stories—CQ, CR and loan balance—look fully
valued, although lower LTV MHA stories appreciated less than model
expectations
Leaving Las Vegas – with little detail
MBS investors worried about a quick loosening of agency mortgage credit and
subsequent rise in prepayment risk can breathe easy for now. Many of the
originator concerns that have kept agency mortgage credit tight for years look
likely to persist despite new efforts from the Federal Housing Finance Agency
to turn the tide.
Christopher Helwig
Research Analyst
(+1) 212 250-3033
[email protected]
FHFA Director Mel Watt laid out a set of ideas on Monday at the MBA Annual
Convention to address originator concerns about having to buy back loans
from Fannie Mae and Freddie Mac. The enterprises had implemented new
rules a few years ago that aimed to provide buy back relief after three years.
However these rules contained numerous exemptions that gave the GSEs the
right to pursue a buy back over the life of the loan. Those exemptions have led
Page 40
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
many originators to limit lending to borrowers with high LTVs, low credit
scores or other features that signal risk of delinquency or default. Originators
hesitate to take on the liability of having to repurchase that loan under current
exemptions.
In the wake of Watt’s speech Monday, the response from originators suggests
that the changes outlined may fall short of the goal of expanding mortgage
credit. The bulk of Watt’s speech focused on improvements to the GSEs’
current rep and warrant framework. Sunset provisions on GSE rep and warrant
claims had been previously set at three years for loans with a clean pay history
or two non-consecutive 30-day delinquencies in a 3-year period. However, the
GSEs maintain life-of-loan carve outs for certain breaches. Under Watt’s
revised framework these carve outs would still include:

Misrepresentations, misstatements and omissions

Data inaccuracies

Charter compliance issues

First lien priorities and title matters

Legal compliance violations

Unacceptable mortgage products
Watt endorsed the idea that these defects had to show a pattern, potentially
signified by the number of breaches, or that they had to be significant enough
that Fannie Mae or Freddie Mac would have refused to buy the loans at
origination. Although a handful of originators said after the speech that the list
was helpful, its scope was too wide to justify a meaningful change in the
tighter rules that originators now lay over GSE underwriting.
The relief prescribed by Watt would only apply to breaches associated with
misrepresentations, misstatements, omissions and data inaccuracies. FHFA
will be setting a minimum number of loans that must be identified from an
issuer to invoke the sunset carve out. They will be also adding a ‘significance’
requirement, meaning that the breach was meaningful enough that it would
have resulted in the GSEs not purchasing the loan at origination. There is a
significant lack of detail on what metrics will be employed to define adequate
frequency or materiality. The lack of detail on all these topics could suggest
that there is still a large gap between protections originators are seeking and
concessions that the FHFA is willing to make to facilitate the extension of
credit—potentially adding further friction to achieving FHFA’s stated goal.
Given the fact that originators still face a 3-year period where they will be
responsible for breaches, the most meaningful relief may come in the form of
how early year breaches will be resolved. To that end, two significant changes
were outlined. First is the concept of alternative dispute resolution. This would
resolve a breach without a repurchase—it would include indemnifications for
risk sharing in lieu of repurchase, potentially reducing liability to originators.
Additionally, Watt proposed a new independent resolution panel that would
ostensibly arbitrate breach claims, also potentially defraying costs to the
originators. On both proposals, Watt will need to fill in the details.
Away from the changes to the rep and warrant framework, Director Watt
briefly outlined FHFA’s efforts to develop ‘sensible and responsible’ guidelines
for purchasing mortgages with LTVs between 95–97%. FHFA would employ
‘compensating factors’ in the purchase of these loans, although there were no
details provided as to what those factors would include. The risk associated
with the GSEs expanding their eligible LTV box is that they could adversely
select a market that has traditionally been serviced by the FHA. To illustrate
this point we looked at GSE versus FHA execution across a matrix of FICO and
LTV buckets (Figure 9).
Deutsche Bank AG/London
Page 41
26 October 2014
Global Fixed Income Weekly
Figure 9: Conventional risk based pricing could adversely select FHA
FICO/LTV
<=60
60–70
70–75
>=740
-4.6
0.0
0.0
720–739
-4.6
0.0
4.6
700–719
-4.6
9.2
680–699
0.0
660–679
640–659
75–80
80–85
85–90
90–95
95–97
4.6
40.8
56.8
77.8
127.8
9.2
46.4
66.4
90.4
138.4
13.8
18.4
59.6
85.6
120.6
169.6
9.2
23.0
32.2
68.8
90.2
125.2
169.6
0.0
18.4
36.8
46.0
95.8
126.6
175.6
200.4
9.2
23.0
46.0
55.2
105.0
135.8
184.8
209.6
620–639
9.2
27.6
55.2
55.2
105.0
145.0
194.0
223.4
<620
9.2
27.6
55.2
55.2
105.0
145.0
194.0
228.0
Source: Deutsche Bank
In performing this analysis we looked first at the relative annual cost of an
LLPA charge plus the up-front and running mortgage insurance premiums on a
Fannie Mae or Freddie Mac loan. We compared this to the annual cost of a
1.75% up-front MIP and a 1.30% running MIP on a FHA loan. For conventional
execution we assumed a standard LLPA charge based on FICO and LTV, and
converted that to an annualized spread using the current IO multiple on Fannie
Mae 4.0%. We then converted an up-front mortgage insurance premium of
1.75% to an annualized number using the same methodology. We then added
the annual MI running spread to those two numbers to derive a total cost. The
shaded boxes are FICO and LTV buckets where GSE pricing is lower than FHA.
As evident by the pricing grid, FHA execution is only favorable in the lower
right quadrant, the intersection of high LTVs and low FICO scores.
This is further supported by issuance volumes across FICO distributions. We
looked at total issuance greater than 80 LTV from November 2013 to March
2014. We broke those volumes out into 80–90 LTV and 90–95 LTV for each
issuer. We then cut those loans into two groups, ones greater than 680 FICO
and loans less than or equal to 680 FICO (Figure 10). The overwhelming
majority of high LTV loans originated by the GSEs were to borrowers with
higher FICO scores. Conversely FHA issuance was skewed towards lower FICO
borrowers. This suggests that if the GSEs expand their footprint into loans
greater than 95 LTV, they would likely adversely select that population of
borrowers as a function of their risk-based pricing—leaving FHA with a more
concentrated pool of riskier borrowers.
Figure 10: Issuance volumes reflect potential for adverse selection
Original LTV
Issued balance
Total issued balance
3,455,318,133
>680 FICO
80.1–90
7,545,862,616
4,090,544,483
<680 FICO
GNMA
3,734,220,641
>680 FICO
90.1–95
8,552,202,958
4,817,982,317
<680 FICO
80.1–90
FNMA
90.1–95
80.1–90
FHLMC
90.1–95
>680 FICO
<680 FICO
>680 FICO
<680 FICO
>680 FICO
<680 FICO
>680 FICO
<680 FICO
15,608,670,874
2,499,307,160
16,146,444,618
1,960,797,501
658,654,972
58,961,611
745,537,099
33,060,272
18,107,978,034
18,107,242,119
717,616,583
778,597,583
Source: Deutsche Bank
Page 42
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Conclusion
While Director Watt’s speech outlined changes to the rep and warrant
framework that could help the flow of mortgage credit, the proposals in and of
themselves will likely not facilitate a meaningful expansion of the credit box in
the near term. Additionally, it is unclear whether expanding the GSE eligibility
to 97 LTV will lead to the expansion of credit or a mere transfer of risk from
one hand to another. Ultimately, the lack of detail in Director Watt’s comments
may be a sign that the two sides are pretty far apart on changes that would
actually make mortgage credit available to a wider market.
Greater short-term speed volatility; longer-term Ginnie
speeds trending faster

VA share in Ginnie Mae pools have been increasing over the past few
years. Speeds for VA loans are significantly faster and a larger VA share
should lead to a greater negative convexity on the newer Ginnie Mae pools.

Aggregate prepayment speeds are expected to be little changed in October,
decrease moderately in November and increase sharply in December.
Newer third-party originated loans are likely to be most vulnerable to the
recent short-lived rate rally.
Doug Bendt
Research Analyst
(+1) 212 250-5442
[email protected]
Jeff Ryu
Research Analyst
(+1) 212 250-3984
[email protected]
Increasing VA share to boost Ginnie Mae speeds and increase negative
convexity
Newer Ginnie Mae pools are likely to display greater negative convexity as VA
share rises. During the first half of 2013, VA loans made up around 35% of
Ginnie Mae pools, but have recently made up closer to 45% (Figure 11).
Prepayment speeds for premium VA loans are substantially faster than FHA
loans, and the increased VA shares should lead to more callable Ginnie Mae
pools. For example, VA loans in 2013 Ginnie Mae II 4.0%s have been
prepaying near 30 CPR while FHA loans have been closer to 10 CPR (Figure 12).
In addition, lower coupon VA loans have been prepaying slower than FHA
loans, which have been benefitting from FHA-to-conventional refinancing.
With the reduction in force in the armed services likely to occur, VA share
could see a further boost in coming years. Overall, newer Ginnie Mae pools
should exhibit greater negative convexity from a larger VA share.
Figure 11: Increasing share of VA loans
Figure 12: VA prepayments are faster than FHA
Shares in Ginnie Mae II at issue
80%
30
CPR (%)
60%
Share (%)
2013 GN II 4.0%s
40
40%
20
10
20%
0%
0
Jan-13
Jul-13
FHA %
Source: Deutsche Bank, Ginnie Mae
Deutsche Bank AG/London
Jan-14
Jul-14
Sep-13
Dec-13
VA %
Mar-14
FHA
VA
Jun-14
Sep-14
Source: Deutsche Bank, Ginnie Mae
Page 43
26 October 2014
Global Fixed Income Weekly
Difference in loan characteristics and program structure affect prepayments
and convexity
Besides the structural differences, three key differences in collateral
characteristics account for some of the variation in speeds between FHA and
VA loans (Figure 13).

Loan balances for VA mortgages tend to be larger

FICO scores for VA mortgages are higher

Note rates for VA loans are lower than FHA loans originated in the same
month
Figure 13: VA mortgages: lower note rates, larger balances and higher credit
scores
-40
150
-60
100
Jul-13
Jan-14
Diff (FHA - VA) (RHS)
720
-10
710
-15
700
-20
690
-25
680
-30
VA
Jul-13
Diff (FHA - VA) (RHS)
Jan-14
4.5
20
4.0
15
3.5
10
3.0
5
0
Jan-13
Jul-14
FHA
25
2.5
-35
Jan-13
Jul-14
FHA
-5
670
-80
Jan-13
730
Note rate
5.0
0
VA
Diff (bp)
200
FICO
-20
Diff (000s)
Loan size (000s)
250
FICO
740
0
Diff
Note rate (%)
Loan size
300
Jul-13
Diff (FHA - VA) (RHS)
Jan-14
Jul-14
FHA
VA
Source: Deutsche Bank, Ginnie Mae
The larger loan balances and higher FICO scores for VA loans are consistent
with faster prepayment speeds while lower note rates are not. In Deutsche
Bank’s prepayment model, the difference in loan balances is the largest factor
accounting for differences in lifetime speeds, holding the other characteristics
constant:

Larger loan balance:

Higher FICO:

Lower note rate:
6 CPR to 7 CPR
1.5 CPR to 2 CPR
-1 CPR to -1.5 CPR
These factors account for about 50% of the difference in the life-to-date
prepayment speeds of 8.2 CPR for FHA and 22.2 CPR for VA in 2013 Ginnie
Mae II 4.0%s.
Structural differences between the FHA and VA programs help explain some of
the residual difference. For example, the FHA imposes an upfront mortgage
insurance premium of 1.75% of the initial mortgage balance, which most
borrowers choose to wrap into the mortgage balance compared with an
upfront fee of just 0.50% for a VA mortgage. Amortized over thirty years, that
has the effect on the monthly payment of increasing the mortgage rate by
0.125% compared to an increase of just 0.03% for the VA fee.
If an FHA borrower chooses to refinance into another FHA loan, however, they
get only a portion of that premium as a credit; after 16 months, the credit is
50%. There is no credit after 36 months or if the borrower refinances into a
conventional loan. Thus, a prepayment that results in the reduction in the
Page 44
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
credit represents a substantial disincentive to refinance. Prepaying after 16
months means that the borrower paid an effective rate of nearly 5% over that
period while prepaying at 36 months would lead to having paid an effective
rate of nearly 4.75%. However, sunk costs are sunk, so the decision to
refinance is still based on the difference in the coupon rate. In fact, because
the borrower gets some credit for refinancing within the first three years, the
negative effect of the upfront premium is reduced and the refinancing
incentive is relatively larger. After 36 months, FHA borrowers’ refinancing
incentive is reduced by the full 0.125%.
Convexity effects
The results of these differences in loan characteristics and programs show up
in greater negative convexity for VA mortgages (Figure 14). Over the past year,
both FHA and VA mortgages have become less convex as higher coupons
(greater incentive) are becoming more burned out and turnover rates increase
for lower coupons (negative incentive). Home price appreciation is the most
likely explanation for faster turnover rates.
Figure 14: Greater negative convexity for VA mortgages
September 2013
35
30
30
25
25
CPR (%)
CPR (%)
35
20
15
September 2014
20
15
10
10
5
5
0
0
-200-150-100 -50 0 50 100 150 200 250
-200-150-100 -50 0 50 100 150 200 250
Rate incentive (bp) (WAC - mtg rate)
Rate incentive (bp) (WAC - mtg rate)
FHA
VA
FHA
VA
Note: Ginnie Mae II 30-year.
Source: Deutsche Bank, Ginnie Mae
Short-term prepayment projections
Aggregate prepayment speeds are expected to be little changed in October,
decrease moderately in November before rising sharply in December. Primary
mortgage rates, which have been ranged-bound and above 4.25% most of the
year, dipped below 4.00% last week in sympathy to a sharp rally in Treasury
rates. While overall rates were lower, there was a large variability in posted
mortgage rates among the largest lenders. For example, the posted 30-year
mortgage rate for Chase was 3.625% on October 15, 50 bp lower than the
posted rate for Wells (Figure 15).
Deutsche Bank AG/London
Page 45
26 October 2014
Global Fixed Income Weekly
Figure 15: Primary mortgage rates are at one-year lows
30YR primary mtg. rate
3.5
3.0
Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14
0
-10
-20
-30
-40
-50
-60
-70
Wells
B of A
Chase
Citi
PHH
US Bank
Quicken
Sun Trust
Provident
Fifth Third
Wtd. Avg
4.0
Mtg rate (%)
30Y primary mtg. rate (%)
4.5
4.3
4.2
4.1
4.0
3.9
3.8
3.7
3.6
Chg (bp)
Mtg. rates by lenders: Oct 8 & Oct 15
5.0
Chg (RHS)
10/8/2014
10/15/2014
Source: Deutsche Bank, company posted mortgage rates
Despite the differences, mortgage rates are near the one-year lows for all of
the lenders, which should spur more refinancing activity. Newer third-party
originated loans are particularly vulnerable to a sharp increase in speeds, as
has been the case over the past few years. For example, during the first half of
2012, broker loans from 2011 Fannie Mae 4.0%s prepaid around 15 CPR faster
than retail loans while correspondent loans were 7 CPR faster as primary
mortgage rates dipped below 4.0%. Once again, newer broker loans from 2013
and 2014 4.0%s and 4.5%s should see largest prepayment gains. Meanwhile,
more seasoned third-party originated loans have already gone through lower
mortgage rates and are likely to experience some burnout. In 2013 Fannie Mae
4.0% and 4.5% cohorts, around 11% of the outstanding amount are broker
loans and 29% are correspondent loans.
Besides the rally in mortgage rates, the number of business days will drive
prepayments over the next couple of months. In October, business days
increase by one day from September to 22 days. In November, it drops to
18 days before jumping back to 22 days in December, assuming a full business
day for the days before and after the Thanksgiving, Christmas and New Year’s
holidays.
Page 46
Figure 16: Average days to close
mortgage applications
60
Time to close (days)
In terms of timing, some of the mortgage applications started last week from
the rate rally should show up in November prepayments, although more are
likely to be completed in December. Average time to funding for mortgage
applications has been steadily decreasing since last year to below 40 days this
summer (Figure 16). Even with an increased volume of applications, easier-torefinance loans, especially the third-party originated loans, should be able to
close the application before the end of November.
55
50
45
40
35
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Source: Deutsche Bank, Ellie Mae
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Overall, we expect aggregate prepayments to be faster by 1% to 2% in
October before decreasing by 13% in November. Aggregate speeds are
expected to increase sharply by more than 25% in December, although a quick
rate sell-off in the near-term could mute this jump. Our short-term prepayment
projections for IOS cohorts are shown in Figure 17 while projections for major
cohorts are listed on Figure 18 and Figure 19. Some highlights of our
projections are as follows.

Speeds for lower coupons are expected to change modestly over the next
three months as turnover seasonality continues to weaken. Fannie Mae
2013 3.0%s are expected to prepay around 5 CPR while 2013 3.5%s are
expected to prepay between 6 CPR and 8 CPR for the rest of the year.

Speeds for 2013 4.0%s and 4.5%s are expected to be impacted the most
from the recent rate rally. Prepayments for those cohorts are expected to
reach 17 CPR by December, around 4 CPR faster than the September
prints.

Impacts on higher coupons are expected to be more moderate as they
have had sufficient rate incentives for several years. Speeds on 2008
5.0%s and 5.5%s are expected to decrease to 24 CPR in November before
increasing to 29 CPR by December.
Figure 17: Short-term prepayment
projections for IOS cohorts
cpn
year
FN 30YR
3.0
2013
3.0
2012
3.5
2013
3.5
2012
3.5
2010
4.0
2013
4.0
2011
4.0
2010
4.0
2009
4.5
2011
4.5
2010
4.5
2009
5.0
2010
5.0
2009
5.0
2008
5.0
2005
5.0
2003
5.5
2008
5.5
2005
5.5
2003
6.0
2008
6.5
0607
GN II 30YR
4.0
2010
4.5
2010
5.0
2010
Day count
30y Mrate (45d lag)
Act
Sep
Projected for
Oct
Nov
Dec
5.3
5.9
6.8
8.0
9.9
12.7
12.0
12.5
14.2
14.5
16.0
18.5
18.7
20.3
26.7
22.1
19.3
27.0
21.8
19.0
27.1
25.4
5.2
5.8
6.9
8.0
9.8
13.0
12.2
12.7
14.6
14.8
16.5
19.1
19.5
21.3
27.7
23.0
20.0
27.9
22.7
19.7
28.0
26.2
4.3
4.7
5.9
6.7
8.4
12.2
11.2
11.5
12.8
13.2
14.4
16.5
16.8
18.1
23.6
19.8
17.1
23.8
19.6
16.7
23.8
22.4
5.4
6.0
7.7
8.6
10.9
16.5
14.8
15.4
17.3
17.1
19.1
22.0
21.7
23.4
29.2
24.4
21.4
29.4
24.1
20.9
28.7
27.1
16.6
18.5
19.2
21
4.27
16.7
18.8
19.6
22
4.20
14.4
15.9
16.8
18
4.10
18.2
20.7
20.0
22
N/A
Source: Deutsche Bank, Fannie Mae, Ginnie Mae
Deutsche Bank AG/London
Page 47
26 October 2014
Global Fixed Income Weekly
Figure 18: Short-term prepayment projections for Fannie Mae 30-year and 15-year
FNM30
cpn
year
bal wala
Aggregate CPR % change
3.0
2013
188.6 18
3.0
2012
139.8 24
3.5
2013
105.7 16
3.5
2012
176.6 28
3.5
2011
31.4
36
3.5
2010
12.1
47
4.0
2013
90.7
13
4.0
2012
55.8
29
4.0
2011
64.4
39
4.0
2010
56.2
48
4.0
2009
35.3
64
wac
Act
Sep
3.59
3.59
4.04
4.01
4.03
4.12
4.59
4.47
4.47
4.49
4.55
5.4
5.8
6.9
8.0
7.9
9.8
12.5
10.9
11.8
12.3
14.2
Projected for
Oct
Nov
Dec
+2%
-13% +29%
5.3
4.4
5.6
5.7
4.7
5.9
7.0
6.0
7.7
8.0
6.7
8.6
7.8
6.5
8.4
9.8
8.3
10.9
12.8
12.1
16.3
11.0
10.2
13.4
11.9
10.9
14.5
12.5
11.3
15.2
14.6
12.8
17.3
cpn
year
bal wala
Aggregate CPR % change
2.5
2013
60.9
18
2.5
2012
66.1
25
3.0
2013
26.9
14
3.0
2012
38.3
29
3.0
2011
23.9
36
3.0
2010
2.9
47
3.5
2013
8.9
12
3.5
2012
6.1
30
3.5
2011
21.1
40
3.5
2010
17.3
48
4.0
2011
10.4
41
4.0
2010
12.9
52
4.0
2009
10.0
63
wac
Act
Sep
2.94
3.00
3.51
3.45
3.45
3.58
4.02
3.97
3.91
3.92
4.37
4.41
4.48
5.8
7.1
7.8
9.0
9.4
11.5
9.7
10.9
12.1
12.4
14.6
15.5
16.8
Projected for
Oct
Nov
Dec
+1% -14% +26%
5.9
4.9
6.1
7.1
6.1
7.3
7.8
7.4
9.7
8.9
7.9
10.2
9.2
8.1
10.5
11.4
9.9
12.9
10.3
9.5
12.1
10.8
9.6
12.1
12.2
10.5
13.5
12.4
10.7
13.9
14.8
12.7
16.1
15.8
13.4
17.2
17.1
14.2
18.1
4.0
09Jan-May
15.4
66
4.58
15.5
16.0
14.0
4.0
09Jun-Dec
19.8
63
4.53
13.2
13.5
11.8
15.9
4.5
4.5
4.5
4.5
4.5
2013
2012
2011
2010
2009
18.0
6.1
52.3
51.8
72.4
12
31
40
52
63
5.04
4.96
4.93
4.94
4.93
13.4
13.5
14.5
15.8
18.5
14.0
13.7
14.8
16.3
19.1
13.3
12.5
13.2
14.3
16.5
17.5
15.9
17.1
18.9
22.0
4.0
09Jan-May
3.3
66
4.50
17.7
18.0
14.8
18.9
4.0
09Jun-Dec
6.7
61
4.47
16.4
16.7
13.9
17.7
4.0
4.5
4.5
2003
2010
2009
2.2
3.2
4.8
134
53
62
4.55
4.85
4.89
16.7
16.2
17.4
16.8
16.7
17.9
14.2
14.1
15.0
17.3
17.7
18.8
4.5
09Jan-May
25.0
66
4.95
20.0
20.7
17.8
23.8
4.5
09Jan-May
1.3
66
4.92
18.9
19.5
16.3
20.4
4.5
09Jun-Dec
47.4
62
4.92
17.6
18.2
15.8
21.1
4.5
09Jun-Dec
3.5
61
4.88
16.9
17.3
14.5
18.1
4.5
5.0
5.0
5.0
2003
2011
2010
2009
5.1
16.1
27.8
21.4
134
41
53
62
5.07
5.37
5.36
5.42
16.9
17.4
18.8
20.3
17.4
17.9
19.6
21.3
15.0
15.6
16.9
18.1
19.1
19.8
21.8
23.5
5.0
09Jan-May
4.0
67
5.50
22.4
23.5
19.9
25.5
5.0
09Jun-Dec
17.4
61
5.40
19.8
20.8
17.7
23.0
5.0
5.0
5.0
5.0
5.5
5.5
2008
2005
2004
2003
2010
2009
8.0
15.1
9.1
21.4
2.3
3.3
77
111
124
134
53
62
5.65
5.64
5.55
5.50
5.85
5.94
26.1
21.9
20.7
19.2
18.1
21.5
27.1
22.7
21.5
19.9
18.9
22.6
23.1
19.6
18.4
17.0
16.2
19.1
28.7
24.2
23.0
21.3
20.5
24.2
5.5
09Jan-May
0.6
67
6.02
25.8
27.0
23.2
29.2
5.5
09Jun-Dec
2.7
61
5.92
20.5
21.5
18.1
23.0
6.03
6.13
6.15
5.98
5.93
5.93
6.54
6.57
6.56
6.50
6.44
6.46
6.99
7.06
7.02
6.98
6.98
7.07
27.1
27.6
27.2
21.4
20.4
19.1
26.7
28.4
24.7
22.4
20.0
18.2
26.1
26.1
24.6
20.1
17.6
20.2
21
4.27
28.1
28.5
28.0
22.3
21.2
19.8
27.6
29.2
25.5
23.2
20.7
18.8
26.8
26.8
25.2
20.8
17.9
20.4
22
4.20
23.9
24.6
24.2
19.2
18.1
16.8
23.5
25.1
21.8
19.9
17.5
15.7
22.8
23.0
21.5
17.8
15.1
17.1
18
4.10
29.6
30.0
29.6
23.7
22.6
21.0
28.4
30.1
26.3
24.0
21.3
19.2
27.1
27.2
25.5
21.0
17.8
20.3
22
N/A
5.06
5.12
4.97
4.96
5.57
5.72
5.66
5.49
5.43
5.44
6.02
6.08
5.91
5.89
5.91
6.53
6.54
6.49
18.1
15.6
16.2
16.7
19.2
18.7
14.7
15.6
16.1
16.6
18.7
19.5
14.5
15.8
15.8
16.6
19.1
16.1
21
3.23
18.3
15.9
16.5
16.9
19.4
18.9
14.9
15.9
16.3
16.8
18.8
19.7
14.8
16.0
16.0
16.8
19.2
16.3
22
3.22
15.1
13.4
13.9
14.2
16.1
15.9
12.6
13.4
13.8
14.2
15.6
16.4
12.4
13.5
13.4
14.1
16.2
13.8
18
3.19
18.5
16.3
16.9
17.2
19.3
19.0
15.2
16.1
16.5
16.9
18.6
19.6
14.9
16.1
16.0
16.7
19.1
16.4
22
N/A
5.5
2008
12.7
77
5.5
2007
11.7
88
5.5
2006
5.7
99
5.5
2005
15.2 111
5.5
2004
13.2 123
5.5
2003
22.1 136
6.0
2008
7.0
76
6.0
2007
15.8
87
6.0
2006
12.5 100
6.0
2005
4.3
110
6.0
2004
5.6
124
6.0
2003
5.0
136
6.5
2008
2.2
76
6.5
2007
4.8
87
6.5
2006
5.6
99
6.5
2005
0.8
110
6.5
2004
0.8
123
6.5
2003
0.5
135
Number of business days
30yr Mtg Rate (45d lagged avg)
19.1
FNM15
4.5
2008
1.8
78
4.5
2005
1.0
112
4.5
2004
2.3
125
4.5
2003
7.4
135
5.0
2008
1.7
77
5.0
2007
0.6
88
5.0
2006
0.4
100
5.0
2005
1.9
111
5.0
2004
1.8
123
5.0
2003
5.0
136
5.5
2008
0.8
75
5.5
2007
1.1
88
5.5
2005
0.7
110
5.5
2004
0.7
123
5.5
2003
0.8
136
6.0
2008
0.3
75
6.0
2007
0.9
87
6.0
2006
0.8
99
Number of business days
15yr Mtg Rate (45d lagged avg)
Source: Deutsche Bank, Fannie Mae
Page 48
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Figure 19: Short-term prepayment projections for Ginnie Mae I and II 30-year
GN I 30
cpn
year
bal wala
Aggregate CPR % change
3.0
2013
23.9
18
3.0
2012
16.0
25
3.5
2013
7.9
16
3.5
2012
22.2
29
3.5
2011
8.2
36
3.5
2010
2.3
46
4.0
2013
1.8
14
4.0
2012
2.5
30
4.0
2011
19.4
40
4.0
2010
27.3
48
4.0
2009
6.7
63
wac
Act
Sep
3.50
3.50
4.00
4.00
4.00
4.00
4.50
4.50
4.50
4.50
4.50
8.9
10.2
11.1
14.2
16.6
14.2
10.3
13.6
18.0
16.5
15.6
Projected for
Oct
Nov
Dec
+1%
-13% +26%
9.0
7.8
10.2
10.2
8.8
11.4
11.4
10.4
13.4
14.2
12.5
16.0
16.6
14.5
18.6
14.2
12.2
15.7
10.6
10.1
12.8
13.6
12.5
15.3
18.1
16.3
20.5
16.6
14.9
18.7
15.7
13.6
17.4
GN II 30
cpn
year
bal wala
Aggregate CPR % change
3.0
2013
110.9 18
3.0
2012
75.7
24
3.5
2013
85.3
15
3.5
2012
131.5 28
3.5
2011
19.5
35
3.5
2010
0.8
47
4.0
2013
50.2
12
4.0
2012
24.0
29
4.0
2011
38.0
38
4.0
2010
25.5
47
4.0
2009
1.3
63
wac
Act
Sep
3.33
3.37
3.85
3.81
3.88
4.00
4.36
4.30
4.35
4.37
4.45
8.2
10.1
10.3
13.6
14.3
15.4
16.8
17.4
17.9
16.6
17.2
Projected for
Oct
Nov
Dec
+1% -14% +26%
8.4
7.1
8.9
10.1
8.6
10.8
10.6
9.2
11.5
13.7
11.7
14.6
14.3
12.2
15.3
15.4
13.1
15.4
17.4
16.1
21.0
17.5
15.8
20.1
18.0
15.6
19.8
16.7
14.4
18.2
17.3
14.7
18.6
4.0
09Jan-May
1.9
66
4.50
14.2
14.3
12.3
15.9
4.0
09Jan-May
0.5
65
4.47
17.1
17.2
14.7
18.5
4.0
09Jun-Dec
4.8
63
4.50
16.2
16.3
14.1
18.0
4.0
09Jun-Dec
0.8
61
4.44
17.2
17.3
14.8
18.7
4.5
4.5
4.5
2011
2010
2009
10.0
29.9
40.7
41
53
63
5.00
5.00
5.00
17.6
18.2
19.5
17.8
18.5
19.7
15.4
15.9
17.1
19.4
20.0
21.2
4.5
4.5
4.5
2011
2010
2009
37.2
41.0
20.5
41
52
62
4.81
4.86
4.91
19.1
18.5
18.6
19.3
18.7
18.9
16.7
15.9
15.9
21.3
20.6
19.5
4.5
09Jan-May
13.4
66
5.00
21.8
22.0
19.1
23.6
4.5
09Jan-May
3.7
66
4.96
21.0
21.3
18.2
22.3
4.5
09Jun-Dec
27.4
61
5.00
18.3
18.5
16.1
19.9
4.5
09Jun-Dec
16.8
62
4.90
18.1
18.3
15.5
18.8
4.5
5.0
5.0
2003
2010
2009
0.9
7.9
28.3
134
54
63
5.00
5.50
5.50
14.0
15.4
19.8
14.1
15.7
20.3
12.1
13.7
17.4
15.0
17.1
22.2
4.5
5.0
5.0
2003
2010
2009
0.3
25.5
26.9
135
54
61
5.09
5.29
5.35
11.7
19.0
20.1
11.9
19.4
20.5
9.9
16.6
17.6
12.7
19.7
21.1
5.0
09Jan-May
9.3
67
5.50
22.5
23.1
19.9
25.2
5.0
09Jan-May
4.9
66
5.39
21.4
22.0
18.7
22.6
5.0
09Jun-Dec
19.0
61
5.50
18.5
18.9
16.1
20.6
5.0
09Jun-Dec
22.0
59
5.35
19.8
20.2
17.3
20.8
5.0
5.0
5.0
5.0
5.5
2008
2005
2004
2003
2009
2.7
1.8
1.3
3.9
3.2
76
112
124
135
64
5.50
5.50
5.50
5.50
6.00
25.5
18.8
18.0
16.3
20.6
26.1
19.2
18.4
16.6
21.1
22.7
16.6
15.8
14.2
18.2
27.8
20.4
19.5
17.5
22.6
5.0
5.0
5.0
5.0
5.5
2008
2005
2004
2003
2009
1.2
1.9
1.0
1.8
3.4
76
112
124
135
62
5.52
5.60
5.57
5.56
5.86
27.1
20.1
18.3
16.1
19.9
27.8
20.6
18.7
16.4
20.3
23.4
17.3
15.6
13.6
17.7
29.9
21.5
19.5
17.6
21.2
5.5
09Jan-May
1.4
68
6.00
22.7
23.4
20.2
25.0
5.5
09Jan-May
0.6
68
5.97
20.8
21.4
18.7
22.5
5.5
09Jun-Dec
1.7
61
6.00
18.8
19.2
16.5
20.6
5.5
09Jun-Dec
2.9
61
5.84
19.7
20.1
17.5
21.0
6.00
6.00
6.00
6.00
6.00
6.00
6.50
6.50
6.50
6.50
6.50
6.50
7.00
7.00
7.00
27.3
24.3
22.2
19.0
16.5
16.8
25.5
23.4
22.5
17.4
17.3
14.2
23.3
20.3
19.5
21
4.27
27.8
24.8
22.7
19.4
16.8
17.2
25.8
23.7
22.9
17.7
17.6
14.4
23.5
20.5
19.8
22
4.20
24.6
21.5
19.5
16.8
14.3
14.6
22.7
20.5
19.8
15.2
14.8
12.0
20.2
17.5
16.7
18
4.10
29.7
25.9
23.9
20.2
17.4
17.8
27.1
24.8
24.0
18.2
18.1
14.6
24.3
21.2
20.3
22
N/A
5.95
6.00
6.01
5.97
5.94
6.01
6.45
6.47
6.48
6.41
6.38
6.43
6.88
6.89
6.89
25.2
26.3
26.9
18.2
17.4
17.4
25.0
26.3
25.2
18.8
18.0
17.6
21.6
22.7
20.7
21
4.27
25.8
26.8
27.6
18.6
17.8
17.7
25.4
26.7
25.7
19.1
18.3
17.9
21.8
22.9
21.0
22
4.20
21.9
22.9
23.5
15.7
15.0
14.9
21.4
22.8
21.7
16.3
15.3
14.9
18.0
19.0
17.1
18
4.10
27.3
27.3
28.6
19.0
18.2
18.6
26.5
27.4
26.3
19.6
18.3
18.3
21.9
22.4
20.5
22
N/A
5.5
2008
6.0
75
5.5
2007
1.1
88
5.5
2006
1.0
101
5.5
2005
2.0
111
5.5
2004
2.2
124
5.5
2003
4.4
136
6.0
2008
5.0
74
6.0
2007
1.8
87
6.0
2006
1.7
99
6.0
2005
0.6
111
6.0
2004
1.0
123
6.0
2003
1.4
135
6.5
2008
1.0
74
6.5
2007
0.6
86
6.5
2006
0.6
98
Number of business days
30yr Mtg Rate (45d lagged avg)
5.5
2008
5.6
76
5.5
2007
2.2
88
5.5
2006
1.7
99
5.5
2005
2.4
111
5.5
2004
2.7
124
5.5
2003
2.3
135
6.0
2008
4.5
75
6.0
2007
3.3
87
6.0
2006
1.9
99
6.0
2005
0.7
111
6.0
2004
1.2
123
6.0
2003
0.7
133
6.5
2008
1.8
75
6.5
2007
1.4
86
6.5
2006
0.9
99
Number of business days
30yr Mtg Rate (45d lagged avg)
Source: Deutsche Bank, Ginnie Mae
Deutsche Bank AG/London
Page 49
26 October 2014
Global Fixed Income Weekly
United States
Credit
HY Strategy
IG Strategy
US Credit Strategy
Talk About Unintended Consequences
Dusting off default break-even analysis
Leveraged credit rallied strongly in sympathy with reversals in equities and
rates this week. Our HY index tightened 62bps from its wides of 515bps
Wednesday a week ago, leaving us at 458bps, or about 70bps from its tights in
late August (Bloomberg ticker: DBHYSDM). IG index, which outperformed
materially on its way wider, posted a modest 3bp spread tightening in recent
sessions, which puts it only 16bps wider from its levels in late Aug (Bbg:
DBHGSDM). Whether this episode is mostly behind us now or there is more
volatility coming ahead is hard to say with any meaningful level of confidence,
given some seven-sigma moves we have witnessed in Treasuries last week –
events that by definition are not likely to occur and yet are taking place in front
of our eyes. What we can say relatively confidently, just as we did a week ago,
is that current levels, where we see our markets post-selloff require a bit more
than just buzzwords of “global slowdown and deflation” to substantiate
themselves.
Oleg Melentyev, CFA
Strategist
(+1) 212 250-6779
[email protected]
Daniel Sorid
Strategist
(+1) 212 250-1407
[email protected]
Figure 1: US HY defaulted issuer
monthly count
Think about the 515bp spread level where the HY bond market topped out last
Wednesday. Significance of this number is in its close proximity to the
historical average HY spread of 520bp going back 30 years. In fact, this
historical average is not very sensitive to timeframe chosen, if one preferred to
look at the last 20 years (515bps) or the last decade (505bps). As always, we
exclude immediate six months post-LEH from all our samples. So if one were
to remain a seller of HY at that level, implicitly, he or she would be willing to
compensate a buyer for credit losses approaching historical averages.
Historical average HY default rate is 4.9% over the past 30 years, which given
the current market size of 1,500 issuers (as per Moody’s US default rate
sample), would translate into 6.2 issuers defaulting each month, for a full year.
Currently we are seeing 1-2 issuers defaulting on a monthly basis, and we have
not seen 6+ counts coming in consistently since 2009 (Figure 1). In fact, we
have only seen 4 out of the last 48 months with counts in the 7-9 range.
9
8
7
6
5
4
3
2
1
0
Jan 13 Apr 13 Jul 13
Oct 13 Jan 14 Apr 14 Jul 14
US HY Monthly Default Count
Required Level
Source: Deutsche Bank, Moody’s
Now, we all realize that this type of break-even default analysis is relatively
static in its nature, and that there is no way it would stop a panic selling
witnessed a week ago just by itself, especially given the extreme moves in
other major asset classes. And yet it is exactly this type of analysis that helps
us, and many of our readers, to look at recent market action under the light of
prevailing fundamentals. A seven-sigma move in Treasuries is capable of
breaking many barriers in a short-term, but for longer-term-minded credit
investors the question of fundamentally-driven valuations should always be a
closing argument in any meaningful discussion on attractiveness of market
levels.
This is not to say that such a view could not be challenged by incoming macro
data, or that signals we are receiving from other asset classes, such as
commodities should be ignored. The risk to this view is that in fact the global
economy takes a material turn for the worst, slips into recession, and pushes
credit losses higher. Our opinion here is that we have not identified signals
strong enough to make us believe this is in fact a likely outcome. One of the
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Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
strongest such signals at the moment remains a pronounced move lower in oil
prices, where Brent has dropped by 25% in the last 3.5 months, with the most
concentrated move taking place over the past seven weeks (-14%).
Such a sharp move in oil certainly deserves close attention, especially at a time
when one would argue the geopolitical situation does not provide a strong
support to lower prices. And yet at this stage we are coming to a conclusion
that it would be premature to say that it signals inevitable weakness in global
macro picture. To arrive at this point we have looked at the 25-year history of
Brent oil price and identified 27 instances where this commodity has declined
by 10% or more in a matter of 7 weeks of less. Well, we certainly did not
experience 27 recessions or financial crises over the past quarter century. In
fact, a closer look at data shows that only 25% of such instances provided
advance signal of a recession/crisis coming around the corner, defined as
taking place within a year before other asset classes started to reflect those
events. In another 25% of cases such price drops coincided with ongoing
recessions/crises and thus provided little value as an advance indicator. And
the remaining 50% of cases, such price drops in oil happened in the middle of
economic expansions. While it is too early to tell which of the three categories
this current experience will eventually fall under, we believe it is important to
keep this historical perspective in mind while making judgments on a daily
basis. The real risk we see from this development is whether this weakness in
oil translates into budgetary pressures of oil-producing nations, and finds its
way into material fiscal tightening. Our understanding of these sensitivities
suggests that such a pain threshold could be below $70/bbl.
Taking a big-picture view on inflation
Additionally, chatter has picked up recently around deflationary pressures
globally, with a few real datapoints presented in support of those concerns,
primarily coming out of Europe. We agree that inflation has been
undershooting its desired levels in across many countries and at this point
remains the largest impediment on the way of the Fed becoming more
confident in its goal of normalizing policy. And yet evidence we are looking at
suggests that the actual softening in inflation trends globally has not been as
pronounced as the recent rhetoric on the subject would make you believe.
Figure 3 shows the history of GDP-weighted broad CPI indexes across major
global economies2 (blue line). Current levels of global inflation (1.9%) appear to
be well within the range established over the past 2 years, between 1.5% and
2.25%. We also overlay the historical inflation data with a global GDPweighted breakeven 10yr inflation rate (red line) derived from traded inflationlinked notes3. Again, the signal here is similar – the markets are pricing in
inflation at border-line acceptable for most central banks 2.0% level, which
makes us wonder what kind evidence provides so much momentum to the
“global deflationary” story.
Figure 2: Sharp declines in oil price:
a predictor of macro weakness?
30
20
10
0
-10
-20
-30
1988 1991 1994 1997 2000 2003 2006 2009 2012
7wk Chg in Oil
10%+ Drops
Early Signal
Coincident
Source: Deutsche Bank
Figure 3: GDP-weighted global CPI
5.0
4.0
3.0
2.0
1.0
1997 1999 2001 2003 2005 2007 2009 2011 2013
Global GDP-Weighted CPI
Global Breakeven CPI
Source: Deutsche Bank
Recent moves in credit consistent with other assets
The next step in our analysis of recent market action would be to step back
from macro events behind these moves and just focus on other major asset
classes with a goal of answering a question: given what happened in other
corners of global capital markets, was reaction in credit consistent with those
moves or were there signs of illiquidity making credit market repricing much
more abrupt. To set up a sample for this study we have taken the five-week
interval between Sept 12 – Oct 21 as the period where bulk of the repricing has
2
Countries/regions in our CPI sample include the US, EU, China, Japan, UK, Brazil, Russia, and Canada.
3
Breakeven inflation-linked data is available for the US, UK, Australia, Sweden, France, Germany, and Italy.
Deutsche Bank AG/London
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26 October 2014
Global Fixed Income Weekly
taken place: -41bp in 10yr Treasury yields, -11.3% in Brent oil, -5.0% in SPX, 1.6% in EUR. We then went back in history and identified other 1-mo intervals,
where all these four asset classes have performed largely similar to this most
recent experience.
We identified five such historical episodes: Aug 1998 (Asian FX/Russian
default), Apr 2005 (Correlation sell-off/GM downgrade to HY), May 2010 (initial
Greece episode), Sept 2011 (US debt ceiling), and May 2012 (peak of EU
crisis/Draghi’s whatever-it-takes moment). All four asset classes moved in the
same direction and roughly to the same extent during these five episodes as
they did recently. On average, 10yr treasury yields dropped by 36bps, oil
declined by 10.0%, SPX was off by 7.6%, and EUR depreciated by 4.0%.
Figures 4 and 5 below show average changes in HY and IG spreads across
those five episodes as well as recent weeks.
Figure 4: HY spread changes in previous episodes of
similar moves in 10yr/oil/SPX/euro
200
180
160
140
120
100
80
60
40
20
0
Figure 5: IG spread changes in previous episodes of
similar moves in 10yr/oil/SPX/euro
50
45
40
35
30
25
20
15
10
5
0
Aug 98
Apr 05
May 10
Sep 11
May 12
Oct 14
Aug 98
Apr 05
Change in HY Spread, bps
Source: Deutsche Bank
May 10
Sep 11
May 12
Oct 14
Change in IG Spread, bps
Source: Deutsche Bank
Average change in HY spread in those earlier episodes comes down to 105bp
(85bp ex outlier 1998); in IG it is 33bp (no outliers on the wides). Changes in
this most recent episode were 60bp in HY and 14bp in IG. Again, these figures
are captured through Oct 21, so a part of the rebound is included. Even if one
were to measure them through the low point last Weds Oct 15, changes were
110bp in HY and 17bp in IG.
Talk about unintended consequences
In other words, even taken at extremes, credit spreads reacted roughly in line
(HY) with or better (IG) than previous similar episodes. We believe this most
recent experience becomes yet another datapoint along with many other we
presented previously, to suggest that concerns about liquidity conditions in our
market are often misunderstood and misinterpreted. Reduced dealer capacity
to absorb risk, trading platform segmentation, and growth in investor base – all
these factors have a negative impact on ability to trade corporate bonds on a
regular day with normal volatility and two-way flow. It is exactly the depth of
two-way flow that gets distorted by these factors.
This differs from times of market stress, where a majority of benchmarked
investors are forced to reduce risk to meet redemptions (or reduce portfolio
beta) and dealer capacity issue plays a smaller role, while strategic, patient,
off-benchmark investors step in to pick up suddenly discounted paper. We
made this point in our piece in mid-September, and this is exactly what we
believe materialized in this most recent episode. It was therefore not surprising
to us to see HY/IG spread levels moving in line with all other major asset
classes, ranging from Treasuries to equities to oil to euro. Recent news reports
Page 52
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
quoting senior management of KKR and Blackstone and suggesting they view
these volatility-impacted levels as interesting entry points to allocate their
credit assets support our expectations4. Interestingly, the biggest surprise of
this most recent episode was not an illiquidity-driven breakdown in credit
markets, where so many spectators were expecting it, but rather in US
Treasuries, where prices moved in seven-sigma steps last Wednesday. Talk
about unintended consequences.
IG: Assessing the bullish case for energy
Oil’s descent has whipsawed the bond and stock valuations of energy
companies for four months, but investors in our view should resist the urge for
now to move to an overweight position in IG energy until more clarity emerges
on the potential for further oil price slippage. We think a stronger case can be
made to return to neutral weight in IG energy from underweight, given how far
bond and stock market valuations have cheapened with the drop in oil prices.
Figure 6: Thirteen episodes of
declining oil prices since 2000
Start of
sell-off
Weeks Oil %
S&P 500 IG Energy
Energy % Spread %
Mar 2000
6 -23%
+6%
Nov 2000
5 -28%
-1%
-1%
The current episode of oil market weakness is among the most severe of such
corrections in recent history. Brent crude prices have dropped 25% over 17
weeks, while energy stocks in the S&P 500 are down 17% (versus a 4%
decline in the S&P 500). Energy spreads are 30% wider (versus a 22%
widening in non-financial IG paper). Of 13 episodes of oil weakness since 2000
shown in Figure 6, only July 2008 and July 2011 saw greater declines in
energy stock prices or bigger percentage increases in IG energy spreads. At 17
weeks, the episode is also among the longest single stretches of oil price
declines since 2000.
Sep 2001
10 -36%
-10%
+10%
Mar 2003
8 -31%
+2%
-22%
Aug 2005
14 -17%
-3%
-7%
Jul 2006
13 -23%
-4%
-3%
Jul 2008
24 -73%
-39%
+167%
Apr 2010
16 -15%
-13%
+26%
Apr 2011
11 -17%
-11%
+18%
Jul 2011
10 -13%
-25%
+62%
Feb 2012
17 -27%
-15%
+7%
Relative to the performance of their respective markets, energy stocks and
bonds have lagged more than typically during prior episodes of oil price
weakness. Energy stocks’ underperformance of 13 percentage points vs the
S&P 500 exceeds the average 7.5 percentage point underpeformance over the
prior 12 episodes. IG energy bonds have widened 15 bps more than nonfinancials, versus an average of 10 bps over the prior 12 episodes (and only 5
bps when 2008 is excluded). On a percent basis, IG energy spreads have
widened 8 percentage points more than non-financial bonds, versus a 3%
average underperformance in spreads. The IG energy sector is ranked last in
excess returns vs Treasuries since June 30, declining -1.3% vs just -0.3% for
non-energy sectors.
Feb 2013
10 -16%
-5%
+1%
Jun 2014
17 -25%
-17%
+30%
Average
12 -27%
-10%
+24%
Avg ex‘08
11 -23%
-8%
+12%
Source: Deutsche Bank; DBIQ indices
Figure 7: IG energy spreads vs all
nonfins over 13 oil sell-off episodes
+100
Spread change over episode
Taking a recovery in oil prices as given, the above event study would indeed
suggest that the energy sector has substantial room to outperform.
Unfortunately, event studies such as these are quite limited in helping us
assess the risk of a more severe oil market reaction. Only 3 of the 13 episodes
in the event study show Brent crude declines of more than 30%. If Brent
declines to $70 a barrel, the cumulative percentage drop in Brent crude would
be 39%, more severe than any prior event except the infamous 2008. With few
recent instances of Brent crude falling much more than they already have
except in an outright crisis as in 2008, event studies have little to say about the
expected move in energy spreads in a further weakening of oil.
+28%
+80
+60
+40
+20
0
-20
-40
Mar Nov Sep Mar Aug Jul
00 00 01 03 05 06
Jul
08
IG energy vs nonfin, nps
Average
Apr Apr
10 11
Jul
11
Feb Feb Jun
12 13 14
Average (ex-'08)
Source: Deutsche Bank
Aside from comparing energy spreads moves to declines in oil prices, we can
also glean some insight into energy bond valuations by considering the
response of energy stocks to similar shocks. In Figure 9, we plot price and
spread changes (in percent) in the S&P 500 Energy sector index as well as
fitted Treasury curve spreads in the DBIQ oil and gas IG index for each of the
4
See Bloomberg Oct 16, 2014: “Blackstone’s Schwarzman Calls Market Decline Overreaction”, and FT
Oct 23, 2014 “KKR reaps benefits of volatility and oil price drop”.
Deutsche Bank AG/London
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26 October 2014
Global Fixed Income Weekly
13 episodes above. An ordinary least squares regression suggests a 3.3%
widening in spread for each additional percent decline in energy stocks. This
simple model has an r-squared of 0.73, but appears less effective at either
extreme in energy stock valuation. The sizable residuals for the two extreme
episodes -- March 2000 (when energy stocks rose) and 2008 (when energy
stocks dropped 40%) – give us caution in relying on the equity-bond
relationship to guide us when oil prices moves are much more severe than at
present.
Figure 8: Energy asset response to oil sell-off episodes
2008
IG Energy OAS vs Fair Value (bps)
Change in IG Oil and Gas (Spread %)
200%
y = -3.37x - 0.11
R² = 0.73
150%
100%
50%
2014
0%
-50%
-50%
2000
2011
-40%
-30%
-20%
-10%
0%
Figure 9: Energy equities vs bonds on fair value model
70
60
50
40
30
20
10
0
-10
-20
-30
-20%
-10%
10%
Change in S&P Energy (%)
Source: Deutsche Bank; Bloomberg Finance LP
0%
10%
20%
SPX Energy vs Fair Value
2010-2014
Oct-14
Source: Deutsche Bank; Bloomberg Finance LP
Looking at changes in energy spreads and stock prices in isolation can be
problematic given that oil prices can fall in a wide variety of economic and
market conditions. Charts such as Figure 9 say little about whether the
cheapening of energy stocks is related to oil-specific factors or to overall
market conditions. This makes it more challenging to benchmark sector bond
performance against sector stock performance as a gauge of value.
To construct an alternative approach, we run regressions of energy-specific
bond and stock indices against broad market indices (log SPX vs log S&P 500
Energy; IG Energy OAS vs comparable duration IG Non-financials OAS) over
various regimes. Each of the two regression lines can be interpreted as a fair
value measure for energy stocks or bonds given the overall level of the market.
By extension, residuals from the regression represent deviations from fair value.
These residuals have a 65% correlation with the natural log of Brent crude
prices over the 2010-2014 period, suggesting that oil prices play a critical role
in explaining deviations from fair value.
With this measure constructed, we can then plot energy stock and bond fair
values against each other. The takeaways from this analysis (shown in Figure
10) are that a) the oil shock has cheapened energy stocks relative to a fair
value measure more substantially than at any point since 2010 and b) given
how cheap energy stocks are to fair value, energy bonds could be doing quite
a lot worse. Energy OAS fair value has been as much as 50 bps wider than
they are currently. If anything, the regression above would favor overweighting
energy equities as a bullish trade. For defensive positioning, energy bonds
would appear to be capable of substantially underperforming energy stocks if
the current episode persists, adding to our caution on moving back to quickly
into the energy sector.
Page 54
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Eurozone
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Abhishek Singhania
Strategist
(+44) 207 547-4458
[email protected]
Euroland Strategy

Given Q2 GDP growth which was much weaker than suggested by the
PMIs the moderate and patchy upside surprise in the October release
remains unconvincing about the strength of the Eurozone economy

The market may very well continue to test the ECB’s willingness to do
more. Compared to two weeks ago while a number of risky assets have
normalised volatility on long-dated swap rates and peripheral yields have
yet to normalise

The CBPP3 programme while more aggressive than CBPP1 and 2 is
unlikely to be enough to meet the ECB’s balance sheet objectives. For that
matter expanding the assets to include non-financial corporate bonds is
unlikely to resolve the issue either

The comprehensive assessment (CA) results will be announced on Sunday
at 12:00 noon CET. The main results might overstate the capital shortfall as
it will not take into account any capital measures over the course of 2014

BTPs have come under pressure recently and have underperformed IG and
HY credit over the past few weeks. However, the more medium-term
outperformance of BTPs vs. credit remains intact

The increased volatility in the periphery and the uncertainty due to the AQR
and the stress test has reduced the sharpe ratio on long periphery
positions. The underperformance of the front-end of the periphery
suggests that domestic banks have not active participants over the past
few weeks. Their behaviour following the CA results will be key to the
market.

The front-end of the periphery offers the best carry and rolldown on the
curve and should benefit from a return of domestic investor is the most
attractive part on these curves in the near term
Neither here nor there
The flash PMI releases this week provide little clarity on either the economy or
the expected policy response for the next few months.
Eurozone growth in Q2 at 0.0% QoQ was materially weaker than that implied
by the composite PMI (+0.4% QoQ). And while the PMIs in Q3 and for October
in Q4 (which surprised moderately to the upside) remain in expansionary
territory they have nevertheless declined from Q2 levels. The hard data
released for Q3 does not indicate any payback and therefore the market is
likely to remain focused on the declining quarterly trend of the PMIs.
Composite PMIs in Q3 would imply QoQ growth of 0.3% while the October
PMI if maintained for Q4 would imply QoQ growth of 0.2% which remains
consistent with a recovery characterized by the ECB as weak, uneven and
fragile. Additionally, in the October release the material weakness in France
and the weakness at the aggregate level as reflected in the declining in new
orders, output prices and employment remains a concern. On a positive note,
the upside surprise on the Eurozone level implies that Italian and Spanish PMIs
should increase by an average of 0.7points.
Deutsche Bank AG/London
Semi-core, periphery and rates vol
have not normalised enough
Change over past two weeks (%, points, bp)
Eurosotxx 50 (%)
0.06
Eurostoxx financials (%)
1.26
DAX (%)
0.47
CAC (%)
0.39
FTSE MIB (%)
0.27
Vstoxx (points)
0.36
Bund 10Y (bp)
-0.40
Bund 30Y (bp)
-0.60
Itraxx Main (bp)
-0.46
Itraxx Xover (bp)
-0.22
EUR 30Y swap rate (bp)
0.20
Italy 10Y (bp)
19.00
France 10Y (bp)
5.00
EUR 3M30Y Vol (bp, norm vol)
14.16
EUR 3M10Y Vol (bp, norm vol)
8.76
Source: Deutsche Bank, Bloomberg Finance LP
Page 55
26 October 2014
Global Fixed Income Weekly
However, the PMIs are clearly not weak enough to suggest negative growth
across the Eurozone broadly. With the ECB having already announced a raft of
policy measures it is unlikely to feel the need to do more unless market
pressures increase further.
In this context, it is worth noting that while equity markets, equity volatility,
credit spreads and core rates are more or less back to the levels seen two
weeks ago, semi-core and peripheral bond yields as well as rates volatility
especially at the long-end remain much higher.
Composite PMI remains consistent with +0.2% QoQ
Details of the PMIs remain weak
growth in Q4 but is declining nevertheless
65
Eurozone composite PMI quarterly average (LHS)
GDP growth QoQ (RHS)
60
1.5
1.0
55
0.5
50
0.0
45
-0.5
40
35
New Orders
Output Prices
2.0
60
Employment
55
50
45
-1.0
40
-1.5
35
-2.0
30
-2.5
30
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jul-11
Jul-12
Jul-13
Jul-14
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
Source: Deutsche Bank, Bloomberg Finance LP
Source: Deutsche Bank, Bloomberg Finance LP
CBPP3 begins, Corporate QE unlikely to be the solution to
the ECB’s dilemma
The ECB has commenced the Covered Bond Purchase Programme 3 (CBPP3)
this week. The ECB will publish the amount purchased on a weekly basis,
every Monday, for operations settling by the previous Friday. According to
Bloomberg, the ECB has purchased EUR 800mn of covered bonds across both
core and periphery countries. It is not as yet clear whether any additional
information for example the county breakdown or the maturity of the
purchases will be provided. The pace and aggressiveness of purchases has
probably been disappointing to some participants but it is also worth noting
that EUR 800mn over 3 days would nevertheless be a pace much faster than
CBPP1 and CBPP2.
It is nevertheless further evidence that the ECB might not be able to achieve
the EUR 1trillion balance sheet expansion it is targeting with the measures
announced so far. This is probably the underlying development behind the
Reuters story published earlier in the week that the Governing council was
discussing purchasing corporate bonds.
This report supports our view that the ECB remains ready to act if necessary. In
fact, our economists’ in their call for public QE within 6 months (Focus Europe:
QE by inertia 26 September 2014) expected that a broad based asset purchase
programme (BBAP) would likely include government bonds and other highquality private debt. Below we highlight some of the key issues likely to be
discussed in assessing the possibility of such a programme.
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Deutsche Bank AG/London
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Global Fixed Income Weekly
Financial/Non-financial corporate bonds: Buying unsecured bank debt would
be logically inconsistent with the ECB’s policy of conducting all repo
operations with banks on a secured basis irrespective of the credit worthiness
of the bank. Therefore, we doubt that ECB’s purchases of corporate bonds
would extend to bank debt.
Size of the market: The move to buy corporate bonds could be justified on the
basis of increasing the universe of assets that the ECB could buy to expand its
balance sheet. The range of estimates of the potential universe of the ECB’s
purchases via the corporate bond market can vary widely.
The outstanding amount of ECB repo eligible non-financial corporate bonds is
EUR 1.4trillion. However, the ECB’s repo eligibility criteria is based on the
issuer/debtor/guarantor being located in the EEA and on a temporary basis the
ECB has expanded its range of assets to also include instruments denominated
in USD, GBP and JPY. Therefore, this universe of non-financial corporate
bonds is likely to be broader than what the ECB could eventually decide to
purchase.
An alternative would be to focus on EUR denominated bonds issued by
residents in the Eurozone countries included in the iBoxx indices. This would
suggest that the universe of the assets which the ECB could target might be
much smaller at ~ EUR 580bn.
Impact on credit flow to the SME sector: An argument against the ECB’s
buying of non-financial corporate debt is that it is unlikely to help to stimulate
credit flow to the SME sector directly as non-financial corporate debt is
primarily issued by larger corporate in the Eurozone. Further, iBoxx eligible
EUR denominated bonds are primarily issued by corporates in core countries
and hence it could be argued that this form of easing will be even less
beneficial for the periphery where credit remains more constrained. However,
the ECB’s purchases of corporate credit could still have an effect via the FX
and the portfolio channels.
EUR iBoxx IG non-financial market
value outstanding by countries
(Eurozone only, EUR bn)
France
200
Netherlands
165
Germany
56
Luxembourg
23
Belgium
16
Austria
8
Finland
6
Italy
57
Spain
42
Ireland
8
Slovakia
1
Portugal
1
Total
583
Core
473
Periphery
110
Source: Deutsche Bank
Another argument is that the ECB’s corporate credit purchases will not free up
banks balance sheets to extend credit to the SME sector as banks hold very
limited amounts of corporate credit. Although this is correct it could also be
argued that the ECB’s buying of the limited non 0% RW corporate debt held by
banks will nevertheless free up more capital than if the ECB bought large
amounts of sovereign bonds which have 0% RW.
Institutional constraints: The ECB’s foray into buying corporate bonds could be
a sign that the there remains considerable opposition to govt. bond QE within
the Governing Council. Although some would say that buying of corporate
debt could also result in legal challenges we view the hurdle to buy corporate
debt as being much lower following the ECB’s decision to buy ABS which is
also directing credit towards particular sectors of the economy.
The analysis of the size of the corporate bond market confirms that the ECB is
unlikely to overcome the issue of trying to avoid buy assets which are already
trading at very rich levels by moving to the corporate bond market. Therefore,
to the extent that the ECB remains committed to further easing if necessary
buying of non-financial corporate debt is unlikely to the solution. Eventually the
instruments chosen will seek to strike a balance between expediency and
efficiency and government bond purchases remains as likely as it was prior to
this announcement.
Deutsche Bank AG/London
Page 57
26 October 2014
Global Fixed Income Weekly
What to look for in the AQR and stress test results
The ECB and the EBA will communicate the outcome of the comprehensive
assessment (i.e. the AQR and the stress test) on Sunday 26 October at 12:00
CET.
The template of the results of the comprehensive assessment is shown below.
The assessment can be thought of as a two step process. The AQR will affect
the capital position (Common Equity Tier 1 ratio) of banks as of Dec-13 while
the stress test will assess the capital position of banks on a forward looking
basis. The minimum capital threshold that banks need to meet after the AQR
adjustment as of Dec-13 and at each year over the 3 year horizon of the base
case of stress test is 8.0% while in the adverse case the threshold is 5.5%.
Illustrative results of the comprehensive assessment
Source: ECB
It is worth highlighting that the capital shortfall identified in the main section of
the results will not take into account any capital raising measures from 1-Jan
to 30-Sep 2014. These measures include issuance/buybacks and conversion of
CET 1 capital as well as incurred fines and litigations which were not already
provided for. Therefore, the capital shortfall identified in the main section will
not reflect accurately the amount of capital that banks will need to identify in
their plans submitted to the ECB in case of a shortfall.
Page 58
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Capital measures until Sep-2014 will not be reflected in the main results
Source: ECB
The format of the stress test component of the comprehensive assessment is
shown below. The basic approach involves projecting the operating profit,
impairments on assets in the banking book, losses from the trading book and
losses on sovereign portfolios including the application of standardized
prudential filters for banks holdings of sovereign bonds in the AFS portfolio to
project the estimate CET 1 ratio in the baseline and adverse scenarios.
Template of stress test results within the comprehensive assessment
Source: EBA
Deutsche Bank AG/London
Page 59
26 October 2014
Global Fixed Income Weekly
Banks where capital shortfalls have been identified will have two weeks after
the disclosure of the results to submit capital plans. These plans should detail
how the shortfall will be covered in the next 6 months (for shortfalls identified
under the AQR and the AQR plus the base case) and 9 months (for shortfalls
identified under the AQR plus the adverse case).
Effectiveness of using BTPs as a hedge against credit
weakness – an update
In late July, when the irregularities in BES had come to the forefront of the
market’s focus we had analyzed the effectiveness of using BTPs as a hedge
against a broader weakness in credit in the Eurozone. Our primary conclusions
were

The increase in trading volumes in BTP futures around key events
suggested that BTPs were indeed being used to hedge broader credit
portfolios

Such a strategy would have been effective only very locally given the trend
outperformance of BTPs vs. credit. On a systematic basis, hedging credit a
yield neutral portfolio of long credit and short BTPs with a balancing
position in Germany would not have generated positive “alpha” except for
periods of idiosyncratic weakness in Italy in Q1 and Q3 2013

The correlation between Italy and credit indices suggests the market is
slowly moving back to a pre-crisis regime which would further weaken the
case for using BTPs as a hedge instrument
We update our analysis to see whether our conclusions would have withstood
the test of the recent market volatility.
Firstly, we find clear evidence of a pickup in trading volume in BTP futures over
the past few weeks which would indicate that BTP futures were once again
used as an active hedge instrument.
Secondly, the outperformance in total return terms of BTPs vs. both IG and HY
credit since the start of the year remains in place despite the recent
underperformance in BTPs.
Thirdly, extending our systematic quantitative analysis of yield neutral
portfolios rebalance every quarter, portfolio returns in Q3 2014 confirms the
outperformance of BTPs vs. both IG and HY credit. For Q4, we do indeed see
that BTPs have underperformed the broader credit market. However, this is not
inconsistent with our view that locally BTPs might underperform the broader
credit market. In fact, over the last few days the underperformance of BTPs
has started to decline.
Fourthly, the move back towards the pre-crisis regime of a higher correlation
between BTPs and IG credit and lower correlation between BTPs and HY credit
also remains in place.
Page 60
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Recent pickup in trading volumes in BTP futures
Outperformance of Italy vs. IG and HY since the start of
confirms use as a hedge instrument
the year remains intact despite recent weakness in Italy
300,000
Trading volume
iBoxx IG non-financials cash
1M average
250,000
Italy cash
110
108
200,000
iBoxx HY non-financials cash
106
104
150,000
102
100,000
100
50,000
98
01-Oct
01-Sep
01-Aug
01-Jul
Source: Deutsche Bank, Bloomberg Finance LP
01-Jun
Sep-14
01-May
May-14
01-Apr
Jan-14
01-Mar
Sep-13
01-Feb
May-13
01-Jan
0
Jan-13
Source: Deutsche Bank, Bloomberg Finance LP
Systematic quarterly hedging of IG non-financial and financial portfolios would not have worked in Q3 2014
Quarterly perfromance of hedged IG non-financials
Quarterly perfromance of hedged IG financials
Cumulative performance of the hedged portfolio
1.0%
Cumulative performance of the hedged portfolio
1.5%
0.5%
1.0%
0.0%
0.5%
-0.5%
0.0%
-1.0%
-0.5%
-1.5%
-1.0%
-2.0%
-1.5%
-2.5%
-2.0%
-3.0%
-2.5%
Q3
2012
Q4
2012
Q1
2013
Q2
2013
Q3
2013
Q4
2013
Q1
2014
Q2
2014
Q3
2014
Q3
2012
Q4
2012
Q1
2013
Q2
2013
Q3
2013
Q4
2013
Q1
2014
Q2
2014
Q3
2014
Source: Deutsche Bank, Bloomberg Finance LP, Markit
Deutsche Bank AG/London
Page 61
26 October 2014
Global Fixed Income Weekly
Systematic quarterly hedging of HY non-financial and financial portfolios would not have worked in Q3 2014
Quarterly perfromance of hedged HY non-financials
Quarterly perfromance of hedged HY financials
Cumulative performance of the hedged portfolio
5.0%
Cumulative performance of the hedged portfolio
10.0%
5.0%
0.0%
0.0%
-5.0%
-5.0%
-10.0%
-10.0%
-15.0%
-15.0%
-20.0%
-20.0%
-25.0%
-25.0%
Q3
2012
Q4
2012
Q1
2013
Q2
2013
Q3
2013
Q4
2013
Q1
2014
Q2
2014
Q3
2014
Q3
2012
Q4
2012
Q1
2013
Q2
2013
Q3
2013
Q4
2013
Q1
2014
Q2
2014
Q3
2014
Source: Deutsche Bank, Bloomberg Finance LP, Markit
In Q4 2014 so far BTPs have in fact underperformed both IG and HY credit, but underperformance is reducing
1.60
IG financials
5.00
IG non-financials
HY financial
HY non-financials
1.40
4.00
1.20
Italy underperforming
1.00
Italy underperforming
3.00
0.80
2.00
0.60
0.40
1.00
0.20
0.00
0.00
Italy outperforming
-0.20
Italy outperforming
-1.00
22-Oct
20-Oct
18-Oct
16-Oct
14-Oct
12-Oct
10-Oct
08-Oct
06-Oct
04-Oct
02-Oct
30-Sep
22-Oct
20-Oct
18-Oct
16-Oct
14-Oct
12-Oct
10-Oct
08-Oct
06-Oct
04-Oct
02-Oct
30-Sep
Source: Deutsche Bank, Bloomberg Finance LP, Markit
Longer-term move towards pre-crisis regime of high correlation between BTPs and IG and low correlation between
BTPs and HY continues
IG non-financials
HY non-financials
1.00
0.80
0.80
0.60
0.60
0.40
0.40
0.20
0.20
0.00
0.00
-0.20
-0.20
-0.40
Italian
elections
Spillover of debt
crisis to Italy
-0.60
-0.80
Oct-08
IG financials
HY financials
1.00
Oct-09
Oct-10
Oct-11
Oct-12
Oct-13
Oct-14
-0.40
-0.60
Oct-08
Italian
elections
Spillover of debt
crisis to Italy
Oct-09
Oct-10
Oct-11
Oct-12
Oct-13
Oct-14
Source: Deutsche Bank, Bloomberg Finance LP, Markit
Page 62
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Recent volatility in periphery has reduced sharpe ratio of
performance
The recent developments have re-introduced volatility into the peripheral
sovereign bond market. The increased volatility has meant that the ex-poste
sharpe ratio of being long the periphery has declined significantly over the past
few weeks which might result in increased caution on the part of investors. In
particular, the underperformance of the front-end of the peripheral curves
would suggest that domestic banks have not been active participants over the
past few weeks in the lead up to the AQR. The behaviour of this investor class
following the publishing of the AQR and the stress test results will be crucial in
determining the short-term outlook for the periphery.
This does not detract from our more constructive medium term stance on the
periphery based on the fact that fiscal balances in the periphery are
significantly better, these countries are running a current account surplus
rather than a deficit, the non-resident ownership is much lower and the ECB
remains willing to do more including further adopting further unconventional
measures.
For investors who wish to go long the periphery we would recommend the
very front-end of the curve given the better carry and roll down profile and the
potential for domestic banks to come back to this market following the
announcement of the AQR/stress-test results over the weekend.
Figure 1: Ex-post sharpe ratio: 3M returns/3M volatility of
Figure 2: Carry profile on Italian curve favourable for the
returns has declined
very front-end amidst increased volatility
8
25.0
Italy
3m carry and roll down
6
20.0
4
15.0
2
0
10.0
-2
5.0
-4
-6
Jan-08
Jan-09
Jan-10
Jan-11
Source: Deutsche Bank, Bloomberg Finance LP
Deutsche Bank AG/London
Jan-12
Jan-13
Jan-14
0.0
Jan-15
Jun-20
Dec-25
Jun-31
Nov-36
May-42
Source: Deutsche Bank
Page 63
26 October 2014
Global Fixed Income Weekly
Global
Credit
Covered Bonds
Bernd Volk
Strategist
(+41) 44 227-3710
[email protected]
Covered Bond and Agency Update

Last Friday, the ECB officially established the third, covered-bond purchase
programme (CBPP3), running for at least two years. Purchases started on
Monday. While covered bonds need to be repo-eligible, denominated in
EUR and issued by euro area MFIs, given that "ambitions and objectives
are way higher" than under CBPP1/2, criteria are broader, for example, do
not stipulate a maturity limit and include Multi-Cedulas, retained covered
bonds and Greek and Cypriot covered bonds. According to the ECB, the
total volume qualifying for CBPP3 amounts to around EUR 600bn.

Weekly updates regarding the total volume purchased will be provided on
Monday. With no CBPP3 qualifying new EUR benchmark issuance this
week, we will see on Monday how many covered bonds the ECB bought in
the secondary market up to Wednesday the week before.

According to Bloomberg, the focus so far has been on shorter-dated
covered bonds. However, the ECB also already bought longer-dated
peripheral covered bonds. We estimate that the ECB bought around EUR
2bn but argue that we need at least one month to assess CBPP3 in more
detail. Moreover, even then, the ECB can constantly adjust its strategy. We
are not aware of any purchases of retained covered bonds yet.

In our view, the volume bought under CBPP3 and the spreads of second
tier versus prime, peripheral, covered bonds are the main variables to look
at. The larger the volume bought under CBPP3 and the tighter weaker
covered bonds trade compared to stronger covered bonds in each country,
the more aggressively the ECB executed CBPP3.

Covered bond spreads have tightened significantly since CBPP3 was
announced beginning of Sept. For the first time ever, all Spanish, Italian
and Portuguese covered bonds trade tighter than their sovereign bonds.
Before CBPP3 was announced, only stronger peripheral covered bonds
traded tighter than sovereign bonds. In the core euro area, other than
some long-dated French covered bonds, almost all covered bonds trade
still wider than respective sovereign bonds.

Despite significant tightening since the announcement of CBPP3, the
spread between weaker and stronger covered bonds is still wider than precrisis. Moreover, the term “weak” is driven by bank credit quality and
covered bond ratings. As confirmed by Fitch and Moody’s indicators,
collateral quality can be even higher in case of so-called “weaker” covered
bonds, likely justifying ECB purchases under CBPP3 at tighter spreads.

While covered bonds of second tier banks widened slightly early this week
and could face further weakness given the strong tightening in recent
weeks, we expect CBPP3 will ultimately lead to further tightening between
covered bonds of weaker and stronger banks. With EUR 47bn of negative
net supply of CBPP3 qualifying covered bonds ytd, spreads seem well
supported to us. Key risks are a significant widening of underlying
sovereign bonds and in the short term, negative stress test headlines.

The volume bought under CBPP3 will also depend on new issuance. In
2012 and 2013, EUR 81bn and EUR 75bn of EUR benchmark covered
bonds by euro area MFIs were issued respectively. Ytd issuance amounts
to EUR 60bn. Since the announcement of CBPP3, no peripheral covered
Page 64
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
bond was issued. Cheap ECB funding could keep public, covered bond
issuance low, allowing only low primary purchases under CBPP3. Besides,
in our view, in the event of a significant risk-off environment, the ECB
cannot buy more than 20% of new issues without seriously further vexing
private investors. New EUR benchmark covered bond issuance amounts to
EUR 4bn this week. However, all issues were by non-euro MFIs
(Nationwide, Caisse Centrale Desjardins du Quebec, Commonwealth Bank
of Australia, Coventry BS), i.e. do not qualify for CBPP3.
Please see more details in our separate publication “Covered Bond and
Agency Update”.

Figure 1: Issuance of EUR benchmark covered bonds by
euro MFIs
Figure 2: Issuance of EUR benchmark covered bonds by
non-euro MFIs (not qualifying for CBPP3)
Bn EUR
Bn EUR
180
50
160
45
140
40
120
100
80
60
35
30
25
20
15
40
10
20
5
0
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
YTD
Source: Deutsche Bank
Source: Deutsche Bank
Figure 3: Net supply of EUR benchmark covered bonds
Figure 4: Net supply of EUR benchmark covered bonds
issued by euro banks
issued by non-euro banks (not qualifying for CBPP3)
Bn EUR
100
Bn EUR
40
80
35
60
30
40
20
0
-20
25
20
15
-40
10
-60
5
-80
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
YTD
Source: Deutsche Bank
Deutsche Bank AG/London
Source: Deutsche Bank
Page 65
26 October 2014
Global Fixed Income Weekly
Figure 5: ASW spread of iBoxx EUR Covered indices
1400
France Legal
Italy
Public Pfandbriefe
Spain Single
UK
Sweden
Portugal
1200
1000
800
France Structured
Ireland
Mortgage Pfandbriefe
Spain Pooled
Norway
Netherlands
600
Figure 6: Yield of iBoxx EUR Covered indices
14
12
10
8
400
6
200
4
0
France Legal
Italy
Public Pfandbriefe
Spain Single
UK
Sweden
Portugal
France Structured
Ireland
Mortgage Pfandbriefe
Spain Pooled
Norway
Netherlands
2
Source: Deutsche Bank
Page 66
0
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
Dec-07
Mar-08
Jun-08
Sep-08
Dec-08
Mar-09
Jun-09
Sep-09
Dec-09
Mar-10
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
-200
Source: Deutsche Bank
Deutsche Bank AG/London
26 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
Minutes: The minutes of the October meeting revealed ongoing concerns over
the slowdown in Eurozone growth, and what that might imply for the UK. A
cautious note was also driven by the downside surprise to CPI which MPC
received on pre release, which was 0.5pp below the Aug IR forecast. The
slowdown in domestic surveys is noted, and seen to be largely inline with
forecasts -”..there were increasing indicates that the slight slowing in the pace
of expansin towards the end of the year that the Committee had been expecting
for some time would indeed occur”. The mixed October Eurozone flash PMIs
are therefore unlikely to have provided much encouragement, while next
weeks UK PMIs will indicate if whether that weakness is feeding through –
something the minority on the MPC note has not yet happened despite
disappointing data.
The Bank’s Agents survey continues to point to robust labour market
conditions, with recruitment difficult and labour costs at extremes while
material and imported goods costs remain weak.
Labour costs on the up
4.0
Contrasts with external pressures
Agents survey, labour cost/employee
3.0
2.0
6.0
5.0
5.0
4.0
4.0
3.0
3.0
2.0
2.0
1.0
1.0
0.0
-1.0
-2.0
2001
Services
1.0
0.0
Manu
0.0
-1.0
-1.0
-2.0
AWE private reg pay %yy (rhs)
2003
2005
2007
2009
2011
2013
Material Costs
Imported Goods Costs
2015
-3.0
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Source: Deutsche Bank, BoE, Haver Analytics
Source: Deutsche Bank, BoE, Haver Analytics
Stress tests: The EBA stress tests will be released over the weekend, with
individual banks receiving results prior to that on the Friday. The BoE is also
running its own stress test, which is built on the EU one, but includes
scenarios specific to the UK. The EBA test covers the four major UK banks,
while the BoE stress test covers the eight largest banks and building societies.
The results of the UK variant will only be released in December however, with
the final decision on the 15th of December, which will be relayed to respective
banks on the same day, with official publication of the results along side the
FSR on the 16th of December. The UK stress scenario tests include the impact
of a sterling depreciation, growth (lower), inflation (higher) and rate (higher)
shocks and house price declines).
Market Update: Rates rebounded this week, lead by the 5Y +15bp. Across the
curve, the sharp rally of the week of the 13th has been largely unwound, bar
the very front end (versus 10th Oct, 30Ysw -1bp, 10Ysw +0.2, 5Ysw -1.1bp,
1y1y ois -5.1bp). We retain the 5y10y steepener, but given the front end has
limited room to rally, it is more of a bearish view from here.
Deutsche Bank AG/London
Page 67
26 October 2014
Global Fixed Income Weekly
The 10Y30Y slope, unusually, sold off largely in parallel likely reflecting
upcoming supply. The 3q44-3h68 slope has also disinverted to the steepest
level this year, suggesting that despite low outright yields, the bond does
appear cheap now on an RV basis. Long end swap spreads have also moved
beyond the 1Y average, +1bp over the week, underperforming 10Y spreads, as
seen in the ASW box.
3h68 on the curve
0
ASW Box
UKT 44-68
UKT 60-68
-1
-2
3
0.0
35.0
2.5
-1.0
30.0
2
-2.0
1.5
-3.0
25.0
-3
-4
20.0
15.0
1
-5
-6
0.5
-7
0
Source: Deutsche Bank
-4.0
10.0
-5.0
3Q44-3H68 ASW (rhs)
-6.0
Oct-13
2Q23-3H68 ASW
5.0
0.0
Apr-14
Oct-14
Source: Deutsche Bank
Long End ASW
Short term regression
30
60
25
50
40
20
30
15
20
10
Fitted
Residual
10Y30Y
10
5
15Y+
35Y+
1Y Ave 15Y+
1Y Ave 35Y+
0
-10
0
Jul-13
Jan-14
Jul-14
Source: Deutsche Bank
Source: Deutsche Bank
Looking at the impact of syndications of the long dated forwards suggests on
average rates rally immediately after the syndication, and subsequently sells
off ten days after – note that that is driven by several large moves, rather than
a more systematic small sell off.
We also consider the impact on swap spreads, taking the benchmark 30Y in
the run up to the syndication as the reference bond. This appears to perform
well after syndications, though we note that the full sample average is biased
lower by two specific instances, the issue of the 34s in 2009 and 52s in 2011 –
removing these two reduces the post-syndication performance.
15Y15Y around syndications
30Y ASW around syndications
6
0.50
Ave 40Y+ nominal
4
0.00
All nominal
-0.50
2
-1.00
-1.50
0
-2
-2.00
All nominal excluding
ukt 34, ukt 52
-2.50
Ave all nominal
-3.00
-4
-3.50
Source: Deutsche Bank
Page 68
-4.00
'negative = lower than
syndication day, positive =
higher than syndication day
-10bd
-9bd
-8bd
-7bd
-6bd
-5bd
-4bd
-3bd
-2bd
-1bd
0bd
1bd
2bd
3bd
4bd
5bd
6bd
7bd
8bd
9bd
10bd
9bd
-4.50
10bd
8bd
7bd
6bd
5bd
4bd
3bd
2bd
1bd
0bd
-1bd
-2bd
-3bd
-5bd
-6bd
-7bd
-8bd
-9bd
-10bd
-8
-4bd
15Y15Y level vs syndication date,
negative implies rates below syndication
level, vice versa
-6
Source: Deutsche Bank
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
The charts below looking at the behavior of the residual of 10Y30Y vs 10Y,
both the averages over the month, and changes over the month.
Changes in the residual
25
Average residual
30
Monthly changes in regression residual
20
Average residual of 10Y30Y vs 10Y over the month
20
15
10
10
5
0
0
-10
-5
-20
-10
-30
-15
2012
2010
2009
2008
2007
2013
-40
-20
1
2
3
4
5
6
7
Source: Deutsche Bank
Deutsche Bank AG/London
8
9
10
11
12
1
2
3
2012
2010
2013
4
5
6
2011
2009
2007
7
8
9
10
11
12
Source: Deutsche Bank
Page 69
26 October 2014
Global Fixed Income Weekly
Japan
Rates
Gov. Bonds & Swaps
Makoto Yamashita, CMA
Strategist
(+81) 3 5156-6622
[email protected]
Japan Strategy
Overview

Last week a BOJ TDB-buying operation went undersubscribed, while
yesterday the MOF auctioned off 3m TDBs at a negative average yield. The
key factor would appear to be an increase in TDB ownership for both the
BOJ and foreigners, who have increased their combined holdings from
JPY80 trillion in March 2013 to an estimated JPY98 trillion as of
September 2014, which amounts to some 63% of total outstanding
issuance. This effectively means that just JPY56 trillion is currently
available to domestic private-sector investors. We believe that
undersubscribed BOJ operations in the TDB market could become quite
common unless US and European interest rates begin to move higher, in
which case bond market participants are likely to start factoring in an
increase in the BOJ's JGB purchases in order to meet its targets for
monetary base expansion.

That said, supply/demand also continues to tighten in the medium- to longterm sector of the JGB market as foreigners step up their investment.
JSDA trading data for September indicate that foreigners were net buyers
of medium-term JGBs to the tune of JPY2.9 trillion, which is likely to have
reflected cheaper yen funding costs (as basis swaps have fallen deeper
into negative territory) and a shift out of TDBs as yields have turned
negative. Demand from domestic investors is generally sufficient to absorb
the entire amount of JGB issuance, meaning that greater buying interest
from foreigners will tend to have quite a significant impact on the overall
supply/demand balance.
Expectations of increased BOJ JGB purchases likely to
intensify if TDB operations keep going undersubscribed
Last week a BOJ TDB-buying operation went undersubscribed, while yesterday
the MOF auctioned off 3m TDBs at a negative average yield. Supply/demand
has clearly tightened at the very short end of the curve, with bid-to-offer ratios
for BOJ TDB operations declined markedly since the start of this year. The
BOJ's offer amounts have also increased sharply this month, making it harder
for the central bank to find sufficient willing sellers.
Figure 1: Bid-to-offer ratios for 2014 BOJ TDB operations vs. offer amounts
Offer amount (rhs)
Bid-to-offer ratio
4.0
(trillion yen)
4.0
3.5
3.5
3.0
3.0
2.5
2.5
2.0
2.0
1.5
1.5
1.0
1.0
0.5
0.5
0.0
0.0
Jan-14
Mar-14
May-14
Aug-14
Oct-14
Source: Bank of Japan, Deutsche Securities
Page 70
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
The BOJ will perhaps struggle to increase its TDB holdings much beyond
current levels. As of end-September the central bank's JPY49.5 trillion in TDB
holdings accounted for some 32% of the entire market, a significant increase
from JPY34.0 trillion (21%) in March 2013 prior to the launch of Quantitative
and Qualitative Monetary Easing (QQE). Foreigners have also increased their
holdings from around JPY19 trillion back in early 2008 to JPY49 trillion (31% of
the market) as of end-September, reflecting the impact of both the eurozone
sovereign debt crisis and the associated decline in overseas interest rates. The
combined holdings of the BOJ and foreigners thus total an estimated JPY98
trillion, leaving just JPY56 trillion or 37% of the market for domestic privatesector investors. With the BOJ looking unlikely to slow the pace of monetary
base expansion below JPY60–70 trillion any time soon, it will probably keep
looking to increase its TDB holdings. However, we believe that
undersubscribed BOJ operations in the TDB market could become quite
common unless US and European interest rates begin to move higher, in
which case bond market participants are likely to start factoring in an increase
in the BOJ's JGB purchases in order to meet its targets for monetary base
expansion.
Figure 2: Breakdown of TDB ownership
200
180
160
140
120
100
80
60
40
20
0
Domestic private sector etc.
BOJ
BOJ ownership percentage
(trillion yen)
Foreigners
Foreign ownership percentage
35%
30%
25%
20%
15%
10%
5%
0%
08
09
10
11
12
13
14
Source: Bank of Japan, Deutsche Securities
Supply/demand to tighten further for coupon-bearing JGBs
as foreigners increase their holdings
Supply/demand also continues to tighten in the medium- to long-term sector of
the JGB market. JSDA Trends in Bond Transactions data for September indicate
that city banks were net sellers of JGBs to the tune of JPY1.1 trillion, but the
breakdown by maturity shows JPY2.7 trillion in net purchases from the longterm sector and JPY4.2 trillion in net sales of medium-term JGBs. Such
behavior is typical of the final month of a fiscal half-year, with March 2014
having seen JPY2.4 trillion in net purchases of long-term JGBs and JPY2.8
trillion in net sales of medium-term JGBs as city banks seemingly shifted a
little further out the curve while also realizing some profits. Regional financial
institutions remained only modest net buyers, buying JPY442.7 billion more
than they sold overall but focusing mostly on the medium-term sector, with
long-term JGBs sold off to the tune of JPY159.5 billion. Some appear to have
reduced their exposure to long-term JGBs—and thus their overall exposure to
interest rate risk—as a weakening of the yen triggered a temporary rise in
yields. Trust banks and insurers were net buyers of JGBs to the tune of
JPY1.68 trillion. Combined net purchases from the super-long sector totaled
just JPY563.5 billion, well below the three-year monthly average for July–
September of around JPY1 trillion. However, insurers' net purchases totaled
Deutsche Bank AG/London
Page 71
26 October 2014
Global Fixed Income Weekly
JPY698.0 billion, only just below the corresponding average of JPY710 billion.
We believe that insurers may have been looking to increase their exposure
towards their original target levels for end-1H FY2014 after seeing yields move
a little higher last month.
Figure 3: Life insurers: cumulative net purchases of JGBs by fiscal year
(trillion yen)
12
10
2011FY
2012FY
2013FY
2014FY
8
6
4
2
0
4
5
6
7
8
9
10
11
12
1
2
3
Source: Japan Securities Dealers Association, Deutsche Securities
Greater investment by foreigners has also caused supply/demand to tighten in
the coupon-bearing JGB market. September saw JPY3.46 trillion in net
purchases (excluding redemptions), although this broke down into JPY2.92
trillion in medium-term JGBs and just JPY386.8 billion and JPY144.7 billion
from the super-long and long-term sectors respectively. This is likely to have
reflected cheaper yen funding costs (as basis swaps have fallen deeper into
negative territory) and a shift out of TDBs as yields have turned negative.
Demand from domestic investors is generally sufficient to absorb the entire
amount of JGB issuance, meaning that greater buying interest from foreigners
will tend to have quite a significant impact on the overall supply/demand
balance. The BOJ may therefore struggle to significantly increase its JGB
purchases in the event that additional monetary easing measures are deemed
necessary. In any case, we expect JGB yields to face a downward bias as
overall supply/demand shows signs of tightening even further.
Figure 4: Foreigners' net JGB purchases by maturity
(trillion yen)
Super-long-term
Long-term
Medium-term
4
3
2
1
0
-1
-2
2013
2014
Source: Japan Securities Dealers Association, Deutsche Securities
Page 72
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Tightening of JGB supply/demand likely to limit the BOJ's
options
With last week's operation going undersubscribed and TDBs having been
auctioned off at negative yields, there is a growing consensus that the BOJ will
find it increasingly difficult to meet its monetary base expansion targets
without increasing its operations outside the TDB sector, with some
suggesting that the central bank will need to hike its JGB purchases by a few
trillion yen per year.
That said, the BOJ now finds itself in somewhat of a bind. Many expect that
the +2% "price stability target" will remain out of reach for at least the time
being and that the BOJ will thus be forced to deploy additional easing
measures at some point, but doing so will be easier said than done for at least
three reasons. First, further expansion of the monetary base could prove
difficult from a technical perspective. The BOJ is already struggling to
purchase sufficient TDBs, and could see also operations in the medium-term
sector go undersubscribed if it were to significantly increase its offer amounts.
Operations in the super-long sector are more likely to go smoothly, but the
BOJ has only limited scope to increase its purchases of super-long JGBs given
that annual issuance totals just JPY30 trillion. Second, as has recently been
pointed out by BOJ Governor Haruhiko Kuroda, it is crucial for Japan to
continue with its fiscal health reforms. The Abe government is due to make its
final decision on next October's consumption tax hike before the end of this
year, but it cannot yet be considered a done deal. Third, additional easing
might be viewed as a deliberate attempt to devalue the yen even further.
Gasoline prices have fallen of late, but there is still considerable resistance to
the idea of a weaker yen among consumers, small businesses, and some
politicians. The BOJ may therefore need to wait until a final decision on the
consumption tax hike has been made and criticism of yen depreciation has
died down to at least some degree, making it difficult to contemplate taking
any further action before the end of this year. That said, if the BOJ were to
increase its JGB purchases (in place of TDBs) as a purely technical measure
aimed at meeting its end-2014 "projection" for the monetary base, that would
likely be viewed as a form of easing. The BOJ's ability to expand the monetary
base during the previous (2001–2006) quantitative easing regime ultimately
owed much to yen-selling interventions in the FX market. With such action
highly improbable in the current climate and TDB issuance holding steady at
best, the current QQE framework could soon start to look unsustainable from a
practical perspective.
Deutsche Bank AG/London
Page 73
26 October 2014
Global Fixed Income Weekly
Pacific
Australia
New Zealand
Rates
Gov. Bonds & Swaps
Dollar Bloc Strategy

The bond rally has run out of steam, at least for now. Among factors
supporting the consolidation have been the rally in equities, some decent
data across a range of countries and talk the ECB might consider buying
corporate bonds.

The key domestic event in Canada was the Bank of Canada’s review of the
overnight rate. A small upward revision to the inflation forecast for 2015
saw the front-end sell-off a few basis points. This still leaves less than one
full rate hike priced into 2015, which is a lot less than we are forecasting.
We doubt, however, that the market will start to move in this direction
ahead of the US front-end pricing Fed rate hikes back into 2015. We think
the CAN front-end will struggle to price the BoC delivering a rate hike well
before the Fed starts.

The slightly below expectation core CPI result in Australia had no
noticeable impact on the AUD front-end. In our view this was due to the
result being pretty close to the market pick and the fact the front-end is
already pricing around a 40% chance of a rate cut on a 12 month horizon.
This is not too far off the low in front-end pricing this year.

In contrast to the benign impact of the AUD CPI, the NZ CPI did trigger a
market reaction when the headline printed at 0.3%qoq versus the market
expectation of 0.5%qoq. The Sep-15 bank bill future, for instance, rallied
some 9bp on the release. As a consequence of the low CPI we have
pushed the expected timing of the next RBNZ rate hike out to September
2015.

This is still earlier than the market, which now only has one rate hike
priced by the end of 2015 and a total of around 50bp by the end of 2016.
The next key event on the NZ calendar is the RBNZ’s Official Cash Rate
(OCR) review on 30 October. We expect the OCR review to be somewhat
more dovish than the September MPS, though not as dovish as market
pricing. Still we think the market will see the RBNZ move as validation of
the shift in pricing. Of potentially greater threat to the current level of
pricing is the employment data in the first week of November. The various
indicators we look at suggest that the labour market has continued to
improve. Evidence along these lines will challenge current front-end
pricing, in our view, especially if there is any evidence of an acceleration of
wage costs.

Our Chinese economic team has lowered Deutsche Bank’s 2015 GDP
forecast for China to 7%. Combining this with our US growth forecast
implies an end 2015 China/US growth differential of around 3.5%. In turn
this points to the 10Y ACGB/UST spread narrowing towards flat over the
medium-term. This will take it back to where it was in the late 1990s and
the beginning of the last decade, before the China boom pushed the 10Y
spread much, much wider. We would expect a much lower AUD in such a
spread environment.
Page 74
David Plank
Macro strategist
(+61) 2 8258-1475
[email protected]
Ken Crompton
Strategist
(+61) 2 8258-1361
[email protected]
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Bond rally runs out of steam – for now at least
Compared to last week’s price action, this week’s could almost be described
as dull. 10Y bond yields across the $-bloc have moved up a little from last
week’s closing low (which were themselves someway above the intra-day low).
Among factors supporting the consolidation have been the rally in equities off
last week’s low, some decent data and talk the ECB might consider buying
corporate bonds.
$-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-14
1.6
Feb-14 Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
Oct-14
Source: Deutsche Bank, Datastream
Major domestic events in the peripheral $-bloc over the past week included the
BoC’s rate decision and Q3 CPI data in Australia and New Zealand. With
regard to the BoC’s rate decision, as universally expected the overnight cash
rate was left at 1%. The Bank did drop its forward guidance, but this had been
flagged in earlier commentary so was of no surprise. While the Bank
acknowledged that core inflation has risen more rapidly than expected, this is
offset by an outlook for the global economy that is softer than previously
expected. All up the Bank left its 2015 and 2016 Canadian growth forecasts
unchanged but lifted its 2015 forecast for core inflation by 0.1% to 1.8%.
End 2015 market pricing for the CAD 3M rate
2.0
1.9
3M rate implied by Dec-15 BA
future
1.8
1.7
1.6
1.5
1.4
1.3
1.2
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
Oct-14
Source: Deutsche Bank, Bloomberg Finance LP
Deutsche Bank AG/London
Page 75
26 October 2014
Global Fixed Income Weekly
There was a small sell-off at the front of the CAN curve when the BoC’s
statement was released. The Dec-15 BA future contract, for instance, sold-off
by 4bp in the 15 minutes following the release but then recovered most of this
loss by the close of day. Still, at current levels the Canadian front-end is
pricing less than one full rate hike by the end of 2015.
This is a lot less tightening than our official forecast. We have the BoC’s
overnight rate at 1.75% by the end of 2015. We doubt, however, that the
market will start to move in this direction ahead of the US front-end pricing
Fed rate hikes back into 2015. We think the CAN front-end will struggle to
price the BoC delivering a rate hike well before the Fed starts.
Australia’s CPI close to expectations, while NZ’s surprises to the downside
The removal of the carbon tax meant that there was quite a bit of focus on the
Australian CPI for the third quarter. In the event the headline CPI printed at
0.5%qoq, slightly higher than the market pick of 0.4%. The annual change
was in line with the market expectation at 2.3%yoy.
Of greater importance from a policy perspective are the core CPIs. While the
average quarterly increase of the trimmed mean and weighted median was in
line with the market at 0.5%qoq, the annual figure of 2.6%yoy was somewhat
below the market pick as a consequence of downward revisions to the
previous quarter’s results.
Core CPI’s drifting back toward the middle of the band
2.7
Underlying Inflation
6.0
Market pricing for the RBA
Cash rate implied by 6th IB contract
Cash rate implied by 12th IB contract
%
Trimmed mean, qoq% chg
5.0
2.6
RBA cash rate
Weighted median, qoq% chg
Trimmed mean, yoy% chg
4.0
2.5
Weighted median, yoy% chg
3.0
2.4
2.0
2.3
1.0
0.0
Jun-03
Source: Deutsche Bank, ABS
Jun-06
Jun-09
Jun-12
2.2
Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14
Source: Deutsche Bank, Bloomberg Finance LP
In its September Statement of Monetary Policy (SMP) the RBA projected
annual core inflation of 2.25% by the end of 2014. We would characterise the
September quarter result as being in line with this projection. We note last
year’s high December quarter result will drop out of the next annual
calculation.
The slightly below expectation core CPI result had no noticeable impact on the
AUD front-end. In our view this was due to the result being pretty close to the
market pick and the fact the front-end is already pricing around a 40% chance
of a rate cut on a 12 month horizon. This is not too far off the low in front-end
pricing seen this year.
Page 76
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Low NZ CPI sees us push our next RBNZ rate hike out to September 2015
In contrast to the benign impact of the AUD CPI, the NZ CPI did trigger a
market reaction when the headline printed at 0.3%qoq versus the market
expectation of a gain of 0.5%qoq (according to the Bloomberg Financial LP
poll). The Sep-15 bank bill future, for instance, rallied some 9bp on the release.
By the close of the day the 2Y NZD swap had rallied some 6bp from the
previous day’s close. This gain on a day when the 2Y AUD swap sold-off by a
couple of basis points.
In commenting on the CPI result, our Chief Economist for NZ note that the
result lowered the annual rate of inflation to 1.0%yoy - the very bottom of the
RBNZ’s target range and well below market and RBNZ expectations. For a
second quarter in a row the downside surprise also owes in part to lower-thanexpected inflation in the non-tradeables sector, with the annual rate declining
to 2.5% from 2.7% previously. He goes on to say that the further soft outcome
in the non-tradeables sector (especially ex-housing) will cause the RBNZ to
apply greater caution in keying policy decisions off its inflation forecasts,
leading to greater policy inertia. As a consequence he thinks that the RBNZ is
now unlikely to feel compelled to tighten policy again until September next
year.
NZ front-end expectations
Market pricing vs the RBNZ MPS track for 3M rate
4.8
5.00
4.7
4.75
Mkt pricing for 3M rate as at 23 October 2014
RBNZ Sep-14 MPS
4.6
4.50
4.5
4.25
4.4
4.00
4.3
3.75
4.2
4.1
3M rate implied by
Dec-15 NZD bill future
3.50
4.0
3.25
3.9
Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14
3.00
Source: Deutsche Bank, Bloomberg Finance LP
Jun-14
Sep-14
Dec-14
Mar-15
Jun-15
Sep-15
Dec-15
Mar-16
Jun-16
Sep-16
Dec-16
Source: Deutsche Bank, Bloomberg Finance LP, RBNZ
The market now has even less than this priced. Out to the end of 2015 market
pricing is for around a single rate hike. This is now well below the track the
RBNZ published in its September Monetary Policy Statement (MPS).
This state of affairs is not all that unusual. The NZ front-end has been quite
happy to price a track well under the RBNZ projection for some time. In part,
however, this reflected the relatively aggressive outlook by the RBNZ
(aggressive in the sense of the number of rate hikes). This created the space
for the market to be well under the RBNZ but still have a reasonably
pronounced tightening cycle priced.
This is no longer the case. Out to the end of 2016 the market now effectively
has only 50bp of rate hikes priced. It hasn’t completely run out of room to rally
further, but we think market pricing is now at the point where the data will
have to be quite favourable to maintain current levels let alone encourage
further gains.
The next key event on the NZ calendar is the RBNZ’s Official Cash Rate (OCR)
review on 30 October. OCR reviews contain much less information than the
Deutsche Bank AG/London
Page 77
26 October 2014
Global Fixed Income Weekly
MPS, so there won’t be an explicit forecast update to allow direct comparison
with market pricing. Rather the focus will be on the tone of the RBNZ’s
comment.
We preview the OCR review in more detail elsewhere in the Weekly, but the
bottom line is that while we expect the RBNZ to be somewhat more dovish
than it was in September on account of global developments and the CPI we
don’t think the Bank will be as dovish as market pricing. Will this be an issue
for the market? Probably not, in our view, as the market can rightly observe
that the RBNZ has been progressing to a more dovish outlook over the course
of this year and the October OCR review represents another small step in this
direction (if it comes out as we expect).
The more important event for the front-end comes a week later with the
publication of the Q3 labour force data on 5 November. The various indicators
we look at suggest that the labour market has continued to improve. Evidence
along these lines will challenge current front-end pricing, especially if there is
any evidence of an acceleration of wage costs.
Our inclination is to be neutral the NZ front-end into the OCR review on the
basis that a dovish evolution by the RBNZ will be seen as validation to some
extent of market pricing. Beyond that we think there may be an opportunity to
get short the NZ front-end and perhaps look at a front-end steepener ahead of
the various employment reports in the first week of November.
What does the downward revision to our forecasts for China GDP suggest
about AUD/USD rate differentials?
In seeking to explain the fundamental drivers of the spread between AUD and
USD interest rates we have put a lot of weight on the growth differential
between China and the US. This differential ‘works’ as an explanatory variable
for the AUD/USD yield gap, in our view, because it explains the broad trend in
the unemployment gap between the US and Australia. Note that in the chart
below we have only shown actual growth data. It has tended to lead the trend
in the unemployment gap by around 12 months.
China/US growth gap vs US/AU unemployment gap
14.0
12.0
5.0
Chinese GDP less US GDP, advanced 4 quarters,
yoy % change (LHS)
4.0
US/AU unemployment gap (RHS)
3.0
10.0
2.0
8.0
1.0
6.0
0.0
-1.0
4.0
-2.0
2.0
0.0
Jan-00
-3.0
-4.0
May-02
Sep-04
Jan-07
May-09
Sep-11
Jan-14
Source: Deutsche Bank, Bloomberg Finance LP
Based on what we already know about the relative growth performance of
China and the US, the above chart suggests that the US labour market will
further outperform that of Australia’s. What happens if we add our forecasts
for Chinese and US growth to extend the outlook for the unemployment gap?
Page 78
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
This week our Chinese economic team lowered their 2015 growth forecast to
7%. This compares with our US GDP forecast of around 3.5%. Thus we
expect the gap between the two countries to narrow even further than has
been the case up till now. The following chart translates this expected growth
gap into the 10Y ACGB/UST spread.
China/US growth gap vs 10Y ACGB/UST spread
13.0
12.0
11.0
Chinese GDP less US GDP, advanced 4 quarters, yoy %
change (LHS)
3.5
10Y ACGB/UST spread (RHS)
3.0
2.5
10.0
9.0
2.0
8.0
7.0
1.5
6.0
1.0
5.0
0.5
4.0
3.0
0.0
End 2015 CHina/US
growth gap implied
by Deutsche forecasts
2.0
1.0
0.0
Mar-95
-0.5
-1.0
Dec-97
Sep-00
Jun-03
Mar-06
Dec-08
Sep-11
Jun-14
Source: Deutsche Bank, Bloomberg Finance LP
If our growth forecasts are correct and the broad relationship between the
growth gap and the bond differential remains intact then the 10Y ACGB/UST
spread is heading toward zero over the next few years. This will take it back to
where it was in the late 1990s and the beginning of the last decade, before the
China boom pushed the 10Y spread much, much wider. We would expect a
much lower AUD in such a spread environment.
Deutsche Bank AG/London
Page 79
26 October 2014
Global Fixed Income Weekly
Global
Markus Heider
Economics
Rates
Gov. Bonds & Swaps
Inflation
Strategist
(+44) 20 754-52167
[email protected]
Global Inflation Update
1. B/Es up, TIPS underperform
Global
25
Market and macro news were more B/E friendly this week, and valuations rose
markedly in EUR and GBP; TIPS underperformed (chart 1). Oil prices were
down again, but showed some signs of stabilisation through the week, while
risk sentiment recovered, equities and bond yields rose (chart 2). Negative data
momentum may be fading, with in particular higher US core CPI and better
euro area PMIs, which should alleviate concerns about downside risks to the
inflation and growth outlook. After weaker prints over the past 3m, US core
CPI in September rose back close to the 0.15% m/m trend in place over the
past year, while October EUR PMIs increased to levels consistent with Q4 GDP
growth of 0.2% q/q or more. B/Es continue to price downside risks to the
inflation outlook, with valuations in most cases well below 1y averages (chart
3). Across markets, 1y z-scores are lowest for long-end TIPS (chart 3) and
regressing (seas. adj.) TIPS B/Es on UKTi of similar maturity shows residuals
close to 1y extremes (chart 4). The widening in the 10y GBP/USD B/E spread
also looks extreme against trends in macro variables (chart 5). Some of the
weakness in USD B/Es can perhaps be explained by the strong long-end B/Es
sensitivity to oil prices (chart 6). We see upside for 10y and 30y TIPS B/Es and
would prefer 5y5y TIPS over 5y5y UKTi B/Es.
3. Long-end TIPS cheap
0.5
1y z-score, BEI
BTPei
OATei
DBRei
UKTi
TIPS
5
0
-5
5y
10y
20y
2. Better market backdrop
4.0%
10.0
3.0%
8.0
6.0
2.0%
4.0
1.0%
2.0
0.0%
0.0
-1.0%
-2.0
-4.0
-6.0
1w change, % (lhs)
residual, B/E1 = f(B/E2), over 1y
-8.0
1w change, pts/bp (rhs)
-4.0%
-10.0
brent metals food
DXY
SPX
VIX
(rhs)
10
10y
UST
(rhs)
10y
Bund
(rhs)
Source: Deutsche Bank
0
-2.0
30y
Source: Deutsche Bank
-0.5
-1.5
USD
10
20
-1.0
FRF
GBP
15
-3.0%
30
EUR
-2.0%
4. USD B/Es low v GBP
0.0
1w change in BEI on 23-Oct, carry adj., bp
20
-10
-2.5
-20
-3.0
stdev
-3.5
5y
10y
20y
Source: Deutsche Bank
Max
Min
-stdev
Last
yday
-30
30y
T19/U19
T22/U22
T32/U32
T42/U42
Source: Deutsche Bank
5. 10y GBP/USD B/E spread too wide v eco indicators
30
6. Oil a negative even for 5y5y TIPS
1.0
TIPS 5y5y BEI, 3m change
10y GBP/USD B/E spread, residual
60
brent, %3m (rhs)
20
0.5
30
0.0
0
10
0
-0.5
-30
-1.0
-60
-10
-20
-30
Nov-11
Apr-12
Source: Deutsche Bank
Page 80
Sep-12
Feb-13
Jul-13
Dec-13
May-14
Oct-14
-1.5
2006
-90
2007
2008
2009
2010
2011
2012
2013
2014
Source: Deutsche Bank
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
EUR
3. SPGei19 cheaper than SPGei24
35
4. Business price trends weak
40
linker rich/cheap vs nominal bond curve
1. EUR B/Es rebound
20
BEI
1w change on 23-Oct, carry adj., bp
15
Real Yld
10
Nom Yld
5
0
-5
-10
-15
-20
-25
SPGei24
BTPei41
SPGei19
BTPei26
BTPei24
BTPei19
BTPei16
OATei40
OATei27
OATei24
OATei22
OATei20
OATei18
DBRei30
DBRei23
OBLei18
DBRei20
-30
DBRei16
EUR ILB valuations rebounded strongly this week, with B/Es rising, and real
yields declining (chart 1); only long-end BTPei B/Es tightened, but this came
after a strong performance in recent weeks. Despite the rebound, B/Es remain
well below the levels seen in early September (chart 2), and cheap relative to
baseline economic and inflation projections. There are tentative signs that the
macro and market backdrop may be improving for euro area B/Es. First, global
risk aversion appears to have declined this week. Second, oil prices have been
showing some signs of stabilization, while industrial metal and agricultural
prices are off the lows. Perhaps more importantly, euro area PMIs have
increased slightly in October, raising hopes that economic growth may be
stabilizing—if sustained, the composite PMI would appear consistent with GDP
growth of 0.2/0.3% q/q in Q4. Data surprise indicators have been declining
through most of this year; they increased this week, and any recovery would
be good news for B/Es (chart 5). Finally, we expect both headline and core
inflation to edge marginally higher in October; the latter should be a positive
after the surprise drop in September. On the negative side, given the drop in
commodity prices over the past couple of months, spot inflation is unlikely to
rise meaningfully this quarter and trends business survey price indicators could
weaken further. The October PMI price indices for example, while mixed
(manufacturing output and services input prices were up), were on balance
weaker given the surprisingly strong drop in services output prices. In all, while
our B/E momentum scores remain negative, they appear to be off the lows
(chart 6). We remain neutral on B/Es for now. In RV, the BTPei41 and -35 have
cheapened again v OATei (chart 3). On the BTPei curve the BTPei26 looks
cheap and BTPei23 rich (chart 3). In SPGei, the SPGei19 looks cheap against
SPGei24; the former trades in line with BTPei, the latter closer to OATei.
Source: Deutsche Bank
2. But still below early Sep levels
15
HICP swaps,
change since
10
1w
1m
5
0
-5
-10
-15
-20
-25
1y
1y1y
2y1y
4y1y
9y1y
5y5y
Source: Deutsche Bank
80
PMI Prices 3m change (lhs)
30
30
DEM
25
FRF
ITL
20
60
5y HICP 3m change
20
40
10
20
0
0
ESP
15
-10
-20
-20
-40
-30
-60
10
5
0
2014
2020
2025
2031
2036
2042
Source: Deutsche Bank
-40
-80
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Deutsche Bank
5. Data surprise indicator up this week
100
6. Macro momentum off the lows
EUR data surprise indicator (lhs)
OATei implied 10y ZC BEI
2.6
0.7
2.4
0.5
3
5y HICPx 4w chge (lhs)
Momentum Score (rhs)
2
50
2.2
0.3
1
2.0
0
0.1
0
1.8
-0.1
-50
1.6
-1
-0.3
1.4
-100
-2
-0.5
1.2
-150
Jan-11
1.0
Jun-11 Nov-11 Apr-12 Sep-12 Feb-13
Source: Deutsche Bank
Deutsche Bank AG/London
Jul-13
Dec-13 May-14 Oct-14
-0.7
Jan-10
-3
Aug-10 Mar-11
Oct-11 May-12 Dec-12
Jul-13
Feb-14
Sep-14
Source: Deutsche Bank
Page 81
26 October 2014
Global Fixed Income Weekly
GBP
UKTi B/Es rebounded strongly (between 5-15bp) this week, with the B/E curve
flattening; real yields from 5y rose. Looking more closely at the front-end, the
B/E rally was led by 2y1y, which was up more than 20bp (chart 1), in line with
our observation last week that valuations in this sector had become excessive.
Compared to ‘consensus-type’ cyclical RPI projections assuming a structural
RPI/CPI wedge of 120bp (i.e. 10-20bp below BoE/OBR estimates) 5y swaps
remain cheap, with largest differences now in 3y1y and 4y1y (chart 5).
Economic news has been mixed. The CBI industrial orders index fell, but
remains at relatively high levels; domestic activity trends are unlikely to be an
obstacle for higher B/Es (chart 2). Headwinds are rather coming from (i) weak
imported inflation and (ii) signs that strong growth is only slowly translating
into higher domestic inflation. The BoE agents’ survey (BAS) for September
had evidence of both. Trends in the ‘costs of material’ and ‘costs of imported
finished goods’ indices remain at unusually low levels, while profits and labour
costs scores are rising gradually (chart 3); output price increases are reported
to remain benign. In these conditions, spot inflation is expected to remain
relatively subdued for now, and RPI could ease to close to 2% around the turn
of the year. Forward–looking indicators continue to point to some acceleration
in domestic prices trends in the quarters ahead however. The BAS suggests
that firms are facing increasing recruitment difficulties, and labour cost as well
as capacity constraint surveys suggest that wage inflation will pick up (chart 4).
In all, given still low valuations we would maintain a cautious positive bias on
5y B/Es. At the long-end, forwards remain highest in the 15-20y sector and
lowest in 40y (charts 5 & 6). This is not only true in absolute terms—10y10y is
about 40bp higher than 30y10y (chart 6)—but also relative to the averages
recorded since the formula effect clarification, with 40y10y and 30y10y
currently close to the lows (chart 6).
3. Imported costs unusually low
25
20
15
10
5
0
-5
RPI swap, 1w change on 23-Oct, bp
-10
1y
1y1y
2y1y
4y1y
9y1y
5y5y
Source: Deutsche Bank
2. 10y B/Es v CBI orders
4.5
30
10y UKTi BEI
4.0
20
CBI orders (rhs)
10
3.5
0
-10
3.0
-20
2.5
-30
-40
2.0
-50
1.5
-60
1.0
1998
-70
2000
2002
2004
2006
2008
2010
2012
2014
Source: Deutsche Bank
4. Pay indicators rising
5
costs labour manuf & serv
profits manuf & serv
4
costs material
costs imp finished goods
AWE, priv ex bonus, % y/y
6.0
BoE agents pay
REC wages
5.0
3
BoE agents capacity constr
4.0
2
3.0
1
0
2.0
-1
1.0
-2
1. UK B/Es rebound
0.0
BoE Agents survey
-3
2004
2006
2008
2010
2012
-1.0
2001
2014
Source: Deutsche Bank
2003
2005
2007
2009
2011
2013
2015
Source: Deutsche Bank
5. 3y-5y remains cheapest relative to baseline RPI fcasts
0.80
6. 30y10y 40bp below 10y10y
4.5
4.3
0.60
0.40
0.20
0.00
ZC swap rich/cheap v RPI projections
-0.20
4.5
GBP RPIswap rate RV since 1-Feb-2013
4.3
4.1
4.1
3.9
3.9
3.7
3.7
3.5
3.5
3.3
3.3
3.1
YY swap rich/cheap v RPI projections
3.1
spot
2.9
-0.40
75% quart
max
min
25% quart
2.7
2.7
2.5
-0.60
1
3
5
Source: Deutsche Bank
Page 82
7
9
11
13
15
17
19
21
23
25
27
29
2.9
2.5
10y
10y10y
15y10y
20y10y
30y10y
40y10y
Source: Deutsche Bank
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
United States
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Alex Li
Research Analyst
(+1) 212 250-5483
[email protected]
Inflation-Linked

Indirect bidders at the 30-year TIPS auction this week set a record high of
64.5%. Better than expected CPI data and cheap valuations on the 30-year
likely attracted investors to the supply.

We show 30-year TIPS breakevens are cheap on a long term history,
10s/30s breakeven curve is too flat, and the real yields in the long end are
cheaper in the US than in Europe.

The September CPI data provided some relief to the market, as the
expectations perhaps had been adjusted too low. TIPS carry turns mostly
positive in November. Front end TIPS look cheap relative to our updated
inflation forecast.
Three ways to see attractive valuation in long end inflation
market
Indirect bidders at the 30-year TIPS auction this week set a new record high of
64.5%. Better than expected CPI data and cheap valuations on the 30-year
likely attracted investors to the supply.
Indirect bidder participations at 30-year TIPS auctions
70%
Indirect Bidders
65%
60%
55%
50%
45%
40%
35%
30%
25%
20%
2/1/2010
2/1/2011
2/1/2012
2/1/2013
2/1/2014
Source: US Treasury and Deutsche Bank
There are multiple ways to see the cheap valuations on 30-year TIPS. We list
three below:

30-year TIPS breakevens are more than two standard deviations below its
three-year average. The current level of 2.06 is 27bp below the average,
and each standard deviation is about 12bp.

10s-30s TIPS breakevens appear too low against the overall breakeven
levels. If we use the ten-year breakevens, the 10s-30s breakeven curve,
currently at 15bp, is about 5bp too flat on a regression that uses last two
years’ data.
Deutsche Bank AG/London
Page 83
26 October 2014
Global Fixed Income Weekly

Long end real yields in the US offer nice pickup over those in Europe. The
FRTR 2040 to TIPS 2041 yield spread is now about +28bp (TIPS cheap).
Although the spread was at wider levels recently, it is still in the wide end
of the long term range.
30-year TIPS breakevens are more than two standard deviations below its
three-year average
Source: Bloomberg Finance LP and Deutsche Bank
10s-30s TIPS breakevens appear too low against the overall breakeven levels
0.30
last 2yrs' data
10/23/2014
10s-30s TIPS BEs
0.25
y = -0.2805x + 0.7348
R² = 0.7178
0.20
0.15
0.10
0.05
0.00
-0.05
1.8
2.0
2.2
2.4
2.6
10-Year BE
Source: Bloomberg Finance LP and Deutsche Bank
Long end real yields in the US offer nice pickup over 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 Finance LP and Deutsche Bank
Page 84
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
The indirect bidder participation hit a record 64.5% in the second re-opening
auction of the TIPS of February 2044 on Thursday. The indirect bidders had
averaged 53.7% in the previous three auctions. Since February 2011, their
takedown in 30-year TIPS auctions has been on an increasing trajectory.
The direct bidders however settled with a meager 4.5% participation after
claiming 8.2% in June. This was their lowest participation since June 2013 and
compares with the prior-year average of 10.8%. The combined buyside
takedown was up from 67.9% in June to its three-year high of 69% and
compares with 64.5%, the prior three auction average.
Despite the good customer participation, the bid-to-cover ratio hit the five-year
low of 2.29 from 2.76 in June and compares with its prior-year average 2.62.
The auction generated a 2bp tail, the typical of the 30-year TIPS auctions since
2011.
30-year TIPS auction statistics
Size
($bn)
1yr Avg
$7.67
Primary
Dealers
35.5%
Direct Indirect
Bidders Bidders
10.8%
53.7%
Cover
Ratio
Stop-out 1PM WI
Yield
Bid
2.62
BP Tail
1.0
Oct-14
$7.00
31.0%
4.5%
64.5%
2.29
0.985
0.965
2.0
Jun-14
$7.00
32.1%
8.2%
59.7%
2.76
1.116
1.082
3.4
Feb-14
$9.00
38.5%
4.9%
56.5%
2.34
1.495
1.475
2.0
Oct-13
$7.00
35.9%
19.1%
45.0%
2.76
1.330
1.353
-2.3
Jun-13
$7.00
38.9%
0.4%
60.8%
2.48
1.420
1.390
3.0
Feb-13
$9.00
31.6%
14.0%
54.5%
2.47
0.639
0.620
2.1
Oct-12
$7.00
37.7%
13.2%
49.1%
2.82
0.479
0.485
0.1
Jun-12
$7.00
37.6%
28.1%
34.3%
2.64
0.520
0.495
2.5
Feb-12
$9.00
45.8%
13.6%
40.6%
2.46
0.770
0.695
7.5
Oct-11
$7.00
30.2%
26.7%
43.2%
3.06
0.999
1.050
-5.1
Jun-11
$7.00
50.5%
26.1%
23.3%
3.02
1.744
1.788
-4.4
Feb-11
$9.00
41.2%
3.6%
55.2%
2.54
2.190
2.214
-2.4
Source: US Treasury and Deutsche Bank
September CPI data provide some relief
The Consumer Price Index for All Urban Consumers (CPI-U) NSA increased
0.08% in September after declining 0.17% in the previous month. This
translates to a year-on-year growth of 1.66%. The core index also grew 0.1%
on seasonally adjusted basis during the month. The yearly change in the core
index however remained 1.7%. The core was lifted by the increases in shelter
and medical care indexes whereas the headline was supported by food
inflation somewhat. The shelter index has gained 0.3% on seasonally adjusted
basis during the month increasing 3%, the fastest since January 2008, in the
last twelve months. The medical care index advanced 0.2% MoM or 2% on
yearly basis.
The energy index fell 0.7% in the month registering its third consecutive
decline. On yearly basis the index has registered 0.6% decline. The food
inflation however accelerated to 0.3% from 0.2% in August. Food index gained
3% in the last 12-months.
The details of the CPI data were encouraging after the subdued August print.
The trend in rent and owner’s equivalent rent prices remains strong while the
Deutsche Bank AG/London
Page 85
26 October 2014
Global Fixed Income Weekly
medical care inflation showed some resilience. The gains in these indexes were
able to offset the decline in energy prices.
The weak CPI print in August seemed to have been an outlier; the September
CPI data provided some relief to inflation markets. TIPS carry turns mostly
positive in November. Front end TIPS appear cheap relative to our updated
inflation forecast.
CPI-U NSA y/y, actual and forecast
MoM CPI-U, actual and forecast (non-seasonallyadjusted)
0.8
6.0
%Y/Y
5.0
%MoM NSA
Projections
Projected
0.6
4.0
0.4
3.0
2.0
0.2
1.0
0.0
0.0
-0.2
-1.0
-0.4
-2.0
-3.0
Sep-05
-0.6
Sep-07
Sep-09
Sep-11
Sep-13
Sep-15
Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15
Source: Bureau of Labor Statistic, Deutsche Bank and Bloomberg Finance LP.
Source: Bureau of Labor Statistic, Deutsche Bank and Bloomberg Finance LP.
Some short maturity TIPS appear cheap relative to our inflation forecast
Price date: 10/22/14
BE Inflation
Implied CPI
DB forecast CPI
Rich/ Cheap
TII 1.625% 1/15/2015
TIPS
-2.38%
236.68
236.79
Cheap: 1 ti cks (19bp)
TII 0.500% 4/15/2015
-0.96%
236.89
237.01
Cheap: 2 ti cks (11bp)
TII 1.875% 7/15/2015
0.67%
239.14
239.96
Cheap: 11 ti cks (47bp)
TII 2.000% 1/15/2016
0.83%
240.42
241.32
Cheap: 12 ti cks (30bp)
Source: Deutsche Bank
TIPS carry turns mostly positive in November
1.5
1.0
0.5
0.0
-0.5
TIPS carry from 10/31/14 to 12/1/14
-1.0
-1.5
TII 1.375% 02/44
TII 0.75% 02/42
TII 0.625% 02/43
TII 2.125% 02/41
TII 2.125% 02/40
TII 3.375% 04/32
TII 2.5% 01/29
TII 3.875% 04/29
TII 1.75% 01/28
TII 3.625% 04/28
TII 2% 01/26
TII 2.375% 01/27
TII 2.375% 01/25
TII 0.125% 07/24
TII 0.625% 01/24
TII 0.375% 07/23
TII 0.125% 01/23
TII 0.125% 07/22
TII 0.125% 01/22
TII 0.625% 07/21
TII 1.25% 07/20
TII 1.125% 01/21
TII 1.375% 01/20
TII 1.875% 07/19
TII 0.125% 04/19
TII 2.125% 01/19
TII 1.375% 07/18
TII 0.125% 04/18
TII 1.625% 01/18
TII 2.625% 07/17
TII 0.125% 04/17
TII 2.5% 07/16
TII 2.375% 01/17
TII 2% 01/16
TII 0.125% 04/16
-2.0
Source: Deutsche Bank
Page 86
Deutsche Bank AG/London
26 October 2014
Global Fixed Income Weekly
Contacts
Name
Title
Telephone
Email
EUROPE
Francis Yared
Head of European Rates Research
44 20 7545 4017
[email protected]
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]
Alexander Düring
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 87
26 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 88
Deutsche Bank AG/London
26 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)
(f)
Deutsche Bank AG/London
Page 89
26 October 2014
Global Fixed Income Weekly
(g) 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
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 90
Deutsche Bank AG/London
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
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