EU Deflation

EU Deflation Stress Test

August 5, 2014

HICP -4%

Scenario 1: Hard Landing

• HICP falls to -4% as a result of a combination of external shocks

• Monetary policy is kept constant, with no additional financing through REPOs, and the benchmark interest is left at 0.25%

• Resulting in a Eurozone recession, soon after dragging other EU economies down with it

• EURCHF floor is assumed to be in place

t814776 [printed: März 8, 2013 8:48 AM] [saved: März 8, 2013 8:50 AM] P:\My Documents\Temp Daten\05_SPOC\Stakeholder Board\ST_Mgt_Updates\WM_Stress_Brown_Bag_2013-03-08.ppt

GDP, Equities, FX, Commodities

3

Gold (USD/t. oz)

Silver (USD/t. oz)

Oil (USD/barrel)

Copper (USD/lb)

Steel (USD/lb)

(25)

(20)

(15)

(10)

(5)

0

5 day 10 day 1 month

GDP1 Components

Consumption Investment Government Exports ImportsWeighting1 56.9 18 23.1 44.9 -42.9

Percentage Change 0.87 0.85 1.15 1.05 1.05Percentage Change x Weight 49.503 15.3 26.565 47.145 -45.045

Percentage Change to GDP (%) -6.532

EU USA JAPAN EM CHINA AUSTRALIA (40) (35) (30) (25) (20) (15) (10) (5)

0

5 day 10 day 1 monthEuro GBP CHF JPY RMB

(4) (2)

02468

% change against USD

Equities2 FX3

Commodities4


Yield Curves, Credit SpreadsTED Spread Movements7

CDX IG CDX HY iTraxx Main iTraxx XO iTraxx Japan

050

100150200250300350400450

Japan USA Switzer-land

UK Germany GIPSI (300) (200) (100)

0100200300400500

Short end (1yr)

USD EUR CHF GBP JPY0

20406080

100120140

Short end (1m) Long end (1yr)

USD

CHF

GBP

JPY

0 50 100 150 200 250 300Long end (bp) Short end (bp)

CDS Spreads8

Libor5

Government Yield Curves6

Scenario 2: Soft Landing

• HICP falls to -4% as a result of a combination of external shocks

• ECB implements quantitative easing (€1.5tn) straight away, embarking on a large-scale asset purchase program resulting in a depreciation of the Euro. It also lowers the benchmark interest rate to 0.10%

• Governments with debt less than 100% of GDP implement fiscal policy

• We assume that precious metal prices fall in response to the strengthening of the dollar

• EURCHF floor is assumed to be in place


GDP, Equities, FX Commodities

6

Gold (USD/t. oz)

Silver (USD/t. oz)

Oil (USD/barrel)

Copper (USD/lb)

Steel (USD/lb)

(16) (14) (12) (10) (8) (6) (4) (2)

0

5 day 10 day 1 month

GDP9 Components

Consumption Investment Government Exports ImportsWeighting9 56.9 18 23.1 44.9 -42.9

Percentage Change 0.9 0.89 1.1 1.1 1.07Percentage Change x Weight 51.21 16.02 25.41 49.39 -45.903

Percentage Change to GDP (%) -3.873

EU USA JAPAN EM CHINA AUSTRALIA (30)

(25)

(20)

(15)

(10)

(5)

0

5 day 10 day 1 monthEuro GBP CHF JPY RMB

(20) (15) (10) (5)

05

10

% change against USD

Equities10 FX11

Commodities12


Yield Curves, Credit Spreads

CDX IG CDX HY iTraxx Main iTraxx XO iTraxx Japan

0

50

100

150

200

250

300

Japan USA Switzer-land

UK Germany GIPSI (150) (100) (50)

050

100150200250300

Short end (1yr) Long end (10yr)

USD EUR CHF GBP JPY0

102030405060708090

100

Short end (1m) Long end (1yr)

USD

CHF

GBP

JPY

0 20 40 60 80 100 120 140 160 180Long end (bp) Short end (bp)

Libor13 TED Spread Movements14

Government Yield Curves15 CDS Spreads16


Data & Reasoning:

8

GDP1

Consumption -13%• Consumer spending falls, saving encouraged, rising unemployment

Investment -15%• Real value of debt rises, credit dries up, business confidence low

Government Spending 15%• Rises without the presence of monetary policy, however many countries have high debt

to GDP ratios.Exports 5%

• Euro depreciation leads to export riseImports 5%

• Imports rise 5% as proportion of GDP due to cost rises through weakening of Euro.

Weightings1 – (CIA World Factbook, 2012)


Data & Reasoning (Cont.)

9

http://www.bbc.co.uk/news/business-15748696

5 day 10 day 1 month Comment

EU -15 -20 -35

• ASE fell 12% previously• Nikkei 225 fell as low as 30%• Interconnection of EU, resulting

in exposure of debt and fact that ALL suffer.

USA -7 -13 -20

• 3rd largest of EU's import sources

• Financial exposure to EU high• Hit by high copper, steel and

gold production. • EU is key for trade.• Low oil exports

JAPAN -3 -6 -10

• 6th largest EU import source• Hit on steel exports• 3rd largest oil importer• Moderate debt exposure to EU • Low financial exposure• Could do well in the longer term

from German decline as the both specialise in manufactured goods.

EM (Brazil, Argentina, Mexico, Russia, India) -4 -15 -25

• Russia suffer as it is a main oil and steel exporter and is the second largest source of EU imports.

• Mexico and Brazil moderate oil exporters.

• 53% Latin American investment from EU and 35% trade into Brazil. EU is Brazil main trade partner (EC)

• 19% Argentinian trade to EU (EC).

• Delayed equity decline as most hits are due to commodity prices falling.

CHINA -6 -14 -23

• Largest EU import source• 50% China exports pass

through 'Western network' (UBS Neo)

• Largest steel, silver and gold producer.

AUSTRALIA -2 -8 -15

• Copper exporter and gold producer.

• 20% exports to China• Mining country• Delayed shock to equities as

Australia is dragged down by China, not EU.

Equities2

http://ec.europa.eu/index_en.htm





10

% change against USD Comment

Euro -3

• Euro depreciates initially due to falling prices. This effect is lessened by the slight increase in exports, leading to an overall fall in the Euro of 3%.

GBP -2• Depreciates less than the Euro as initially GBP is

viewed as a safe haven within the EU.

CHF -3• CHF depreciates with the euro as the peg

remains.

JPY 7• JPY appreciate against USD as US is a main EU

trade partner as well as being exposed to a lot of EU debt.

RMB 0• Remnimbi stays the same as the USD as it is

pegged.

FX3

Commodities4 5 day 10 day 1 month Comment

Gold (USD/t. oz) -3 -5 -10• Gold performs best when inflation is high, dollar

is weak and there are elevated levels of financial stress

Silver (USD/t. oz) -5 -10 -14• Silver more volatile than gold, more widely used

in industry = larger fall.

Oil (USD/barrel) -10 -16 • EU makes up 14.9% global oil demand

Copper (USD/lb) -15 -22• EU makes 20% global copper – demand from

emerging market economies also weakening = larger falls

Steel (USD/lb) -8 -14

• EU makes up 9.2% global steel demand - demand from emerging market economies also weakening (steel very widely used in industry = large fall also)


Data & Reasoning (Cont.)Libor5

Ted Spread Movements7

Short end (bp) Long end (bp)USD 72 250CHF 31 20GBP 100 140JPY 23 25

Libor Yields Short end (1m) Long end (1yr) CommentUSD 65bp 50bp • USA has high bank exposure to the EU.

EUR 120bp 110bp • Sovereign default risks in European countries make interbank lending riskier.

CHF 30bp 20bp • Safe bank lending GBP 90bp 70bp • GB has high bank exposure to EU.

JPY 20bp 15bp • Japan has low bank exposure to EU.



http://www.six-swiss-exchange.com/services/yield_curves_en.html

Current Govt. Yields (05/08/2014)

Short end (1yr)

Long end (10yr)

Japan 0.054% 0.51%

USA 0.10% 2.5%Switzerland 0.05% 0.52%UK 0.43% 2.55%Germany 0.04% 1.148%

Japan USA

Switze

rland

German

y UK 0

0.10.20.3

Japan USA

Switze

rland

German

y UK 0

0.51

1.52

Short end Long end

Resulting yields following deflation

Govt. Yield Curves6

Govt. Yields Short end (1yr) Long end (10yr) CommentJapan -3bp -10bp • Safe haven – Both short and long end yields. Should have lowest

yields due to low risk and low exposure.

USA -7bp -200bp • Relatively low yields in short end. Expect investors to flock to 10 year bonds due to safety and high yield.

Switzerland -1bp 0bp • Higher exposure to EU than US or Japan, already low yields mean there will not be much movement.

UK -10bp -70bp • Initially UK seen as a safe haven in Europe so yields fall.

Germany 0bp -30bp • Germany, as another usually 'safe' EU country will also see yield falls initially, however UK Gilts with their higher yields will be preferred.

Gre, Ire, Portugal Esp, It 400bp 350bp • Deflation leads to real value of debt rising. These weak European countries become riskier investments.



CDX IG 50 • In response to falling US equity market these rates rise also.

CDX HY 150 • The above problem is accentuated for high yield bonds.

iTraxx Main 130• As European equities deteriorate and there is no monetary policy allowing

companies access to capital, the risk of default rises.

iTraxx XO 420 • The above problem is accentuated for high yield bonds.

iTraxx Japan 20• Japanese companies are less exposed to EU than USA – 2011, 10% S&P 500 sales in

Europe.

CDS Spreads8 – nb: Figures based around UBS Eurozone crisis LAS. Gauged that at the long end, this scenario sees higher yield rises as deflation is a long term problem – real value of debt rising over time. In the short end, yield rises aren't as severe, as the euro crisis is more of an initial shock.

GDP9

Consumption -10%• Less of a shock to consumption as QE and lowered interest rates encourages spending.

Investment -11%• QE injects capital, easing flow of credit and allowing investment.

Government Spending 10%• Less rise in government expenditure as, with the implementation of expansionary

monetary policy, countries with high debt to GDP avoid spending.

Exports 10%• Extreme currency depreciation leads to further rise in exports. • However exports less sophisticated than Japan's (proxy).

Imports 7%• More significant cost increase for imports due to the Euro depreciation leads to their rise.

Weightings9 – (CIA World Factbook, 2012)


Data & Reasoning (Cont.)Equities10

5 day 10 day 1 month Comment

EU -8 -13 -25

• Monetary policy intervention will curb the trend in falling equities as bank lending and consumer spending is encouraged.

USA -4 -9 -14• American equities supported by EU

monetary policy expansion.

JAPAN -2 -4 -6

EM (Brazil, Argentina, Mexico, Russia, India) -2 -10 -15

• Effect on emerging markets is still delayed however as demand for commodities does not fall as much in this scenario, EM equities do not suffer as much.

CHINA -3 -5 -14

AUSTRALIA -2 -5 -10• Delayed effect again, however as

China does not suffer as much, neither does Australia.


FX11

% change against USD Comment

Euro -17• The implementation of QE leads to a heavy

depreciation of the Euro.

GBP -10• GBP depreciates slower as it is viewed as a safe

haven within the EU initially. CHF -17 • CHF pegged to EuroJPY 5 • Yen appreciates due to its safe haven status.RMB 0 • RMB fixed to USD.



15

5 day 10 day 1 monthComment - All commodity price falls curbed by monetary policy expansion as demand fall from industrial use is less severe.

Gold (USD/t. oz) -3 -4 -8Silver (USD/t. oz) -5 -6 -12Oil (USD/barrel) -8 -12Copper (USD/lb) -12 -15Steel (USD/lb) -7 -11

Commodities12

Libor13

Ted Spread Movements14

Short end (bp) Long end (bp)USD 45 150CHF 25 17GBP 90 155JPY 21 21

Short end (1m) Long end (1yr) Comment – for all, long end rises less as monetary policy and eases lending, lowering the risk of default in the near future.

USD 40bp 20bpEUR 90bp 60bp

CHF 25bp 15bpGBP 75bp 50bpJPY 20bp 15bp



Japan USA

Switze

rland

German

y UK 0

0.10.20.3

Japan USA

Switze

rland

German

y UK 0

0.40.81.21.6

Current Govt. Yields

Short end (1yr)

Long end (10yr)

Japan 0.054% 0.51%

USA 0.10% 2.5%

Switzerland 0.05% 0.52%

UK 0.43% 2.55%

Germany 0.04% 1.148%http://www.six-swiss-exchange.com/services/yield_curves_en.html

Short end Long end

Resulting yields following deflation

Govt. Yield Curves15

Govt. Yields Short end (1yr) Long end (10yr) Comment – Reduced scenario 2 by scale factor 2/3.Japan -1bp -6bp • All safe havens see a lower fall in yields as investing in Europe is not

as risky due to monetary policy.

USA -5bp -130bp • There is still a significant fall in the long end for US bonds as a result of their higher yield and safety.

Switzerland 0bp -2bp • Both short and long end yields for Switzerland are already low.

UK -15bp -105bp • More significant fall for UK Gilts as risk is reduced by monetary policy, investors are also attracted to high yields initially. QE pushes long end down for all EU.

Germany 0bp -45bp • Short end bunds are low yielding already. Larger fall in this scenario in the long end due to monetary policy.

Gre, Ire, Esp, It, Portugal 260bp 230bp • Less significant rise in yields due to ECB action. Not much difference between long end and short end rise as deflationary spiral is long term.



CDX IG 35

CDX HY 100

iTraxx Main 80

iTraxx XO 280

iTraxx Japan 13• Scenario 2 is scaled to 2/3 of scenario 1.• Monetary policy ensures that companies have adequate access to capital, lowering risk.• Japan is again considered a safe haven, with companies having low exposure to EU, therefore insignificant rise.

CDS Spreads16