Interest Rates Monthly 8Jan14 2014 Word of the Year 'Normalisation

8/13/2019 Interest Rates Monthly 8Jan14 2014 Word of the Year 'Normalisation'

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Interest Rates Monthly08 January 2014

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Crdit Agricole Corporate and Investment Bank is authorised by the Autorit de Contrle Prudentiel et deRsolution (ACPR) and supervised by the ACPR and the Autorit des Marchs Financiers (AMF) in Franceand subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority.Details about the extent of our regulation by the Financial Conduct Authority and the Prudential Regulation

Authority are available from us on request.

David Keeble

Global Head of Interest Rates [email protected]+1 212 261 3274

Luca Jellinek

Head of European Interest [email protected]+44 20 7214 6244

Peter Chatwell

Senior Interest Rates [email protected]+44 207 214 5289

Frances Cheung

Head of Asian Rates [email protected]+852 2826 1520

Orlando Green

Senior Interest Rates [email protected]+44 20 7214 7467

Jean-Franois Perrin

Inflation [email protected]+33 1 41 89 94 22

Jonathan Rick

IRD [email protected]+1 212 261 4096

2014 word of the year:

normalisation

US Directional View..................................................................................... 2

Global growth is accelerating and 2014 should see the days of financialrepression pass. Once again we see UST yields rising, but only atapproximately half the pace of 2014. The worst-performing part of thecurve should be the 5Y.

US Directional ViewRates Derivatives....................................................... 4

With 3M10Y implied volatility lagging during the recent rise in volatility, we

examine the underperformance and the potential paradigm shift that isoccurring in rates volatility markets.

Eurozone Directional View........................................................................... 6

Given that economic leading indicators and export performance suggestan ongoing recovery in the Eurozone economy, the recent lag betweenUST and core EGB yields is likely to be reduced going forward, leading tohigher rates and a steeper curve. ECB support will focus more onaddressing banking system fragmentation.

Eurozone Relative Value............................................................................. 8

The beginning of the year seems to confirm our expectation of renewed

interest in periphery convergence trades, partly due to calendarconsiderations and partly due to further evidence of fundamentalimprovement in the periphery. Periphery curve flattening will feature aspart of the RV normalisation.

Asian Rates View......................................................................................... 13

Asian rates will be driven primarily by changing capital flows in a post-tapering environment. Yield pick-up from asset swap trades in sovereignbonds is negative for most Asian markets. We would expect most Asiansovereign yields to move higher to become appealing again to foreigninvestors so Asian rates are to rise alongside USD rates. However, therecould be divergences in the near term due to local factors, creating adelay in Asian market reactions. Curve moves could also differ because

some have steepened a lot already while others are lagging.

Inflation-Linked Strategy.............................................................................. 15

Stuck between subdued inflation for at least six more months and risingnominal rates, European linkers are currently not well positioned,especially core ones. Italian linkers should perform better in 2014 from arelative value standpoint. In the US, we expect a bear flattening of the realcurve.


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Interest Rates Monthly

08 January 2014 2

US Directional View

What the US environment will be at the end of 2014What will the world look like at the end of 2014? Our economists forecastsexpect each of the main global economic blocs to grow at the same pace or

faster this year than in 2013. In the US, we cannot see any good reason toexpect a significant slowdown in the pace of jobs growth assuming that GDPgrowth (at around 2.7%) will be around 100bp faster in the coming year than itwas in 2013 and US corporates are rudely profitable. By the end of the year,there should be evidence of supply constraints and there are already sporadichints of issues in some industries.

By end-2014, the whole nature of monetary policy will have changed in the US. Ifthe Feds own forecasts are approximately correct, Taylor rules would be arguingfor higher rates by the end of 2014, so if the Fed is sticking with its zero interestrate policy, the zero percent Fed Funds rate flips from being too restrictive tobeing stimulative by itself and without the assistance of QE or forwardguidance.

Then there is the financial repression itself. By the end of this year, the Fedsasset purchases will likely have concluded and forward guidance will no longerappear so forward. Remember that the Fed sweetened the start of the taper bysaying that it likely will be appropriate to maintain the current target range for thefederal funds rate well past the time that the unemployment rate declines below6-1/2 percent, especially if projected inflation continues to run below theCommittee's 2 percent longer-run goal.

By the end of 2014, the unemployment rate will be around 6.5% and theprojected PCE deflator from the Feds summary of economic projections for 2015and 2016 will be close to 2%. If the economy develops approximately as theFed expects, then forward guidance will be close to its sell-by date at end-2014.

Structural impediments to growth have eased: the household sector has

improved its balance sheet, the fiscal drag lessens this year and Europe looksmuch, much better. There may be other less familiar drags upon growth in thecoming year: problems in emerging markets, higher US mortgage rates and thedebt-ceiling problem doesnt seem to want to die. However, growth should bepretty decent.

Overall, stronger global growth, disappearing financial repression andgrowing evidence that the copious spare capacity is disappearing create agood environment for somewhat higher Treasury yields and we see the 10YUST at around 3%by year-end.

Fig 1. UST yield increases since October 2013 Fig 2. Global growth expectations rising

Source: Bloomberg Source: Bloomberg

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08 January 2014 3

The belly really is achingA 3% UST 10Y can be achieved by the end of the year because by then thefirst Fed hike will be viewed as a matter of months rather than years away. A75bp movement from todays yield of around 3% is roughly half the sell -off paceof 2013 and will take the 10Y yield back to the upper end of the trading rangesseen in 2009-11. With this in mind, Treasury investors need to find a place to

hide.Throughout the Great Recession and recovery, FX strategists have often usedthe phrase picking the least-ugly currency because no currency had strongfundamentals behind it. For the US rate market maturity selection this year,investors are in the same boat; we do not expect good returns from anywhere.

For example, the 2Y yield has often been considered the safe-haven sector but,over the past few weeks, even this sector has started to move. Aside from a briefperiod in 2013, the existing 2Y yield is at the highest levels witnessed since mid-2011 and the front end of the curve is just beginning its sell-off. As the economymoves inexorably toward the first Fed hike, we have every expectation that the2Y yield will leap. However, in the first half of this year, the 2Y will still possesssomething akin to a safe-haven property.

In Figure 3we have plotted the 2-5Y UST spread showing that it is getting closeto the highest levels at which it has ever traded (the spread generally hits around150bp before the start of any rate-hiking cycle). The 2-5Y spread is currentlyaround 130bp, so perhaps the risk/return does not look that great. But, if therewas ever an environment in which we might argue that the spread should gosteeper than usual, it is this one. The level of Fed Funds is zero and the Fed haspromised to keep rates this low for longer than it really should, to ensure thatspare capacity is quickly soaked upthe Fed wants to overheat the economy.Figure 3is one reason why investors are quite content to sit in the 2Y part of thecurve at present; in a sell-off, the front end of the curve is a long way fromreaching the moment when the 2Y really leads a sell-off from the sub-5Y sector.

Equally, when we look at forward rates such as 5Y5Y, it is usual that such aforward would move up at a slower pace than the spot rate might once it

reaches reasonable levels. For the yield curve to do this, there is a flatteningbias between 5Y and 10Y spot in the later stages of a bond bear market. It canbe seen from Figure 4 that the 5Y5Y swap has reached the 4-6% range thatprevailed in the years before the Great Recession (currently 4.54%). We expectthe 5Y5Y can go higher but will likely do so at a slower pace than the spot 5Y.

It is difficult to convince people to underweight the belly of the curve because it isthe best part of the curve for roll and carry. However, the assumed returns fromrolling down the curve will work only if the yield curve is stable, but this is notsomething that should be expected this year. In short, the recent weakness ofthe 5Y sector compared to other sections of the curve looks set to continueat least through the early part of the year. The underperformance of the bellywill swamp its roll and carry advantage.

Fig 3. 2-5Y Treasury spread Fig 4. 5Y swap versus 5Y5Y swap rate

Source: Bloomberg Source: Bloomberg

[email protected]

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mailto:[email protected]:[email protected]


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08 January 2014 4

US Interest Rates Derivatives

Market normalisation finally beginsAfter five years of extraordinary measures, positive momentum in the economyhas led to growing expectations of an end to quantitative easing and an eventual

end to zero interest rate policy (ZIRP); following last months taperingannouncement, things have changed. Across markets we have begun to see aparadigm shift, as markets are beginning to normalise. We have seen this beginto play out in rates markets as, for example, the 5-30Y curve has flattened in abear market as growth has accelerated.

Moreover, in non-rates volatility markets, what were fairly benign short expirymarkets began to exhibit rising implied volatility. In particular, in the past monthboth EUR-USD 3M volatility and the VIX have risen noticeably and brokenthrough their 100-day moving averages. The former touched levels it last saw inSeptember, while the latter breached 16, a level it had not been near since theUS government shutdown. Meanwhile, 3M10Y implied swaption volatility, aftera mild rise to start the month, declined and flat-lined for the remainder ofthe month and has been effectively unchanged since the December FOMC

announcement. We acknowledge that long-term correlations between cross-asset volatility markets are weak. However, typically short-term trended rallies ordeclines tend to be coincidental across volatility markets. There are severalfactors that could explain this lack of excitement, as of late in rates volmarkets, but we would focus on three main ones:

1. A change in the dynamic of the curve;

2. Proximity of long-term rates to natural levels; and

3. A normalisation of the volatility surface.

The first factor is the most basic: as we move towards a more normal rate cycle,the front end of the curve should be more susceptible to variance between Fedpolicy and market expectations. Each additional step in tapering as well as avirtuous cycle in the economy brings markets one step closer to an exit fromZIRP. Furthermore, as Fed officials have noted in recent comments, the Fed iscapable of raising interest rates without first removing excess liquidity. As thepotential for bear flattening increases in the market, conditional bearflatteners provide less and less attractive terms.

Specifically in the current market, to strike a 3M->2s10s conditional bear flattenerat zero-cost, and if you strike the 3M2Y payer at at-the-money forward (ATMF),the 3M10Y payer would be struck at ATMF+22bp. Leaving everything elseconstant and shifting vols to levels just prior to the FOMC, the 3M10Y payercould be struck at ATMF+35bp for a zero-cost tradepreviously attractive termsare disappearing.

Fig 5. Both FX and equity vols rose towards the endof the year

Fig 6. Front-end vols have outperformed back-end

Source: Bloomberg, Credit Agricole CIB Source: Bloomberg, Credit Agricole CIB

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08 January 2014 5

The first factor is obviously only part of the story in rates, and the second factoralso helps explain the recent underperformance of gamma (ie, short expiryoptions) of longer tails (ie, maturities). The second driver is that, with the 10YTreasury bouncing around 3.00% and the long bond very near 4.00%, long-datedinterest rates no longer look that expensive, as the ten-year average for the twois 3.49% and 4.22%, respectively. For comparison purposes, the 2Y note has amean of 2.00% over the same period. Volatility markets seem to have taken this

into consideration, as noted by the recent and significant decline in volatility skewshown in Figure 7. With longer-term rates moving to a more neutral rate, theexpected probability of rates moving higher vs rates moving lowerbecomes more symmetric, which helps explain why the difference in level ofimplied volatility of a 3M10Y ATMF+25 option and ATMF-25 the skew hasdecreased.

Furthermore, we have decomposed the volatility surface via principal componentanalysis (PCA), to highlight the three main analytical drivers of the shape of thesurface. This is similar to performing PCA on the yield curve to decompose theyield curve into shift (level), twist (curve), and bow (convexity), with similarinterpretations. Obviously, with PCA there are as many principal components asthere are time series used, but traditionally the first three provide a significantamount of the explanatory power.1When comparing the first principal component

(PC) to the level of 3M10Y implied volatility we notice that, in the past month orso, the two have diverged as the gamma of tails 5Y and longer havegenerally underperformed the rest of the surface .2In other words, 3M10Y volis not moving so precisely with the global move in vol there is moreindependence.

Fig 7. Vol spread for 3M10Y +/-25 risk reversal Fig 8. 3M10Y vol no longer correlates with first PC

Source: Bloomberg, Credit Agricole CIB Source: Bloomberg, Credit Agricole CIB

The final factor that is likely to drive volatility as we look to escape from a world ofquantitative easing is a fundamental change in the volatility surface towardsnormalisation. The current shape of the volatility surface is far from a normal one.At the moment, the peak of the volatility surface is at the 5Y1Y point as the belly

of the curve has been the most volatile. However, with the Fed in play in thecoming year or two, one would not expect a one-year strip of rates five years outto be the one most conditioned upon Fed policy. Instead, we typically wouldsee implied vols around the 2Y2Y point of the surface to be at the peak ofthe hump. There is a two-fold reason for this: although markets have a decentidea of what the Fed will do over the next two years, thanks in part to the FedsSummary of Economic Projections, the pace at which it proceeds beyond thatpoint as well as the economic conditions that may arise between now and thenare far less certain.

jonat han .r ick@c a-c ib.com

1When performing PCA on the level of volatility the first three principal components explain 98%

of cumulative variance on the past one year of data with the first PC explaining 90% on its own.2Using the first three PCs shows a similar divergence, and can be seen in our daily USD Interest

Rates Derivatives Report.

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08 January 2014 6

Eurozone Directional View

Bearish bond outlook remains in place for 2014In 2013, the almost uninterrupted drop in core EUR rates that began in early2011 finally came to an end. However, with the 10Y EUR swap rate closing just

45bp higher on the year, the sell-off was a fraction of the bear market moves thatbegan in 1999 and 2005 or even the abortive sell-off of late-2010 (Fig. 9). Thevery moderate rise in rates reflects a number of factors from still moderateEurozone output growth to advances in ECB policy communication (forwardguidance, etc).

The limited upside momentum for rate levels has left core EUR rates trailingwell behind UST yields, to which they have traditionally been very highlycorrelated (Fig. 10). As a result, despite both the ECB and Fed promising to keeppolicy rates near 0% for protracted periods, the EUR curve is much flatter thanthe USD curve. For instance, the 2s10s spread is around 170bp in Germany ascompared to nearly 260bp in USTs. Such large pick-ups by US rates relative toEUR ones are not unusual in the initial stages of past bond sell-offs but havetended to be reduced significantly over time.

Fig 9. EUR 10Y rate in past sell-offs Fig 10. EGB yields lagging rise in UST yields

Source: Bloomberg, Crdit Agricole CIB Source: Bloomberg, Crdit Agricole CIB

The standard explanation for the historically high difference between US andEurozone medium-term rates is that the US has been growing and shouldcontinue to grow more rapidly the latest YoY real GDP figures being,respectively, +2.0% and -0.4%. However, the key consideration going forward isthat Eurozone growth has been gradually accelerating and should continueto do so. The Eurozone PMI points upward and has been catching up to the USISM. The Eurozone as a whole continues to post current account surpluses,despite a firm exchange rate, suggesting that accelerating growth elsewhere inthe Atlantic rim will generate further growth in the Eurozone.

Signs of renewed growth potential are also evident in the pick-up in gross fixedcapital formation, which in Q3 marked the first set of two consecutive positivefigures since 2008. Lastly, the overall level of intra-EMU dispersion in economicsentiment has decreased significantly, despite ongoing differences betweencountries.

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08 January 2014 7

Fig 11. EMU-US ISM-PMI spread and EMU C/A balance Fig 12. EMU GDP out of recession (%)

Source: Markit, ISM, Eurostat, Crdit Agricole CIB Source: Eurostat, Crdit Agricole CIB

Another factor that suggests that EUR rates will rise more steadily in 2014 is thatthe safe-haven premium associated with core EGBs should shrink moremarkedly(we discuss the reasons for this view in our EurozoneRelative Valuesection). In the second half of last year, the core-peripheral yield spreadcompression decelerated clearly as domestic periphery investors booked profitsand core institutions postponed some periphery buying until after the 2013 year-end. This was mirrored just as clearly in the lack of reduction in Target 2balances at national central banks, an indicator of banking system fragmentation.

Spreads have recently resumed their convergence process, and we think that acombination of improving fundamentals and ECB policy measures will also fostera degree of normalisation in EMU banks and, as a consequence, core EUR rates.

Another way to conceptualise the steeper/higher core EUR curve (in absoluteterms and relative to the US) is to consider that, in the moderate but positivegrowth scenario we have for the Eurozone economy, ECB policy support thisyear is likely to be targeted firmly at maintaining and improving interbankliquidity, reversing the negative corporate credit growth rateand reducing

banking system fragmentationalong national lines. We do not expect any ofthe measures linked to this effort to be announced in January, but there shoulddefinitely be significant progress in H1.

Between now and year-end, we expect further, significant rises in core EURrates, especially beyond the 2-3Y maturity.

luca. jel l [email protected]

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08 January 2014 8

Eurozone Relative Value

New Yearsresolutionfor periphery spreadsThrough the second half of last year, flows and pricing momentum for theperiphery convergence trade decelerated significantly. On the one hand,

domestic investors (especially banks) booked some profits on their largeperiphery bond positions, and on the other that outflow was not met with sufficientinterest from abroad (although it did increase) to prevent a deceleration in therate of yield spread convergence. Similarly, in the run-up to year-end, indicatorsof Eurozone banking system fragmentation such as gross Target 2 balanceswith national central banks and recourse to money-losing deposits with the ECBsuggested that risk aversion has been retreating at a less robust rate thanbefore.

This apparent loss of convergence momentum brought forth an understandablebut, in our opinion, misled flood of questions about whether periphery spreads (atleast in the liquid issuers) had reached some sort of fairor equilibriumlevel. Wethink that is unlikely for a number of reasons:

First of all, the overall trend remains firmly in place. If we divide the data setfrom tops to troughs, that naturally tends to exaggerate the dynamics as

observed ex-post; but, if we look at more neutrally-defined time periods, wesee that progress has been comparatively even. Using the Spain-Germany10Y spread as a benchmark, the rate of convergence went from 76bp inH212 to 105bp in H113 and then 81bp in H213. The corresponding figuresfor the Italy-Germany spread were 106bp, 36bp and 72bp. Furthermore, wewould point out that on a month-to-month basis, weighted average peripheryspreads have not suffered a major reverse since April 2013 and noactual losses (on that basis) since September.

In any case, there is a plethora of evidence, including in our research 3, tosuggest that the relationship between sovereign spreads andmacroeconomic or fiscal differences is too econometrically unstable to be

able to define usefully a stable fairvalue. The fundamentals certainly matterbut within a context of often turbulent flows.

Fig 13. Re-acceleration in EMU spreads convergence Fig 14. Periphery deficit/GDP* tightening

Source: Bloomberg, Crdit Agricole CIB. Source: Nation finance ministries, Crdit Agricole CIB.

* = Italian data adjusted for funding flows referring to previous FY.

The strong convergence price action more recently needs to be confirmed in amore normal environment of flow volumes, but it does suggest we were correct inthinking that, come the New Year, both domestic and internationalinstitutions would be minded to allocate more risk budget to the peripherytrade4. That is not to deny that there are always significant domestic and EUpolitical risks to the convergence process, ranging from the variable willingness of

German authorities to support more mutualistic solutions to the stability of variousperiphery governments and their commitment to austerity. At the same time,

3See for instance:Fundamentals and EGB valuations still converging,Nov. 2013.

4With specific reference to banks, see:Will periphery banks still support their govvies in 2014?,

Dec. 2013.

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08 January 2014 9

however, investor sentiment regarding sovereign risk in the Eurozone has beenunderstandably buoyed by the broad improvement in economic sentimentand external sector balances, confirmed most recently by strongmanufacturing and service sector PMI data.

The early part of the fiscal year sees the publication of final deficit figures forthe preceding year and adjusted forecasts for the current one . Since 2010,that newsflow has had a significant impact on spread trends. The indications we

can glean from the 2013 data available at this point is that the broad thrust fromthe periphery will, again, be positive. This, too, should provide a seasonalfillip to the convergence process.

Turning to individual sovereign issuers within the periphery:

Italys expected central government (CG) supply looks rather differentdepending on whether one looks at net or gross measures. Gross supply willremain quite high at over 15% of GDP but, in net terms, the figure is arelatively slim 3.5% of GDP and a major drop from last years 6.5%5. At anyrate, supply is due to fall slightly even in gross terms and we expect this mostliquid periphery issuer to attract demand despite still so-so growth.

Spain has recently put in some strong macro figures, especially in terms offorward-looking indicators. Having exited the bank recap support programme,it seems reasonable to believe that there will be no shocking surprises fromthe AQR, a view confirmed by the Spanish debt agency itself. If that is so, weexpect the still-substantial net supply requirement (above 5% of GDP, in2014) to be cut too.

Ireland and Portugal are perceived by rating agencies and the market quitedifferently, but they are both scheduled to return more decisively to themarket this year. In both cases, the amount they need to raise on bondmarkets is unlikely to be above EUR10bn and therefore should bestraightforward to achieve. The Irish are already funded through this year andtherefore their new 10Y issue amounts to further pre-funding.

In positioning terms, we continue to like:

The absolute valuation of Portugal, with 10Y yields still above 5.5% and 3Yyields above 3%,

Periphery-Core relative flatteners (periphery term structures are muchsteeper than in the core)

The strategic recommendation to switch duration risk into sovereigncredit risk for a similar running yield (the Aug-2023 Bund yield not morethan the Jul-2017 Obligacin, for instance).

Fig 15. The Italy-Germany relative flattener Fig 16. Return of switching duration into credit

Source: Bloomberg, Crdit Agricole CIB. Source: EFFAS, Crdit Agricole CIB.

Total return difference between EFFA index maturity buckets.

luca. jel l [email protected]

5The large difference between Italys financing need and Eurostat deficit in 2013 was due

principally to the payment of pre-existing debt, which had, correctly, already been accounted forin previous years.

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Normalisation remains the dominant RV regime for 2014If we are right about the path for interest rate markets in 2014, with a likelyprotracted sell-off of long-term core rates driven by further US economicrecovery, then we would expect to see more investors utilising RV strategies toboost returns in the coming quarters. No longer will it suffice to find extra yieldsimply by taking on more duration or credit risk. If more investors turn to RV, then

market efficiency should continue to improve, and we expect the strategies weemploy (a combination of curve fitting and mean reversion) in ourEUR Govt RVpublicationto improve in the consistency of their returns.

Normalisation was a great theme of 2013, not only in terms of periphery yieldlevels returning to historical averages and spreads tightening from crisis levels,but also in the RV space, as much of the periphery curve was unevenly pricedlast year as it continued its transition away from distressed pricing. The yieldcurve models we use in our EUR Govt RVpublication have proven very effectivein highlighting normalisation RV opportunities.

Currently, there are still very large standard errors in our models forinvestors to exploit, particularly in Italian (4.8bp) Spanish (6.5bp) and French(3.6bp), which are comfortably larger than the typical bid-offer spreads in thesemarkets, which augurs well for micro-RV strategies to continue to perform well.

Moreover, as the ECB is likely to keep the Refi rate very low for a long time (ourmacroeconomists forecast a first rate hike in 2016), the favourable fundingenvironment should further aid RV strategies.

One of the biggest normalisation opportunities in 2013 was the excessivecurvature of peripheral markets particularly in Italy and, although this wassomething that took considerable time to correct, strategies based on this (suchas theBTP 2015-2017-2019 fly that we closed recently)paid handsomely. Theequivalent periphery curve trade for 2014 is, we believe, the 5s10s flattenerin Spain and Italy. We wrote about theattractiveness of receiving Italys 5Y5Yearly in December 2013(the same applies for Spain), and in Figures 17 and 18below we simply note the directional relationship of Italys 5s10s slope againstthe 10Y Italy-Germany spread. The steepening which took place in Q413 hastaken the slope back up to extremes, not only in outright terms but also in

these directionally-adjusted terms.

Fig 17. Italy 5s10s slope vs 10Y BTP-Bund spread Fig 18. BTP 5s10s residual to 10Y BTP-Bund derived fit

Source: Crdit Agricole CIB Source: Crdit Agricole CIB

One could look at Figure 17 above and think that the 5s10s flattener is a bearishtrade. We think not it is a trade which has optionality within it due to theinflection we expect to see in periphery 5s10s slope directionality. Figure 19 putsthe 5s10s slopes in context with other core and semi-core EGB paper (thedataset is the past year) and we have fitted a quadratic function through the data.Our point is simple as periphery spreads continue to tighten, the 5s10sslopes should enter a bull-flattening regime, but on the other hand the 5s10sflatteners should perform well if any serious stress materialises in periphery

markets. The Italian or Spanish 5s10s flattener is thus not only cheap comparedto the spread to Germany but we also expect it to be far less directional .

y = -0.1381x + 153.2R = 0.1769

80

90

100

110

120

130

140

150

150 200 250 300 350 400

IT5

s10s

(bp)

ITDE10 (bp)

-20-15

-10

-5

0

5

10

15

20

25

Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13

bp

IT 5s10s steep
https://catalystresearch.ca-cib.com/web/guest/interest-rates/publication?p_p_id=lastreleases_WAR_lastreleasesportlet&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&p_p_col_id=column-1&p_p_col_pos=1&p_p_col_count=2&_lastreleases_WAR_lastreleasesportlet_filterIdx=7&_lastreleases_WAR_lastreleasesportlet_filterLabel=EUR+Govt+RV+Report&_lastreleases_WAR_lastreleasesportlet_filterType=408&_lastreleases_WAR_lastreleasesportlet_tabIdx=1&_lastreleases_WAR_lastreleasesportlet_pageIdx=1&_lastreleases_WAR_lastreleasesportlet_displayGroupLabel=&_lastreleases_WAR_lastreleasesportlet_type=https://catalystresearch.ca-cib.com/web/guest/interest-rates/publication?p_p_id=lastreleases_WAR_lastreleasesportlet&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&p_p_col_id=column-1&p_p_col_pos=1&p_p_col_count=2&_lastreleases_WAR_lastreleasesportlet_filterIdx=7&_lastreleases_WAR_lastreleasesportlet_filterLabel=EUR+Govt+RV+Report&_lastreleases_WAR_lastreleasesportlet_filterType=408&_lastreleases_WAR_lastreleasesportlet_tabIdx=1&_lastreleases_WAR_lastreleasesportlet_pageIdx=1&_lastreleases_WAR_lastreleasesportlet_displayGroupLabel=&_lastreleases_WAR_lastreleasesportlet_type=https://catalystresearch.ca-cib.com/web/guest/interest-rates/publication?p_p_id=lastreleases_WAR_lastreleasesportlet&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&p_p_col_id=column-1&p_p_col_pos=1&p_p_col_count=2&_lastreleases_WAR_lastreleasesportlet_filterIdx=7&_lastreleases_WAR_lastreleasesportlet_filterLabel=EUR+Govt+RV+Report&_lastreleases_WAR_lastreleasesportlet_filterType=408&_lastreleases_WAR_lastreleasesportlet_tabIdx=1&_lastreleases_WAR_lastreleasesportlet_pageIdx=1&_lastreleases_WAR_lastreleasesportlet_displayGroupLabel=&_lastreleases_WAR_lastreleasesportlet_type=https://catalystresearch.ca-cib.com/web/guest/interest-rates/publication?p_p_id=lastreleases_WAR_lastreleasesportlet&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&p_p_col_id=column-1&p_p_col_pos=1&p_p_col_count=2&_lastreleases_WAR_lastreleasesportlet_filterIdx=7&_lastreleases_WAR_lastreleasesportlet_filterLabel=EUR+Govt+RV+Report&_lastreleases_WAR_lastreleasesportlet_filterType=408&_lastreleases_WAR_lastreleasesportlet_tabIdx=1&_lastreleases_WAR_lastreleasesportlet_pageIdx=1&_lastreleases_WAR_lastreleasesportlet_displayGroupLabel=&_lastreleases_WAR_lastreleasesportlet_type=https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=08fa700b-f2ee-4f76-9778-5b3f249c8a8e&groupId=10138&articleId=754375https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=08fa700b-f2ee-4f76-9778-5b3f249c8a8e&groupId=10138&articleId=754375https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=08fa700b-f2ee-4f76-9778-5b3f249c8a8e&groupId=10138&articleId=754375https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=fa902ca8-e3ff-44a1-ad69-0479f5af18a4&groupId=10138&articleId=736007https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=fa902ca8-e3ff-44a1-ad69-0479f5af18a4&groupId=10138&articleId=736007https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=fa902ca8-e3ff-44a1-ad69-0479f5af18a4&groupId=10138&articleId=736007https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=fa902ca8-e3ff-44a1-ad69-0479f5af18a4&groupId=10138&articleId=736007https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=fa902ca8-e3ff-44a1-ad69-0479f5af18a4&groupId=10138&articleId=736007https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=fa902ca8-e3ff-44a1-ad69-0479f5af18a4&groupId=10138&articleId=736007https://catalystresearch.ca-cib.com/web/guest/reportreader?uuid=08fa700b-f2ee-4f76-9778-5b3f249c8a8e&groupId=10138&articleId=754375https://catalystresearch.ca-cib.com/web/guest/interest-rates/publication?p_p_id=lastreleases_WAR_lastreleasesportlet&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&p_p_col_id=column-1&p_p_col_pos=1&p_p_col_count=2&_lastreleases_WAR_lastreleasesportlet_filterIdx=7&_lastreleases_WAR_lastreleasesportlet_filterLabel=EUR+Govt+RV+Report&_lastreleases_WAR_lastreleasesportlet_filterType=408&_lastreleases_WAR_lastreleasesportlet_tabIdx=1&_lastreleases_WAR_lastreleasesportlet_pageIdx=1&_lastreleases_WAR_lastreleasesportlet_displayGroupLabel=&_lastreleases_WAR_lastreleasesportlet_type=https://catalystresearch.ca-cib.com/web/guest/interest-rates/publication?p_p_id=lastreleases_WAR_lastreleasesportlet&p_p_lifecycle=0&p_p_state=normal&p_p_mode=view&p_p_col_id=column-1&p_p_col_pos=1&p_p_col_count=2&_lastreleases_WAR_lastreleasesportlet_filterIdx=7&_lastreleases_WAR_lastreleasesportlet_filterLabel=EUR+Govt+RV+Report&_lastreleases_WAR_lastreleasesportlet_filterType=408&_lastreleases_WAR_lastreleasesportlet_tabIdx=1&_lastreleases_WAR_lastreleasesportlet_pageIdx=1&_lastreleases_WAR_lastreleasesportlet_displayGroupLabel=&_lastreleases_WAR_lastreleasesportlet_type=


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08 January 2014 11

Fig 19. EGB 5s10s slopes vs 10Y BTP-Bund spread

Source: Crdit Agricole CIB

[email protected]

Firm agency/supra market, but some intra-market valueHigh-quality liquid Euro agency/supra bonds6performed solidly last year, in bothoutright and relative terms, following what was a big revival of the market in 2012.At least part of this markets attraction has been the valuable yield inrelative termsduring a two-year period of low core sovereign bond yields thatfrequently set new record lows. Another test of the lows in the 10Y Bund yield isvery unlikely this year. On the contrary, both internal (improving macro core andperiphery data) as well as external factors (Fed tapering and signs of a sustainedUS economic recovery) are key driving forces that should push Euro core bondyields higher, to levels not seen for two to three years.

A persistent rising yield move this year (our scenario) would present adifferent environment for the Euro agency/supra market. In theory, highersovereign yields make maintaining tight spread levels harder as some investors

feel the return on sovereigns has become more desirable. However, over thepast year higher yields have coincided with the core-agency/supra yield ratiofalling and vice versa (Fig. 20). The spread remained broadly stable even asyields rose. That said, the high point for the 5Y German yield over the past twoyears has been only 1%. A yield in close proximity to 1.75% (our year-endscenario) could be more of a challenge to keeping the spread tight. Even in arising-yield environment, we maintain our long-standing positive stance onthe Euro agency/supra market relative to sovereigns and swaps, given theminimal risk concerns that have featured prominently in the past, such as EFSFssovereign and banking exposures pre-LTRO/OMT. However, at spread levelsto sovereigns there is limited room to richen further.

Fig 20. 5Y agency-sovereign yield ratio* vs direction Fig 21. Euro-liquid core issuance and 2014 target

Source: Crdit Agricole CIB, Bloomberg.* KfW, CADES and BNG versus their core sovereign issuers

Source: Issuer websites, Crdit Agricole CIB* Crdit Agricole CIB forecast

6We classify high-quality liquidissuers here as KfW, CADES and BNG alongside pan-

European issuers like EIB, EFSF, ESM and EU/EFSM.

40

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Austria France

Belgium SpainItaly Netherlands

5s10s

(bp)

10Y Bund spd (bp)

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1.2

1.1

1.2

1.3

1.4

1.5

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1.7

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

Yield ratio * - lhs

5Y German yield - rhs

% %

7971

4530

20 15

6572

58

14 6 15 9

68 70

35

15 5 15 17

0

10

20

30

40

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8090

KfW EIB EFSF CADES* EFSM(EU)

BNG* ESM

2012 2013 2014

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12/22


08 January 2014 12

The few risks going into this year are likely to be specific to a minimal numberof issuers. For instance, the ESM is lender/investor of last resort for thebanks, which could be triggered if banks find raising capital difficult following theAQR and stress tests later this year. This could see the ESMs modest EUR17bnissuance target increase. Broadly speaking, the markets supply volume should be roughly similar to last year (Fig. 21), though this has hardly been a point ofconcern for some time. Another potentially vulnerable issuer is CADES due to

pressure from French economic concerns. However, we do not see adecoupling of French sovereign bonds relative to their core counterparts in themonths ahead even if there could be some pressure in the near term.

When looking intra-market(Fig. 22 and 23) we still see potential for CADESbonds to underperformneighbouring EFSF bonds, especially the 3-7Y area ofthe curve. Despite the bank recapitalisation risk, we think ESM looks decentvalue against EFSFgiven its guarantee structure and creditor status. Among themore expensive issuers, KfW bonds that trade cheaper than EU bonds areattractive, such as KfW 4.375% Jul-18 at a 7bp pick-up against EU 3.25% Apr-18. Meanwhile, there could be an argument for stronger-performing EIBbonds beyond the 5Y relative to their richer peers helped by its guaranteestructure and diverse and historically sound loan portfolio.

Fig 22. Agency/supra ASW term structures Fig 23. Duration-weighted ASW quarterly change

Source: Crdit Agricole CIB, Bloomberg Source: Crdit Agricole CIB, Bloomberg

[email protected]

-50

-40

-30

-20

-10

0

10

20

30

40

1 2 3 4 5 6 7 8 9

bp

Duration

KFW CADES BNG

EIB EU EFSF

ESM-6

-4

-2

0

2

4

6

8

KfW CADES BNG EIB EU EFSF

Q3

Q4

bp

Cheapeningvs swap

Richeningvs swap


13/22


08 January 2014 13

Asian Rates View

Adjusting higher in a post-tapering environmentThere have been a few exceptions to the generally upward movement in Asianrates in the past month, despite the beginning of the Fed taper. Notably, KRW

IRS and THB IRS moved down across the curve in December, with a resilientbond market for the former and likely increasing demand for overseas investmentfor the latter of which the floating leg is an FX swap implied rate. For otherrates, the development is clearly to the upside, most obviously for CNY IRSwhere domestic factors are adding to the momentum, followed by HKD IRS andSGD IRS, which have high correlations with USD IRS.

For the year ahead, there is no one rule fits allwhen it comes to monetary policyin Asia. But the bottom line is that real interest rates are either negative or verylow, pointing to very limited room for individual economies to cut their policyrates. This backdrop sets a floor to rates.

Asian rate movements will be driven primarily by changing capital flows in a post-tapering environment. Yield pick-up from asset swap trades in sovereign bonds from a USD-funded investors perspective is negative in most Asian markets.We would expect most Asian sovereign yields to move higher to becomeappealing again to foreign investors.

Given high correlations between USD IRS and most Asian IRS on a 12M horizon,we expect Asian IRS to go higher alongside USD IRS in the coming quarters.However, there could be divergences in the near term, as already suggested bysome breakdowns in 3M correlations, when local factors are the driver, such thatthere could be a delay before Asian markets react. Curve moves could also differ,because some Asian curves have steepened a lot already while others arelagging. Towards the latter part of 2014, whether Asian rate curves will flattenback depends on market expectations on front-end rates, which in turn dependsin part on how effectively the Feds forward guidance works.

The HKD IRS, TWD IRS and SGD IRS curves have steepened relatively more

than other Asian curves. These curves could remain steep during Q114 asinvestors are still gauging the pace and impact of Fed tapering. However, as theyear progresses, these curves, especially the HKD and SGD IRS curves, couldflatten back if front-end rates start to react to the prospect of a Fed funds targetrate hikealthough this expected hike may still be some time away. On the otherhand, the CNY IRS curve looks relatively flat, compared with its own history andwith its regional peers. We expect the CNY repo-IRS curve to steepen across the1-5Y and 2-5Y segments in particular, with the risk to this view being a yet-unexpected tightening in CNY liquidity.

Fig 24. Asian rates to rise with USD rates Fig 25. There will be short-term divergences


12-month correlation betw een LCY IRS and USD IRS

0.00

0.25

0.50

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1.00

SGD HKD TWD PHP KRW MYR INR CNY THB

2Y 5Y 10Y

Correlation betw een 2Y LCY IRS and USD IRS

-1.00

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1.00

HKD SGD PHP TWD THB INR MYR KRW CNY

3M 12M


14/22


08 January 2014 14

Individual marketsFront-end HKD IRS can continue to rise relative to USD IRS, with HKD liquiditypotentially tightening. It is worth monitoring the HKD bank loan situation thepercentage of HKD loans for use outside Hong Kong keeps increasing. We alsonotice there have been carry trades receiving 2Y and 3Y HKD IRS we wouldbe looking to pay these rates beyond Q114. EFBNs have become bearish

alongside USTs, but we see EFBNs outperform USTs, as EFBNs have a morefavourable demand/supply dynamics.

When asset swap trades are not viable in most Asian markets, bond investors willgo for local currency bonds with a relatively stable FX outlook KRW is one ofthe obvious choices. Structural flows from the foreign public sector are key forKTB outperformance compared with regional peers. That said, KTB yields haveto adjust higher to become attractive to more foreign investors. In this process ofupward adjustments in yields, we expect the KTB curve to steepen, as foreigninvestors will likely choose not to leave the KRW bond market entirely but ratherto shorten their portfolio duration. The KRW IRS curve should follow.

In Thailand, while net LB supply in FY13/14 is scheduled to be less than inFY12/13, there is a risk that fiscal policy will become even more expansionaryover the course of the year after disbursement gets back on track, with needs for

stimulus and for extra money allocated to the rice pledging scheme. Asset swaptrades in LBs from a USD-funded investors perspective are not appealing either.LB yields would be under upward pressure. The LB curve, however, is alreadyvery steep so we see scope for a flattening move in 2014. The THB IRS is steepas well, but it may maintain its steepness relative to the LB curve, as increaseddemand for overseas investment will push down 6M THBFIX an FX swapimplied rate, and front-end THB IRS.

In the offshore RMB market, we see further upside to CNH cross-currency swap(CCS) and offshore CGB yields across the curves. First, offshore rates have tocatch up with the recent, marked upward moves in onshore CNY rates. Secondly,there would be a lack of receiving flows in CNH CCS, with the current levels stillnot attractive for opportunistic dim sum bond issuers to issue CNH bonds andswap the CNH proceeds back into USD. Thirdly, we suspect that a large bulk of

the HKD loans for use outside of Hong Kong have been extended to mainlandentities, which could result in paying flows at CNH CCS if they decide to swap theHKD loans into RMB. We expect more offshore RMB bonds to be issued inTaiwan in 2014. With the withholding tax in place, RMB bonds in Taiwan may notbe particularly attractive to foreign investors. Still, there would be interest fromlocal investors, especially if RMB bonds issued in Taiwan are to be exempt fromthe overseas investment limit (nothing is confirmed yet).

Fig 26. Curve slope dynamics have varied Fig 27. Asset swap trades not attractive


f [email protected]

2/5 IRS slope

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0

2040

60

80

100120

140

160

180

11 12 13 14

bpUSDAverage of HKD, SGD, MYR, THBAverage of CNY, KRW, TWD

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-160

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0

HKD MYR INR KRW THB CNH SGD

bp

yield pick-up from 5Y LCY

govies, USD funded


15/22


08 January 2014 15

Inflation-Linked Strategy

Dealing with very weak EUR inflation until Q3Overall, 2013 was a painful year for European linkers, with falling realisedinflation and increasing real yields, which resulted in large negative total returns

and declining interest from investors. As an illustration, in the 10Y area, German,French and Italian breakevens all declined by about 30bp (Fig. 28). Even Italianbreakevens, which had recovered in 2012 thanks to improving sentimentregarding the periphery, disappointed in 2013.

Among the different factors driving breakevens, realised inflation will not helpbefore late 2014 (Fig. 29). Indeed, we expect that Eurozone HICP inflation willremain stuck in a 0.6-1.0% corridor until end-Q314, meaning nine more monthsof very subdued yearly inflation. To be more precise, our hypotheses arerelatively consensus-like regarding both oil prices and EUR/USD (which we seedeclining towards USD102/bl and 1.28 by end-2014, respectively). Only later in2014, a declining EUR and slightly better macro conditions forecast by oureconomists suggest gradually rising headline inflation, to around 1.3% by end-2014 and into a 1.3-1.5% range in 2015.

Fig 28. Falling B/E in 2013 Fig 29. More subdued inflation ahead in 2014 (%)

Source: Crdit Agricole CIB, Bloomberg.

B/E are seasonally adjusted.

Source: Crdit Agricole CIB, Bloomberg, Markit.

Supply-wise, the issuance programmes look relatively benign in 2014. InGermany, the Finanzagentur announced an I/L issuance programme of EUR10-14bn in 2014, similar to the EUR12.4bn seen in 2013. The 2014 programme willlikely include new 5Y and 10Y Bundis.In France, 2014 OATi and OATei shouldmake up about 10% of total AFT issuance, ie, about EUR17bn, which is a touchhigher than 2013 total issuance (EUR15bn).

The Italian issuance programme is more uncertain, given that the ItalianTesoro takes a more pragmatic approach, particularly with newer instrumentssuch as the BTP Italia. The success of the BTP Italia 2017 issue last year (arecord EUR22bn was issued in a day and a half) implies the Italian Treasury maysupply more modest amounts of BTPei than in the past and tap some BTP Italiasecurities or attempt new maturities.

With relatively stable I/L supply (France, Germany) and realised Euro inflationgyrating around 0.8% YoY in H113, the upside for core breakevens thereforelooks limited for at least six months,but a further fall looks equally unlikely inour view. All in all, given our nominal yield scenario of higher core, thestabilisation in breakevens means that core real yields will rise again . A risein 10Y German real yield of roughly 40bp by mid-June is plausible.

0.4

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Jan-12 Jan-13 Jan-14

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All down about

30bp in 2013 -2

-1

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08 09 10 11 12 13 14 15

Energy FoodIndus. Goods ServicesHeadline inf lation


16/22


08 January 2014 16

Italian linkers look more attractive in relative terms . First, Italian HICPx-linkedsupply may be more limited than before, given a possible orientation towardsBTP Italia. Secondly, Italian nominal yields should rise much more slowly thancore yields (see Eurozone Relative Value section) in 2014, implying a limitedrise in real yields assuming Italian breakevens stabilise. Already in 2013,Italian real yields stabilised, being the exception in the EUR I/L universe (Fig. 30).Lastly, there remains value in Italian HICPx-linked products, with real yields close

to 2.6% in the 10Y area and a steep real yield curve slope. The main flipside ofgoing long Italian I/L products is that in the past three weeks the BTPei 10Y realyield has fallen 30bp.

Fig 30. Core and Italian real yield paths have diverged Fig 31. Italian B/E still lower than core

Source: Crdit Agricole CIB, Bloomberg.

Real yields and breakevens are seasonally adjusted

US TIPS strategy: real curve bear flattening aheadOur US economists forecast that inflation will rise only gradually this year,from 1.24% to 1.80% by year-end (Fig. 32), driven by relatively cautiousunemployment forecasts (6.8% by Q414), a strong USD against most OECD

currencies and soft energy prices. Our core inflation forecast remains in a 1.6-1.9% corridor until year-end. Given stability in other breakeven determinantslike TIPS supply/demand, energy prices, etc, realised inflation will beimportant.Thus, low inflation means that the nominal yield rises that we areforecasting will manifest themselves mostly in the real yield rising. It is hardto imagine the 5Y breakeven (Fig. 33) much above 2% before mid-year, which isthe post tapering-talk-era high. We see the nominal 5Y UST at 2.55% by mid -year (+90bp or so) and somewhere in the region of +70bp in the 5Y real rate.

Fig 32. US realised inflation to rise very slowly in 2014 Fig 33. providing limited upside in breakevens

Source: Crdit Agricole CIB, Bloomberg Source: Crdit Agricole CIB, Bloomberg.

Breakevens seasonally adjusted

jean-f ran cois .p er r in@c a-c ib.com

-1.0

-0.6

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1.0

1.4

Jan-12 Jan-13 Jan-14

2

3

4

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6

7

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Core

Italy

season & carry adj. B/E

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2014 2019 2024 2029 2034 2039

OAT i Germ i BTP i

1.94

1.821.24

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0.5

1.0

1.5

2.0

2.53.0

3.5

4.0

10 11 12 13 14 15

CPI-U, NSA, y/y, % fcast

Nov. 13Dec. 14

Dec. 15

1.44

1.91

2.10

2.38

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1.6

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2.2

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2.8

Jan-12 May -12 Sep-12 Jan-13 May -13 Sep-13 Jan-14

TII 2 01/15/16, B/E TII 2.125 01/15/19, B/ETII 2.375 01/15/25, B/E TII 0.75 02/15/42, B/E


17/22


08 January 2014 17

Trade recommendations

rade Type Buy/ Receive Sell/PayEntryLevel

EntryDate

Exit Date Target Stop Latest 1M Carry P&L

1Switch old forcurrent 7Y USD

Current 7Y (T1.375% Jan

20)

Old 7Y (T1.125% Dec

19)2.2 bp 04/02/13 08/01/14 2 bp 3 bp 2.4 bp 0 bp 0.2 bp

22-5Y German ASWbox

Schatz ASWspread

5Y OBL ASWspread

-9.5 bp 03/04/13 08/01/14 -2 bp -12 bp -2.2 bp 0 bp 7.3 bp

3Buy 10Y OATs vsDSLs & RAGBs

Current 10YOAT

Current 10YDSL & 10Y

RAGB18 bp 20/05/13 open 10 bp 11.9 bp 0 bp 6.1 bp

4Switch duration intosovereign credit risk

1-3Y EFFASSpanish index

7-10Y EFFASGerman index

19/06/13 open 0 bp 5.25%

55Y KfW vs EUbonds

KFW 4.375Jul-18

EU 3.25 Apr-18

-7.9 bp 02/07/13 08/01/14 -12 bp -12.8 bp 0 bp -4.9 bp

610Y UST vs 10YGermany

10Y UST (T1.75% May-23)

10Y Bund(DBR 1.5%

May-23)94.9 bp 17/07/13 open 85bp 105bp 105.7 bp 0 bp -10.8 bp

7Spain-Italy 4-5-5Yfly BTP Jun17

Bono Oct16

and BonoJan18

52.7 bp 11/09/13 08/01/14 5bp 13.7 bp 1 bp 38 bp

8Buy 7Y SwapSpread

US 7Y SwapSpread

-15.4 bp 30/09/13 08/01/14 -4.4 bp 0bp -11 bp

9Sell current 3Y USTand buy current 2YUST

2Y UST 0.25Sep-15

3Y UST 0.875Sep -16

-31 bp 01/10/13 open -50bp -20bp -34.8 bp -3bp 6.8 bp

10Buy Current UST10Y vs 2nd UST10Y

UST 2.5 Aug-23

UST 2 Feb-23 5.9 bp 16/10/13 open 4bp 6.8 bp 0bp -0.9 bp

11Sell 5Y UST vs 3YUST & 7Y UST

UST 0.62510/16 & UST 2

09/20

UST 1.37509/18

-8.8 bp 17/10/13 08/01/14 0bp -8bp -23 bp 0bp -14.2 bp

12 2Y Swap SpreadUS 2Y swap

spread12 bp 05/11/13 open 15bp 8bp 10.9 bp 0 bp -1.1 bp

13 10Y - 30Y Flattener

UST 3.625

08/43 UST 2.5 08/23 110.1 bp 05/11/13 open 100bp 112bp 96.5 bp 0 bp 13.6 bp

14 2-3-5Y Fly sell bellyUST 0.25

10/15 & UST1.25 10/18

UST 0.62510/16

51.6 bp 07/11/13 open 45bp 62bp 60.2bp 0 bp -8.6 bp

15 BTP 3-4Y flattenerBTPS 3.5

11/17BTPS 2.75

11/1648.8 bp 11/11/13 open 25bp 50bp 50.1 bp 0 bp -1.3 bp

16 5Y Swap SpreadUS 5Y Swap

Spread11.3 bp 14/11/13 open 5.5 bp 0 bp 5.8 bp

17Buy ESM Oct-18against EFSF Jul-18

ESM Oct 18 EFSF Jul 18 -0.9 bp 08/11/13 open -10bp 2.1 bp -1.7 bp 0 bp 0.8 bp

18Receive 3M Eoniaand pay 9 x 12MEonia

3M Eonia 9x12M Eonia -0.5 bp 28/11/13 open -10 bp 5.5 bp . bp 0 bp -0.5 bp

19Sell 5Y UST vs 7Y

UST

UST 2 Nov-20UST 1.25 Nov-

18

73 bp 03/12/13 open 66 bp 74 bp 69.4 bp 0 bp 3.9 bp

20BTP-Bund 2023-2016 Box

BTP 4.5 03/24& OBL 1.25

10/16

DBR 1.5 05/23& BTP 2.75

11/1663 bp 04/12/13 open 25 bp 85 bp 65 bp -2.5 bp -4.4 bp

21buy 2Y Schatz inASW

Schatz ASWspread

-29.1 bp 04/12/13 open -40bp -25 bp -32.3 bp 0 bp 3.2 bp

22 US 2-3Y steepenerUST 0.25 Nov-

15UST 0.625

Nov-16-29.4 bp 05/12/13 08/01/14 -39 bp -27 bp -37.3 bp 0 bp 7.9 bp

23 US 5-10Y flattenerUST 2.75 Nov-

23UST 1.25 Nov-

18136.8 bp 06/12/13 open 120 bp 140 bp 128.5 bp 0 bp 8.3 bp

24Buy 30Y UST vs10Y

UST 3.75 Nov-43

UST 2.75 Nov-23

103.2 bp 09/12/13 open 90 bp 115 bp 93.3 bp 0 bp 9.9 bp

25Sell 2Y UST intoGerman 2Y

2Y SchatzDec-15

UST 0.25 Nov-15

-7.6 bp 12/12/13 open -18 bp -4 bp -17.1 bp 0 bp 9.5 bp

26Sell 3Y UST vs 10YUST

UST 2.75 Nov-23

UST 0.625Dec-16

219.2 bp 13/12/13 open 190 bp 235 bp 221.2 bp -1.75 bp -0.2 bp

27Switch out of 10Y1st old into 10YCurrent

UST 2.75 Nov-23

UST 2.5 Aug-23

3 bp 16/12/13 open 2.2 bp 3.4 bp 2.9 bp 0 bp 0.1 bp


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08 January 2014 18

Trade 1: The 7Y current (Jan 2020) appears cheap compared to older 7Y securities. Analysis of the past two years showsthat a new 7Y starts off poorly but then picks up steam. The pattern of performance suggests that the 7Y current will becomemore expensive to the spline curve in the coming weeks. Take Profit.

Trade 2: The heightened perception of banking credit risk in recent weeks has benefited bonds in the 5Y area most againstswaps. Our medium-term view for a simmering of fears should therefore see the OBL cheapen against swaps gradually. Werecommend selling the OBL against swaps in a 2-5Y German swap spread box.Take Profit

Trade 3: We plotted the z-spread of benchmark core-Eurozone 10Y bonds to the Euribor swap curve against both creditratings and adjusted required-primary-balances. From a statistical standpoint, French OATs offer better value than Dutchand Austrian paper in the 10Y area, and we would overweight it until the spread shrinks.Hold.

Trade 4: This trade involves swapping interest rate risk for credit risk while maintaining running yield in EGBs. Essentially,we sell longer-dated core paper and buy short-duration periphery paper with comparable yields. If economic recovery in theG10 bond markets does take place, then fiscal benefits to the periphery will be considerable.Hold.

Trade 5: In the intra-market, relative moves have made the pricing order among issuers fuzzier than before (eg, KfW wasthe most expensively priced issuer, pre-LTRO). In some cases, EU bonds are trading more expensively than neighbouringKfW bonds. We think the KfW 4.375% Jul-18 looks decent value against the EU 3.25% Apr-18 at -8bp. Take Loss

Trade 6: The spread between the two blocs is at its 89th percentile. If the US economy really begins to grow, a lot of thesafe-haven premium for Bunds will go.Hold.

Trade 7: Spain has outperformed Italy since mid-2012 with the trend accelerating post the Italian elections. Though we lookupon the current economic position of Spain more favourably than that of Italy we see relative headline risks as morebalanced than the current market suggests and note that sharp Italy-Spain spread swings have provided good tradingopportunities in the past. Given current momentum in favour of Spain we would be very cautious about building a long Italyposition. We enter the Spain Italy 3-4-5Y.Take Profit

Trade 8: Swap spreads tend to widen on a seasonal basis leading into Q4. This widening bias should be reinforced by thecurrent government shutdown/debt-ceiling concerns. Based on our models, existing swap spreads are due an adjustment.This trade looks particularly good at the 7Y tenor since the 7Y swap spread has cheapened of late. Buy 7Y swap spread. Take Loss.

Trade 9:Following the unexpected Fed tapering delay, the 3Y yield has dropped to an important support level of 0.61 and,without further impetus, we dont see it dropping below this level so we consider this a good level to sell. However, sellingthe 3Y directly would generate roll and carry losses of about 14.5bp per 3 months. To offset this we recommend buying the2Y, which in turn will reduce the losses to about 3bp. Hold.

Trade 10:As the debt ceiling approached, off-the-run issues declined in liquidity; in the event of a default this effect would ybe exacerbated, in which case we would expect some liquidity premium from holding the current 10Y, which would reducesome of the recent cheapening of the 10Y. However, if the debt-ceiling issue was resolved so the 5-10Y part of the curveshould probably flatten as the belly unwinds its recent outperformance leading to some flattening of the current 10Y relativeto the 2nd old. Buy current 10Y UST and sell 1st old 10Y UST. Hold.

Trade 11:Carry and roll have recently moved inversely to yield movements strengthening the 5Y sector (due to improvedcarry). We believe that delayed Fed tapering and the appointment of Yellen are already priced into markets and that thefollowing month will be data-heavy with added uncertainty on the impact of the shutdown. For this reason we sacrificepotential carry by selling the 5Y UST vs the 3Y and 7Y USTs.Take Loss.

Trade 12:Since the 2Y swap spread is highly influenced by the date of the taper and also highly correlated to the MOVEvolatility index, which has increased of late, we expect the spread to increase. Buy the 2Y swap spread. Hold.

Trade 13:The 10-30Y spread is also a taper proxy since the lack of a taper reduces the attractiveness (in roll and carryterms) of the 10-30Y flattener, leading to the unwinding of such trades in the event of a taper. Whats more, this spread sitsjust below an important resistance of 110bp. Therefore, positive surprises from Fridays announcement have scope toimpact the spread to the upside, with more limited potential to influence to the downside. We enter the 10-30Y flattener atabout 110bp with a target of 100bp and a stop at 112bp.Hold.

Trade 14:Whilst Yellen advocated the optimal control method for calculating interest rates recently suggested in two papers(which suggests very low rates for some time to come), she also noted that it suffers strong assumptions and advocated aTaylor rule, which produces much higher appropriate rate levels for end-2015 than implied by OIS forwards. We believe thatthe recent disjointedness in the curve is overdone and that the market is fully priced only at the front end of the curve. Wesell the US 3Y in a 2-3-5Y Butterfly trade.Hold.

Trade 15: Given ongoing spread convergence and ECB liquidity support we would expect the 2s4s spread to flatten inSpain and Italy to about 80bp (from about 110bp at present). However, that trade has a carry cost of about 6bp over the nextsix months. A less carry-expensive alternative is the BTP 3s4s flattener (currently about 50bp) with a 6-month carry cost of

about 1bp. Hold.

Trade 16:UST Swap spreads have not widened as much as anticipated recently. This can be attributed to a number ofpossible factors including curve steepening and an improved swap curve credit rating. However, the current situation of an


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08 January 2014 19

improving US budget deficit and an imminent tapering of the Federal Reserves asset purchasing programme should besufficient to drive up spreads going forwards. We enter the 5Y US Swap Spread widener. Hold.

Trade 17:In October the ESMs 5Y bond issue was well received. The bonds subsequent performance does not reflect theinitial strong primary market interest. Since launch this bond has cheapened relative to neighbouring EFSF and EIB bonds.We would recommend buying ESM 1.25% Oct-18 against EFSF 1.25% Jul-18.Hold.

Trade 18:A number of factors have contributed to a reduction in excess liquidity of late, driving Eonia to its highest level in

over a year. Eonia forwards have not risen to the same extent and thus we expect an upcoming ECB loosening to undosome of the current Eonia forward term structure inversion. We enter the trade receiving 3M Eonia and paying 9 x 12MEonia at -0.5bp targeting a move to -10bp and setting a stop at +5.5bp.Hold.

Trade 19: The 7Y suffered a poor auction last week and has been on the unfortunate end of the popular 7-30Y flattenertrade. Conversely, forward guidance enthusiasm has bolstered the 5Y leading to a severely broken curve relationship between the 5Y and the 7Y. The current spread is 72.5bp; we target a move to 66bp with a stop at 74bp. Buy 7Y vs 5Y.Hold.

Trade 20: One potential source of valuable trading opportunities is the extreme steepness of the periphery term structurerelative to the already steep core yield curves. Though most box spreads between BTPs and Bunds look interesting, the2015-2023 and 2016-2023 box spreads seem to offer the best outright mix between outright spread size and deviation fromthe norm. Hold.

Trade 21: Though Euro core swap spreads have generally traded in a tight range this year, the Schatz ASW spread is

trading at the tightest levels of the year. Since the Schatz ASW can be seen as a derivative of money market bases but hasrecently moved unilaterally, we believe it to be about 12bp too cheap. Furthermore, any sense that the ECB is behind thecurve will likely benefit core bonds relative to swaps. We buy the Schatz in ASW terms. Hold.

Trade 22:. The market has been very excited about the prospect of new forward guidance but we think that it will be verydifficult for the Fed to live up to expectations in this regard and that the combination of decent payrolls and largelyunchanged Fed forecasts could really shift the short end around. We enter the 2-3Y steepener trade.Take Profit.

Trade 23: The yield curve is looking increasingly steep; more so in some areas than others. Using data going back to 1978the 5-10Y spread is in its 99th percentile. As the US economy shows increasing signs of improvement the impact of Fedforward guidance will begin to stretch less far in the future. We believe that even enhanced forward guidance would lack thecredibility to hold down the 5Y yield and prevent 5-10Y flattening. We enter the US 5-10Y flattener trade.Hold

Trade 24:The usually close relationship between client positioning (ie, duration-weighted dealer positions across all euro$futures contracts) and the UST 10Y yield has broken down of late. Unusually large institutional longs sit in the 5Y and Ultra

contracts; around year-end strange position-driven moves may occur with the 5Y looking particularly susceptible. We seescope for flattening of the 10-30Y into year-end. Buy 30Y UST vs 10Y UST. Hold

Trade 25: The current spread of the 2Y T-Note over the German Schatz is 8bp (around its lowest level since 2011). We aresomewhat bearish on the front end of the US curve. The has begun tapering its asset purchases and may even hike rateswithin the next couple of years. This contrasts against the ECB with its unlimited supply of MROs and LTROs until the end of2015 and the possibility of a new round of vLTROs. These contrasting stances will likely support the Schatz-T-Note spread.We buy the 2Y Schatz vs the 2Y T-Note looking for a move to 18bp with a stop at 4bp. Hold

Trade 26:Historically the 3-10Y spread has flattened in a bull market and steepened in a bear market. Thanks to the Fedscommitment to low rates the 3Y has struggled to show any significant movement of late. We expect the status quo to returnin the not-too-distant future. However, before it does we see an opportunity. If we transition into a bear market the 3Y and10Y will initially rise in parallel before giving way to a bear flattening. In contrast if the current bond rout becomes a rally wewill likely see the 10Y lead the bull flattening. Sell 3Y UST vs 10Y UST. Hold

Trade 27: The 10Y current has cheapened significantly. Unusually, the newer benchmark is trading with a spline spreadwhich is cheaper than the 1stold. We think that the current unusual cheapening of the 10Y is linked to investor reluctance toown 10Y paper ahead of the possible taper and that this could lead investors to switch out of the front end and into the 10Yfollowing the taper announcement. Hold


20/22


08 January 2014 20

Interest rate forecasts

Source: Crdit Agricole CIB

Now Mar-14 Jun-14 Sep-14 Dec-14 Mar-15

USD FF target 0.25 0.25 0.25 0.25 0.25 0.25

FF effective 0.08 0.10 0.10 0.10 0.10 0.12

3M $ Libor 0.24 0.25 0.40 0.50 0.60 0.60

USTs 2Y 0.39 0.75 1.25 1.55 1.85 1.95

5Y 1.68 2.20 2.55 2.85 2.95 3.05

10Y 2.94 3.15 3.40 3.55 3.75 3.85

30Y 3.88 3.95 4.05 4.10 4.20 4.30

USD swaps 2Y 0.50 0.95 1.45 1.75 2.05 2.15

5Y 1.74 2.35 2.85 3.15 3.25 3.35

10Y 3.01 3.30 3.70 3.85 4.05 4.1530Y 3.86 3.95 4.05 4.10 4.20 4.30

EUR Refi rate 0.25 0.25 0.25 0.25 0.25 0.25

Eonia 0.10 0.10 0.15 0.15 0.20 0.25

3M Euribor 0.28 0.25 0.25 0.30 0.35 0.40

Germany 2Y 0.21 0.30 0.50 0.70 0.90 1.10

5Y 0.88 1.00 1.25 1.50 1.75 1.9510Y 1.89 2.10 2.35 2.55 2.70 2.80

30Y 2.72 3.00 3.20 3.30 3.40 3.45

France 2Y 0.29 0.40 0.55 0.75 0.95 1.15

5Y 1.17 1.25 1.45 1.70 1.90 2.10

10Y 2.49 2.60 2.75 2.90 3.00 3.10

30Y 3.43 3.60 3.70 3.75 3.80 3.85

Italy 2Y 0.99 1.10 1.25 1.40 1.55 1.70

5Y 2.44 2.50 2.65 2.80 2.95 3.05

10Y 3.87 4.00 4.05 4.05 4.10 4.10

30Y 4.77 5.00 5.05 5.05 5.05 5.00

Spain 2Y 1.04 1.10 1.25 1.40 1.55 1.70

5Y 2.34 2.45 2.65 2.80 2.95 3.0510Y 3.80 3.95 4.05 4.05 4.10 4.10

30Y 4.71 4.95 5.05 5.05 5.05 5.00

EUR sw aps 2Y 0.53 0.60 0.80 1.00 1.20 1.40

5Y 1.23 1.35 1.55 1.80 2.05 2.25

10Y 2.13 2.40 2.65 2.85 3.00 3.1030Y 2.72 3.05 3.30 3.40 3.50 3.55

JPY Call rate 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10

3M Libor 0.15 0.14 0.14 0.14 0.14 0.14

JGBs 2Y 0.09 0.10 0.10 0.10 0.10 0.10

5Y 0.21 0.25 0.20 0.25 0.25 0.30

10Y 0.69 0.75 0.65 0.70 0.75 0.80

30Y 1.70 1.85 1.75 1.80 1.85 1.90

JPY swaps 2Y 0.21 0.25 0.25 0.25 0.25 0.25

5Y 0.38 0.40 0.35 0.40 0.40 0.40

10Y 0.89 0.90 0.80 0.85 0.90 0.9030Y 1.87 1.95 1.85 1.90 1.95 1.95

GBP Bank Rate 0.50 0.50 0.50 0.50 0.50 0.50

Sonia 0.43 0.45 0.45 0.50 0.50 0.50

3M Libor 0.52 0.55 0.55 0.60 0.60 0.60

UK Gilts 2Y 0.52 0.70 0.90 1.25 1.35 1.40

5Y 1.77 1.95 2.25 2.40 2.50 2.55

10Y 2.95 3.20 3.35 3.40 3.45 3.50

30Y 3.62 3.80 3.85 3.90 3.95 4.00

GBP sw aps 2Y 0.96 1.10 1.20 1.50 1.60 1.65

5Y 2.04 2.20 2.50 2.65 2.75 2.8010Y 2.92 3.20 3.40 3.45 3.50 3.6030Y 3.37 3.65 3.75 3.80 3.85 3.95


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08 January 2014 21

Global Markets Research contact details

v.19/04/13 Herv Goulletquer Head of Global Markets Research+33 1 41 89 88 34

Asia (Hong Kong & Tokyo) Europe (London & Paris) Americas (New York)

Mitul KotechaHead of Global Markets Research for Asiaand Global Head of FX Strategy+852 2826 9821

Sbastien BarbHead of Global Markets Research for Europe andHead of EM Research and Strategy+33 1 41 89 15 97

David Keeble**Head of Global Markets Research for theAmericas and Global Head of Interest RatesStrategy+1 212 261 3274

Macro Strategy(Facilitator: Herv Goulletquer) Kazuhiko Ogata

Chief EconomistJapan+81 3 4580 5360

Yoshiro SatoEconomistJapan+81 3 4580 5337

Frederik DucrozetSenior EconomistEurozone+33 1 41 89 98 95

Michael P. Carey **Chief EconomistNorth America+1 212 261 7134

Interest Rates(Head: David Keeble)

Frances CheungHead of Asian Rates Strategy+852 2826 1520

Luca JellinekHead of European Interest Rates Strategy+44 20 7214 6244

Peter ChatwellSenior Interest Rates Strategist+44 20 7214 5289

Orlando GreenSenior Interest Rates Strategist+44 20 7214 7467

Jean-Franois PerrinInflation Strategist+33 1 41 89 94 22

David Keeble**Global Head of Interest Rates Strategy+1 212 261 3274

Jonathan Rick **IRD Strategist+1 212 261 4096

Emerging Markets(Head: Sbastien Barb)

Frances CheungHead of Asian Rates Strategy+852 2826 1520

Dariusz KowalczykSenior Economist/StrategistAsia ex-Japan+852 2826 1519

Sbastien BarbHead of EM Research and Strategy+33 1 41 89 15 97

Jakub BorowskiChief Economist - Crdit Agricole Bank Polska SA+ 48 22 573 18 40

Alexander PecherytsynChief EconomistCrdit Agricole Bank Ukraine+ 38 44 493-9014

Guillaume TrescaSenior Emerging Market Strategist+33 1 41 89 18 47

Mark McCormick** FX Strategist+1 212 261 4108

Foreign Exchange

(Head: Mitul Kotecha)

Mitul Kotecha

Global Head of FX Strategy+852 2826 9821

Adam Myers

European Head of FX Strategy+44 20 7214 7468

Manuel OliveriFX Strategist+44 20 7214 7469

Mark McCormick**

FX Strategist+1 212 261 4108

** employee(s) of Crdit Agricole Securities (USA), Inc.

CertificationThe views expressed in this report accurately reflect the personal views of the undersigned analyst(s). In addition, the undersigned analyst(s) hasnot and will not receive any compensation for providing a specific recommendation or view in this report.

David Keeble Luca Jellinek Peter Chatwell Orlando Green Jonathan Rick Frances Cheung Jean-Franois Perrin

Important: Please note that in the United States, this fixed income research report is considered to be fixed income commentary and not fixedincome research. Notwithstanding this, the Crdit Agricole CIB Research Disclaimer that can be found at the end of this report applies to this report

in the United States as if references to research report were to fixed income commentary. Products and services are provided in the United Statesthrough Crdit Agricole Securities (USA), Inc.

This commentary has been produced by Credit Agricole Securities (USA) Inc.s (CAS-USA) Fixed Income FX Department and is not a fixed income research reportprepared by a research analyst. These views may differ from those of the Research Department.The material contained in this commentary is intended solely for accredited, expert institutional investors and is provided for informational purpose only. This commentaryis based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Any comments regarding thefuture direction of financial markets is illustrative and is not intended to predict actual results. It should not be construed as advice designed to meet the particularinvestment needs of any investor, nor as an offer or solicitation to buy or sell the securities or other products mentioned herein. Changes to assumptions may have amaterial impact on any returns detailed. Price and availability are subject to change without notice. No representation is made that any t ransaction can be effected at thevalues provided. The values provided are not necessarily the values carried on CAS-USAs books.


22/22


Disclaimer 2014, CRDIT AGRICOLE CORPORATE AND INVESTMENT BANK All rights reserved.

This research report or summary has been prepared by Crdit Agricole Corporate and Investment Bank or one of its affiliates (collectively CrditAgricole CIB) from information believed to be reliable. Such information has not been independently verified and no guarantee, representation orwarranty, express or implied, is made as to its accuracy, completeness or correctness.

This report is a commercial communication as defined in article 6 of the Directive 2000/31/CE of 8 June 2000. For the avoidance of doubt, it is nota communication caractre promotionnel within the meaning of the Rglement General AMF. It is provided for information purposes only.

Nothing in this report should be considered to constitute investment, legal, accounting or taxation advice and you are advised to contactindependent advisors in order to evaluate this report. It is not intended, and should not be considered, as an offer, invitat ion, solicitation or personalrecommendation to buy, subscribe for or sell any of the financial instruments described herein, nor is it intended to form the basis for any credit,advice, personal recommendation or other evaluation with respect to such financial instruments and is intended for use only by those professionalinvestors to whom it is made available by Crdit Agricole CIB. Crdit Agricole CIB does not act in a fiduciary capacity to you in respect of this report.

Crdit Agricole CIB may at any time stop producing or updating this report. Not all strategies are appropriate at all times. Past performance is notnecessarily a guide to future performance. The price, value of and income from any of the financial instruments mentioned in this report can fall aswell as rise and you may make losses if you invest in them. Independent advice should be sought. In any case, investors are invited to make theirown independent decision as to whether a financial instrument or whether investment in the financial instruments described herein is proper,suitable or appropriate based on their own judgement and upon the advice of any relevant advisors they have consulted. Crdit Agricole CIB has not

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