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Deutsche Bank
Markets Research
Global
Rates
Credit
Date
17 October 2014
Francis Yared
Global Fixed Income Weekly
Strategist
(+44) 020 754-54017
francis.yared@db.com
Dominic Konstam

The market volatility stopped us out of out of the long BTP 5y earlier this
week (entry 1.03% stop at 1.2%), and we exit the corresponding hedges
EUR10s30s flattener, receiver spreads in EUR3m30Y and long US
breakeven vs. euro. The recent market moves present both some
opportunities and some threats

From an opportunistic perspective, USD breakevens, rates gamma and
European equities have overreacted relative to IG credit and conventional
metrics of financial market stresses such as swap spreads. The spike in
gamma offers opportunities to enter conditional bearish positions in the
front-end of the US curve and conditional bullish position in the front-end
of the EUR curve

In Europe, the dynamics in the periphery are likely to dominate the price
action. Despite recent market volatility, there are important structural
differences which should prevent a repeat of 2011-12. However, political
risk in Greece remains high and is unlikely to be resolved soon

From a medium-term perspective we should be mindful about the threat of
a tightening of credit conditions in the Eurozone if the market stresses
worsen further in a lasting fashion

Though the markets settled at levels far from intraday extremes last week,
the persistent elements of the re-pricing were anything but a surprise from
our perspective. The 5y sector outperformed and first rate hikes were
pushed out in time. We think this will continue and expect markets
ultimately to push the first hike well into 2016.



Research Analyst
(+1) 212 250-9753
dominic.konstam@db.com
Table of contents
Bond Market Strategy
Page 02
US Overview
Page 09
Treasuries
Page 15
Derivatives
Page 19
We think the 5y sector will be sticky at current yield levels or even lower,
while we expect a modest steepening of 5s10s achieved via higher 10y
yields. Our end of year forecast for the 10y Treasury remains at 2.35%. A
twist of 5s10s from current levels will keep the 5y5y rate within the bottom
of the 3.25%-3.75% range in the short run, while allowing markets to price
out the Fed until 2016 and potentially lower the lower the terminal cyclical
rate.
European ABS update
Page 24
Covered Bond and Agency
Update
Page 25
UK Strategy
Page 26
Japan Strategy
Page 29
Asia
Page 32
There is an investor debate around whether we should ignore recent
events and focus on familiar themes of US recovery (risk on), if anything
helped by low oil and a delayed Fed and at worst being slightly more
cognizant of European growth worries VERSUS a more profound concern
for the limits of global QE all around and the existential threat of deflation.
We all have our biases but for now we think it is best to think about the
markets trading between the two extremes based on policy maker actions
and data. Event risk will therefore be high. Weaker than expected inflation,
disappointing Euro PMIs, harsh AQR results coupled with a complacent
Fed and policy inertia in Europe will squarely get us back into risk off mode.
Dollar Bloc Strategy
Page 38
Global Inflation Update
Page 50
Inflation Linked
Page 53
Contact
Page 56
That said by contrast the longer the Fed is seen to push out normalization,
the more time there is for the US recovery to be a better one and the more
healing time Europe has even in the context of bumbling policy.
________________________________________________________________________________________________________________
Deutsche Bank AG/London
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.
17 October 2014
Global Fixed Income Weekly
Europe
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Bond Market Strategy

The market volatility stopped us out of out of the long BTP 5y earlier this
week (entry 1.03% stop at 1.2%), and we exit the corresponding hedges
EUR10s30s flattener, receiver spreads in EUR3m30Y and long US
breakeven vs. euro. The recent market moves present both some
opportunities and some threats
Francis Yared
Strategist
(+44) 020 754-54017
francis.yared@db.com
Abhishek Singhania
Strategist
(+44) 207 547-4458
abhishek.singhania@db.com
Jerome Saragoussi
Research Analyst
(+1) 212 250-3529
jerome.saragoussi@db.com
From an opportunistic perspective, USD breakevens, rates gamma and
European equities have overreacted relative to IG credit and conventional
metrics of financial market stresses such as swap spreads. The spike in
gamma offers opportunities to enter conditional bearish positions in the
front-end of the US curve and conditional bullish position in the front-end
of the EUR curve
George Saravelos

In Europe, the dynamics in the periphery are likely to dominate the price
action. Despite recent market volatility, there are important structural
differences which should prevent a repeat of 2011-12. However, political
risk in Greece remains high and is unlikely to be resolved soon
Strategist
(+44) 20 754-52167
markus.heider@db.com

From a medium-term perspective we should be mindful about the threat of
a tightening of credit conditions in the Eurozone if the market stresses
worsen further in a lasting fashion

Strategist
(+44) 20 754-79118
george.saravelos@db.com
Markus Heider
Threats and opportunities
The market volatility stopped us out of out of the long BTP 5y earlier this week
(entry 1.03% stop at 1.2%), and we exit the corresponding hedges EUR10s30s
flattener, receiver spreads in EUR3m30Y and long US breakeven vs. euro. The
recent market moves present both some opportunities and some threats.
First from an opportunistic perspective, we search for market dislocations
across asset classes. The aim of the exercise is to identify those assets which
have either over or under reacted in the latest moves. This scanning exercise
suggests that USD breakevens, rates gamma and European equities have
overreacted relative to IG credit and conventional metrics of financial market
stresses (such as asset swaps). The spike in gamma offers opportunities to
enter conditional bearish positions in the front-end of the US curve and
conditional bullish position in the front-end of the EUR curve. This analysis also
supports our constructive view on USD breakevens.
In the US, the data remains broadly consistent with a resilient growth
trajectory. In the context of a Fed which has ratcheted up its dovish rhetoric,
the curve remains too flat given the level of front-end rates. We continue to
recommend USD5s10s steepeners with a beta weighted short position in the
front-end of the curve. In Europe, the dynamics in the periphery is likely to
dominate the price action. Despite the recent market volatility, there are
important differences today relative to the height of the Eurozone crisis in
2011-12. From a strategic perspective, we remain constructive on Italy and
Spain as the fiscal & current account position and reduced non-resident
ownership should ensure that they are more resilient today, especially in the
context of an ECB which is more pro-active. However, political risk in Greece
remains high. Given that Greece is now running a primary budget surplus and
the vast majority of the redemptions in the coming years are due to the Troika
there is an increased risk of political brinkmanship.
Page 2
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Finally, from a macro perspective, the easing of credit conditions was one of
the positives for the Eurozone economy. We should be mindful about the
threat of a tightening of credit conditions if the market stresses worsen further
in a lasting fashion.
Market dislocations – monetizing new opportunities
This week has been marked by an extreme volatility across asset classes and
by an increase in most stress indicators. However the market response to the
spike in risk aversion has not been homogeneous. We build a stress monitor
for an extensive list of assets (see below). The stress indicator for each asset
corresponds to the position of the current asset price relative to its past level at
the peak of the EU crisis in Q4 2011 and relative to its level at the time of the
June ECB meeting before the drop in commodity prices. A stress indicator
around 100% means that the asset is roughly as depressed as it was back in
Q4 2011, a stress indicator around 0% means that the asset price is very close
to the price observed this June before the start of the risk-off environment.
Stress monitor
Assets
EUR 5Y5Y BE
USD 5Y5Y BE (Fed measure)
EUR 30y vol slope (3M vs 2Y expiry)
USD 30y vol slope (3M vs 2Y expiry)
Treasury 10Y yield
Italy FTSE MIB
V2X (Eurostoxx vol)
VIX (S&P vol)
European Bank stocks
UST 5Y ASW
USD 3M30Y gamma
Eurostoxx 50
US 10Y real yield
EUR 3M30Y gamma
Itraxx X-Over - EU HY CDS 5Y
CVIX (FX vol)
Libor/OIS 2Y2Y basis
EURUSD 2Y2Y Xccy basis swap
OAT Bund spread
Libor/OIS 5Y basis
Euribor/Eonia 2Y2Y basis
CDS EU Sub Financials 5Y
US CDX IG
EURUSD 5Y Xccy basis swap
BTP Bund spread
US CDX HY
US Libor/OIS 3M basis (4th IMM)
Bund ASW
Libor/OIS 2Y basis
Itraxx Main - EU IG CDS 5Y
EURUSD 2Y Xccy basis swap
Euribor/Eonia 5Y basis
JPYAUD exchange rate
Bono Bund spread
Euribor/Eonia 3M basis (4th IMM)
Spain 5Y CDS
Italy 5Y CDS
CDS EU Senior Financials 5Y
Bobl ASW
France 5Y CDS
Schatz ASW
Euribor/Eonia 2Y basis
German 2Y-30Y ASW slope
Today
Peak EU crisis
Q4-11
June-14 ECB
meeting
1.76
2.25
11.62
9.90
2.15
18,083.1
31.5
25.1
130.0
20.3
87.7
2,874.7
0.25
68.4
401.1
8.0
25.77
13.75
44.24
23.34
20.50
176.9
74
13.3
175.93
398
19.5
27.5
18.62
75.6
14.3
19.05
1.07
139.5
17.0
90.3
116.9
74.9
33.8
44.0
28.7
15.60
20.01
1.95
2.24
23.33
28.25
1.82
14,244
50.4
40.8
97.8
35.3
135.8
2,091.1
0.04
126.9
874.4
14.6
39.00
34.75
82.92
39.00
32.60
550.7
148
43.0
376.8
867
51.0
74.9
47.01
208.4
63.8
38.70
1.36
337.2
44.0
390.3
486.3
296.4
83.5
200.0
88.0
51.20
72.3
2.12
2.44
(8.31)
(13.40)
2.60
22,472
13.1
11.2
160.8
8.0
61.2
3,305.3
0.38
45.6
218.6
5.5
19.95
6.50
32.21
18.48
17.00
85.1
57
6.8
132.55
297
13.1
18.2
14.47
56.5
8.0
16.90
1.04
119.6
14.4
61.6
81.8
57.6
31.1
35.9
26.4
15.40
28.25
Stress
indicator
208%
92%
63%
56%
58%
53%
49%
47%
49%
45%
36%
35%
38%
28%
28%
27%
31%
26%
24%
24%
22%
20%
18%
18%
18%
18%
17%
16%
13%
13%
11%
10%
10%
9%
9%
9%
9%
7%
5%
5%
4%
1%
-19%
Source: Deutsche Bank
Deutsche Bank AG/London
Page 3
17 October 2014
Global Fixed Income Weekly
Some key messages and trading opportunities emerge from the table
a)
Long-term inflation expectations are particularly depressed in EUR
and USD, not only relative to where they were at the peak of the EU
crisis but also relative to other asset classes.
Trade implication: we maintain our long TIPS 5Y5Y breakeven as an
asymmetrical normalization trade. Any delay in policy normalization
triggered by a persistent risk-off mode or by the recent commoditydriven disinflation should lead to a gradual recovery in long term
inflation expectations. Conversely, a return to a risk-on mode in a
context of good domestic data should naturally help the normalization
of the inflation risk premium and 5Y5Y breakeven.
b)
The rates gamma spike has been remarkable, outright and relative to
intermediate expiries. While this gamma spike has been felt across the
USD curve, the EUR gamma spike has mostly been concentrated at
the long end in EUR between the 10Y and 30Y sector.
Trade implication: We recommend monetizing the rich volatility by
selling it in a midcurve put ratio 1x2 on EDZ6 (expiry Dec-14) to gain a
cheap and asymmetrical bearish position in the belly of the USD
curve. The money market curve is now pricing in a first hike in Dec-15
and only 75bp of rate hikes in 2016, so that the Dec-16 target rate is
now seen at 1.25, The underlying midcurve vol is close to historically
high levels following this week’s spike in realized vol while EDZ6 is
back towards pre-QE taper levels. At the time of writing, ref EDZ6
98.375, buy 1 2EZ4 put at 98.375 for 17cts and sell 2 2EZ4 puts at
98.125 for 7cts per put and a net cost of 3cts. Leverage ratio of 8:1.
Max payoff at expiry of 25cts is achieved if EDZ6 reaches 1.875%
(which would be consistent with a delay of the rate hike cycle from
June-15 to Sept-15 at a pace of 25bp per quarter). The trade makes
money as long as the sell-off does not push EDZ6 beyond 2.1%.The
trade should capture roughly a 1.25%/1.75% range on FFZ6.
Alternatively one can also enter the 2EZ4 put ratio 1x2 98.25/98.00 for
also ~3cts and capture a positive payoff range of 1.75%/2.25% on
EDZ6 and 1.375%/1.875% on FFZ6.
Cheapness of TIPS 5Y5Y BE
Impressive richening of USD gamma in the belly
3.6%
0.9
3.4%
0.8
3.2%
0.6
3.0%
2.8%
0.5
2.6%
2.4%
2.2%
0.3
0.2
2.0%
0.0
1.8%
-0.2
1.6%
-0.3
Long term inflation uncertainty from SPF:
difference between 75th & 25th percentile of 10Y
CPI forecast
-0.5
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: Deutsche Bank
Page 4
140
1.4%
120
100
80
60
40
2EZ4 midcurve Eurodollar
vol, corresponding today
to implied vol on Dec-14
expiry midcurve options
on EDZ6
20
1.2%
1.0%
0
Aug-12
Feb-13
Aug-13
Feb-14
Aug-14
Source: Deutsche Bank
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
c)
European equity indices embed a much deeper level of stress than
European synthetic credit indices. The correction experienced on the
Eurostoxx 50 has been more acute than the widening of spread on
EUR 5Y Itraxx Main. Based on the historical relationship between the
Eurostoxx and Itraxx, the Itraxx Main looks particularly tight relative to
the level of European equities. Moreover, Eurostoxx implied vol
remains expensive relative to Itraxx Main implied vol.
Trade implication: We favor 17-Dec-2014 expiry payers on Itraxx
Europe S22 rather than 19-Dec-2014 expiry put on Eurostoxx 50 to
hedge further deterioration of the risk environment. The historical
analysis suggests that the Eurostoxx 50 has moved on average with a
beta of 8 relative to Itraxx (droping 80 ticks for a 10bp widening of 5y
Itraxx main) while the option market (expiry Dec-14) is implying a beta
closer to 13. An ATMF Dec-14 expiry payer on Itraxx Europe S22 is
cheaper than the equivalent position in an ATMF Dec-14 expiry put on
Eurostoxx 50 by nearly 40%. Beyond the cheapness of credit vol vs.
equity vol, the underlying Itraxx index trades ~15bp rich against the
level of Eurostoxx 50.
iTraxx Main is too tight relative to Eurostoxx
Source: Deutsche Bank
Some short-term stresses, but it ain’t 2011
The recent market pressure on Italy and Spain and the renewed political risk in
Greece could seem all like déjà-vu with a repeat of the 2010-2012 Eurozone
sovereign debt crisis. The low growth and inflation environment has revived
concerns about the debt sustainability for Italy. Indeed, if we assume that
current conditions persist in a “Japanification” scenario, with nominal GDP
growth of 1.2%, primary balance unchanged from the 2013 level at 2.2% of
GDP and an average interest rate on debt of 4%, Italian debt/GDP ratio will not
stabilize and remain on an upward trajectory rising by about 1.5% per year.
While this creates a long-term debt sustainability issue, the experience of
Japan itself suggests that a favourable net external debt position is more
relevant than the fiscal dynamics as long as there is no domestic capital flight.
With this in mind, there are some important differences today relative to 20102012.
Deutsche Bank AG/London
Page 5
17 October 2014
Global Fixed Income Weekly
Budget balances have
stabilized/improved since 2011-12
General govt. budet balance (% of GDP)
4
Italy
Spain
2
0
-2
-4
-6
-8
DB
Forecasts
-10
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
-12
1999
First, the fiscal balance and hence the net new issuance of debt by the
governments have stabilized or improved. In 2010, Italy was running a 4.5%
deficit vs. 3% in 2013. Second, there has already been a de-risking of nondomestic investors which was initially accommodated by the ECB support via
the SMP and the first LTROs. Since, there has been some increase in the nondomestic ownership of government debt, but the share remains low and we
estimate it to be below 30% in Italy after adjusting for the SMP and domestic
ownership via funds domiciled outside of Italy. This compares to a level of
more than 50% in 2010. Third, current account balances have turned from
deficits into surplus implying that the Italian economy does not require
additional external funding (i.e. that its reliance on non-domestic investors can
be further reduced). Fourth, the capitalization levels of banks are much higher
and preparations to clear the upcoming AQR and the stress tests should
reduce the vulnerability of the sovereign via the financial sector. Last but not
least, the ECB has already in place a TLTRO and soon to be launched private
asset purchase programmes (both of which are likely to benefit
disproportionately the periphery). If the success of these programs in a low
yield environment is doubtful, they will automatically become more relevant in
a situation of further stress. Moreover, the ECB’s willingness to expand its
balance sheet with more aggressive easing should also increase if the recent
developments result in a significant tightening of credit conditions.
Source: Deutsche Bank, Haver Analytics
In short, relative to 2010, budget deficits are smaller, current accounts are
positive, non-domestic ownership is lower, banks are better capitalized, the
ECB has liquidity and asset purchase programmes in place and Draghi has
repeatedly suggested that it is willing to do more if necessary. The situation in
Spain is not dissimilar with the caveat that the net international investor
position, i.e. the cumulative current account balances in Spain is a lot more
negative which would imply that overall Spain remains more vulnerable to a
change in sentiment from the international investor community. However, the
improved growth outlook as a result of the structural reforms should help to
offset some of these concerns.
Taken together, these factors suggest a more robust position of Italy and Spain
today than in 2010, which should make large scale sell-off less likely to be
persistent in the medium term as long as there is no domestic capital flight.
This remains a risk, but the threshold of political and economic stresses is
likely to be higher than what we are witnessing at present. Deposit outflows
from peripheral countries would be one way to monitor this risk. Note that
even in 2010-2012 there were no meaningful deposit outflows from Italy.
Deposit flows need to be closely
monitored
Deposits excluding banks and central govt.
indexed to 100 at Jan-09
150
140
130
Italy
Spain
Ireland
Portugal
Greece
120
110
Page 6
100
90
80
70
Jul-14
Jan-14
Jul-13
Jan-13
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
60
Jan-09
However, there is still scope for some market volatility for several reasons.
First, being long the periphery has been a fairly consensus trade and recent
positions could be vulnerable especially if the increase in market volatility
could generate forced selling. Second, while spreads today are broadly similar
to 2010, the lower absolute level of yields makes the investment less attractive
given the increase in volatility. Third, the ECB may be reluctant to cross the
government QE Rubicon without being pushed by the market. Finally, the
increased risk of brinkmanship in Greece could keep political risk high.
Source: Deutsche Bank, Haver Analytics
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Italy and Spain are in current account surplus rather than
deficit
Rolling 12M cumulative CA balane (EUR bn)
40
Spain
20
Non-resident holdings in Italy and Spain are lower now
than in 2011
55%
Share of govt. securities held by non-residents
Italy
50%
Italy
0
45%
-20
Spain
40%
-40
-60
35%
-80
30%
-100
25%
Jul-14
Jan-14
Jul-13
Jan-13
Jul-12
Jan-12
Jul-11
Jan-11
Jul-10
Jan-10
Jul-09
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
Source: Deutsche Bank, Bloomberg Finance LP, Haver Analytics
Jan-09
-120
Source: Deutsche Bank, Haver Analytics
Greece Update
The ‘gap’ move lower in Greek government bond prices over the last couple of
weeks is largely the market coming to terms with the political risk on the
horizon which is unlikely to be resolved any time soon. In the presidential
elections, to be held in Feb 2015, the current government would need to obtain
approval of 180 MPs. Failure by the current government to get its candidate
elected as the President will lead to an automatic dissolution of the parliament
and calling of fresh elections. In the vote of confidence held last week the
government received the support of 155 MPs implying that it would be short
by around 25 in February. In order to get the necessary support and prevent
elections the government is looking to exit a full Troika programme and opt for
an ECCL (Enhanced Conditions Credit Line) while the main opposition party
Syrzia is campaigning that it would obtain debt relief from the Troika if it came
to power.
Even before the recent sell-off, significant reliance on market funding rather
than extending the Troika programme was likely to be economically suboptimal. The latest sell-off is likely to make it even more difficult for the Greek
government to fund in the market although political reasons might still
necessitate an attempt at a sub-optimal outcome.
Irrespective of the political configuration following the Presidential elections
there is clearly some concern that the next Troika review and any subsequent
negotiations with the Troika would be more contentious given the stall in the
reform process. From the Greek perspective, with the government in a
comfortable primary surplus and no debt held by private sectors maturing over
the next few years there is the clear risk of brinkmanship. From the perspective
of the Troika, with Greek debt repayments over the next few years primarily
implying the Troika paying itself there could be more reasons for the Troika to
be conciliatory rather than confrontational. However, the political situation
does imply that we could be in for a rather ‘messy’ few months.
Deutsche Bank AG/London
Page 7
17 October 2014
Global Fixed Income Weekly
Greece govt. primary surplus could make negotiations
more noisy
5,000
General govt. primary balance and interest
expenses (EUR mn)
Maturity profile of Greek debt (excluding bills) over the
next few years (EUR mn)
9,000
IMF
8,000
ECB, EFSF, Bilateral loans
0
7,000
-5,000
6,000
-10,000
5,000
-15,000
4,000
3,000
-20,000
Greece general govt.
interest expenses
-25,000
Greece general govt.
primary balance
-30,000
-35,000
2009
2010
Source: Deutsche Bank, Haver Analytics
Page 8
Held by pvt. Sector
2011
2012
2013
2014 YTD
2,000
1,000
0
2014
2015
2016
2017
2018
2019
2020
Source: Deutsche Bank, EFSF, IMF, Bloomberg Finance LP
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
United States
Rates
Gov. Bonds & Swaps
Rates Volatility
US Overview



Though the markets settled at levels far from intraday extremes last week,
the persistent elements of the re-pricing were anything but a surprise from
our perspective. The 5y sector outperformed and first rate hikes were
pushed out in time. We think this will continue and expect markets
ultimately to push the first hike well into 2016.
We think the 5y sector will be sticky at current yield levels or even lower,
while we expect a modest steepening of 5s10s achieved via higher 10y
yields. Our end of year forecast for the 10y Treasury remains at 2.35%. A
twist of 5s10s from current levels will keep the 5y5y rate within the bottom
of the 3.25%-3.75% range in the short run, while allowing markets to price
out the Fed until 2016 and potentially lower the lower the terminal cyclical
rate.
There is an investor debate around whether we should ignore recent
events and focus on familiar themes of US recovery (risk on), if anything
helped by low oil and a delayed Fed and at worst being slightly more
cognizant of European growth worries VERSUS a more profound concern
for the limits of global QE all around and the existential threat of deflation.
We all have our biases but for now we think it is best to think about the
markets trading between the two extremes based on policy maker actions
and data. Event risk will therefore be high. Weaker than expected inflation,
disappointing Euro PMIs, harsh AQR results coupled with a complacent
Fed and policy inertia in Europe will squarely get us back into risk off mode.

That said by contrast the longer the Fed is seen to push out normalization,
the more time there is for the US recovery to be a better one and the more
healing time Europe has even in the context of bumbling policy.

Empirically, the fiscal channel appears to have been far more effective in
increasing growth relative to trend than decreases in private sector net
lending.
In Europe, the data suggest that fiscal action has been
constrained from fully offsetting increases in private sector net lending.
Dominic Konstam
Research Analyst
(+1) 212 250-9753
dominic.konstam@db.com
Aleksandar Kocic
Research Analyst
(+1) 212 250-0376
aleksandar.kocic@db.com
Alex Li
Research Analyst
(+1) 212 250-5483
alex-g.li@db.com
Stuart Sparks
Research Analyst
(+1) 212 250-0332
stuart.sparks@db.com
Daniel Sorid
Research Analyst
(+1) 212 250-1407
daniel.sorid@db.com
Steven Zeng, CFA
Research Analyst
(+1) 212 250-9373
steven.zeng@db.com
The New Trading Regime
The debate now is what if any legacy do the recent violent and, in some cases,
unprecedented market moves leave. Treasury yields have reclaimed the
majority of their weekly declines; some rate vol measures have cut in half their
gains while the VIX has almost returned to October 10 levels along with SPX
itself. Cash credit indices remain a little wider although again off their wides. In
Europe the story is broadly similar. Bunds having almost touched 70 bps back
at 86 bps
(vs. 89 bps October 10t), SX5E largely recovered although
peripheral spreads are still wider. Importantly some markets have not returned
to previous levels -- notably Eurodollars where, although off their extremes,
Fed expectations have clearly been pushed back at least one meeting.
There seem to be two camps around this would be “legacy”. The optimistic
camp is that really nothing much has changed except the markets were
reminded of the real weak links in the global economy, i.e. Europe. After the
Draghi euphoria “we will do everything it takes”, reality has set in that a) they
can’t do what it takes not because of what they can do but because of what it
Deutsche Bank AG/London
Page 9
17 October 2014
Global Fixed Income Weekly
takes and b) even what they do has its limitations, most obviously around the
public qe uncertainty but even around the extent of beggar thy neighbor weak
euro policy. Fundamentally though the US recovery remains largely orthogonal
to Europe. So while the Fed may duck and weave around Euro currency
weakness and global disinflation, US inc. is sound. The issue is still not if they
normalize rates but when. Normalizing from 2016 doesn’t mean much
compared with 2015 from a big picture perspective, not withstanding those
prior 1 million + net short spec positions that were forced to cover.
The pessimistic camp can readily embrace the same Europe outlook but is less
prepared to be so sanguine about US inc’s island of prosperity. QE won’t work
in Europe, even if they did it wholeheartedly, because it never worked in the
US. It largely raised asset prices without stimulating new credit demand that
would have put the US recovery on a clearer self sustaining track to full
employment and higher inflation. Equity valuations are highly dependent on
the trajectory for inflation expectations and even if earnings are stable now,
valuations are vulnerable around the end of qe. A reversal of inflation
expectations threatens a much deeper risk off that might infect business and
consumer confidence. Merely delaying the Fed a year isn’t the issue. The issue
is with the very ability to countenance rate normalization amid the existential
threat of global deflation.
We think appreciating this tug of war may prove to be the best guide to market
volatility into year end. It will also provide the right kind of framework for
discounting policy action. We don’t think either camp is so obviously correct
that the other can be ignored. At the very least it also suggests that there is
some longevity to the recent “new risk off and then “partially” on phase. i.e.
we do not think it appropriate to assume that the recent risk off should be
readily reversed, with a return to risk asset highs and tights. At least not until
there is better clarity from European policy makers. We also think it is
important that the Fed emphasizes the free risk asset “put option” with some
form of commitment to delayed tightening, perhaps even including an
extension of QE.
Specifically what is critical is clarity over whether the ECB really will do public
QE and, partly subject to that whether there is any commitment to fiscal
stimulus as a backup jumpstart to structural reforms. Fiscal is more important
and, if anything, a better trade off if public sector qe is too much.
Unfortunately we doubt there is clarity anytime soon on either so that risk
remains vulnerable to data (PMIs this week) as well as the AQR results on
October 26.
Below we analyse in more detail some of the issues surrounding fiscal easing
in Europe compared with the US in the context of its efficacy in boosting
demand. It is very clear that US fiscal is a very effective means of boosting
growth, conditional on a private sector in deleveraging mode. In Europe the
private sector is empirically that much more important. It might be precisely
because of the fiscal straightjacket that this has been the case and a proper
fiscal response could relieve the private sector. It could also be consistent with
recognizing the limits to fiscal stimulus effectiveness and redoubling efforts on
private sector credit relief – perhaps even some bank regulatory relief. One
thing for sure, though, there is little room to expect nothing but at best, for
now, Europe muddles along with very low nominal growth and persistent
worries for debt sustainability.
Which brings us to the US and the Fed. To our minds it is clear the Fed is
drawing a line in the sand (along with US Treasury) as to how far Europe might
expect to rely on a weaker currency as a relief mechanism. Yes, the US
recovery is clearly more entrenched and different monetary policy trajectories
Page 10
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
warrant a tendency towards a stronger dollar. But equally there are limits. As
we have highlighted persistently the US recovery is not bad but nor is it
particularly good. In particular it has a mature profit cycle. It relies on low
wages not high prices as productivity is low. Thank you Tarullo and yes, Yellen
recognized this in her inequality speech. This means it needs to be nurtured
and not derailed by foreign elements like exported “excess” disinflation from
Europe. The Fed wants markets to be more data dependent and for that reason
it is still reasonable that QE ends as envisaged, despite Bullard. But we think
the risk on-off pull will be with us for a while. Taper delay would be a big
positive for risk and 5s10s can steepen further though probably more bearishly.
Front eurodollars though would be more firmly locked down. To the extent that
the Fed fails to embrace a more cautious approach to normalization and,
especially, if the data slacks (worst, a disappointing CPI print) then clearly rates
can sharply rally again. Our logic remains that absent assertive policy action
from either Europe or the Fed, bouts of risk off can easily dominate around
disappointing data.
Whether or not these bouts are as extreme as we’ve recently seen depends to
a large extent on the weight of positions. Our positioning metrics give some
comfort that risk is more balanced now – less extremely contrite about the
world being a beautiful place. The most dramatic position adjustment has been
in Eurodollars. While we don’t have the latest CFTC data at the time of writing
and anyway it would not capture data after Tuesday, October 14, if we assume
the collapse in open interest was all due to short spec positions being closed,
we think there may only be about -300k net spec short positions still
outstanding. This is down from a peak of -1.8 m and -1.3 m only 10 days ago.
Last week we suggested these shorts were vulnerable and the violence of the
move has clearly forced, in our view, a healthier equilibrium in rate
expectations. We suspect the Fed will essentially endorse this and over time
what remains of rate hike expectations in 2015 will be pushed into 2016.
We note however that there is a residual bearish rump that while acceding to a
delayed rate normalization believes that any delay must be offset by a still
more aggressive trajectory. We wholeheartedly disagree with this logic. For a
start, the logic of the delay is to buy more time for the US recovery to become
a better recovery. It also is designed to secure the recovery and stem the rise
in the dollar that might otherwise undermine it. None of that is achieved if we
double up rate expectations in 2016. Or at least, doubling up expectations
requires much clearer evidence of stronger data going forward. In addition we
continue to emphasize the Fed doesn’t need to rush to neutral. Neutral is a
mere 10 meetings away at 25 bps. Taking their time over a two year cycle
doesn’t seem unreasonable.
Deutsche Bank AG/London
Page 11
17 October 2014
Global Fixed Income Weekly
3m Eurodollars futures spec net positions – with estimate of current (end
week 10/17)
1500K
Net Position (contracts)
1000K
500K
0K
-500K
-1000K
-1500K
-2000K
-2500K
Oct-08
Net Position (estimated): -300K
1 Week Ago :-1297K
4 Weeks Ago: -1800K
TY contract equivalents: -92K
Oct-09
Oct-10
Oct-11
Oct-12
Oct-13
Oct-14
Source: Deutsche Bank and CFTC
The other big positioning issue we think still, is with real money asset
managers. Overall duration hasn’t shifted very much according to money
manager surveys while based on the top 20 money manager returns we can
still see the heavy exposure to credit and implied underweight to rate. In the
violent rally and credit spread widening, every money manager
underperformed with average weighted underperformance being around 50
bps. There was also some partial recovery later in the week. Our rolling beta
analysis of the first principal component on excess returns suggests that IG
exposure is dominant in excess returns. Given the relative stability of IG
spreads in the risk off, we suspect that real money used alternative hedging
vehicles to risk rather than test the dealers’ liquidity provision. This probably
explains the sharp rise in the VIX and gamma rate vol. HY spreads note did test
and bounce from their taper tantrum highs as feared (520-ish on cash OAS DB
index) while high grade hardly came close (taper tantrum wides 150 bp cash
oas). Going forward if we are right that we may continue to be rocked back
and forth between the optimistic and pessimistic camps, we think spreads can
stay volatile not least because positioning seems to still be much the same i.e.
long credit, underweight Treasuries amid “strong” hands with a bias to hedge
opportunistically when vol or VIX looks cheap.
High Yield and High Grade cash spread indices
900
300
800
taper tantrum
700
600
200
500
150
400
300
200
High Yield cash oas
High grade cash oas
100
50
100
0
1/1/2010
250
0
1/1/2012
1/1/2014
Source: Haver and Deutsche Bank
Page 12
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Last one-week return
Last one-week excess return over index
0.80
0.00
0.20
0.00
-0.20
-0.40
-0.60
-0.80
10/9/14 to 10/16/14
1
2
3
4
5
6
7
8
Weighted
9
10
11
12
13
14
15
16
17
18
19
20
Index
-1.00
-0.20
-0.40
-0.60
-0.80
-1.00
10/9/14 to 10/16/14
-1.20
-1.40
-1.60
1
2
3
4
5
6
7
8
Weighted
9
10
11
12
13
14
15
16
17
18
19
20
Index
Total return (%)
0.40
Excess return vs. Benchmark (%)
0.60
Performance ranking, sorted by return
Performance ranking, sorted by return
Source: Deutsche Bank
Source: Deutsche Bank
Year-to-date return
Year-to-date excess return over index
2.00
7.00
1.50
5.00
4.00
3.00
2.00
1.00
1
2
3
4
5
6
7
8
9
10
11
Weighted
12
Index
13
14
15
16
17
18
19
20
0.00
Performance ranking, sorted by return
1.00
0.50
0.00
-0.50
-1.00
-1.50
-2.00
-2.50
1
2
3
4
5
6
7
8
9
10
11
Weighted
12
Index
13
14
15
16
17
18
19
20
Total return (%)
6.00
Excess return vs. Benchmark (%)
8.00
Performance ranking, sorted by return
Source: Deutsche Bank
Source: Deutsche Bank
Fiscal alternatives for accommodation?
Much has been made of central bank divergence, and ECB President Draghi
has amplified expectations that ECB and Fed policy will move in different
directions for some time. This was the rationale between rate divergence
trades and strength in the dollar. We have been skeptical of this argument visà-vis Europe for two reasons. First, ECB purchases of public sector assets
remain quite politically contentious. Second, Fed rate hikes in an environment
of a static accommodative stance in Europe or further easing portend for a
stronger dollar and additional downward pressure on US inflation. We think
investors will be well served to consider the scenario whereby the Fed doesn’t
tighten – at least not in 2015 as has been the consensus expectation – and the
ECB does not ease beyond the tLTROs and its current plans for asset
purchases.
This is not to say that nothing will be done to support growth in Europe. There
remain fiscal alternatives, and although these are also contentious politically, it
is possible that they are less so than public sector asset purchases. Moreover,
it is possible that fiscal measures might be more effective than public sector
QE.
Evidence from the last 15-20 years suggests that the cyclical element of
growth is more responsive to changes in the structural deficit than to changes
in private sector net lending. We would argue this is clearly the case in the US
and perhaps more subtly so within the Eurozone. To illustrate this we looked at
Deutsche Bank AG/London
Page 13
17 October 2014
Global Fixed Income Weekly
annual changes in the real output gap as a function of changes in structural
public sector deficits and changes to private sector net lending. For the US,
we used CBO estimates of the real output gap, while for Europe we used IMF
estimates. In the US we used CBO budget estimates without automatic
stabilizers for the structural deficit, while in Europe we used the European
Commission’s net lending series adjusted for cyclical elements, expressed as a
percentage of trend GDP. For both the US and Europe, we used private sector
net lending as a percentage of nominal GDP. In both cases the regression
intercepts were not statistically significant and results are given with the
intercept forced to zero.
US: changes in cyclical growth as function of changes in structural fiscal
deficit and private sector net lending
Coefficients
Standard Error
t Stat
Structural Deficit
0.641
0.11
5.94
Private sector net
lending as % GDP
-0.062
0.05
-1.28
Adj R^2
0.667
Source: Deutsche Bank
In the US, the sensitivities are as one would expect: an increase in the
structural fiscal deficit results in higher growth relative to potential, and an
increase in private sector net lending (savings) slows growth relative to trend.
The structural fiscal variable is strongly significant, while the private sector net
lending variable is not. Moreover, the coefficient of the structural deficit
variable is far larger in magnitude than for the private sector variable.
In our view the results suggest a limited efficacy of QE in that QE would affect
private sector investment (lowering net lending) by lowering the cost of capital
to very attractive levels. While the sign of the coefficient is consistent with this,
the magnitude and (lack of) significance during a historical period which
includes Fed QE suggests limited observed impact.
Europe: changes in cyclical growth as function of changes in structural fiscal
deficit and private sector net lending
Coefficients
Standard Error
t Stat
Structural Deficit
0.52
0.32
1.59
PrivSec net
Lending % GDP
-0.87
0.16
-5.53
Adj R^2
0.65
Source: Deutsche Bank
In Europe the results are somewhat different, but we think suggest a similar
interpretation. The coefficient signs are again consistent with intuition; a
higher structural deficit increases growth relative to trend, and higher private
sector net lending (saving) reduces growth relative to trend. In Europe,
however, the structural deficit isn’t statistically significant, while private sector
net lending is significant and larger in absolute value than the structural deficit
variable.
One can square the circle here by noting the differences in the political and
fiscal infrastructure in Europe versus the US. Throughout the crisis Europe has
been constrained by limits on excessive deficits, so in this light the statistical
result of less responsiveness to structural deficits and more to the private
sector is no surprise. We would argue that because of these constraints, fiscal
policy was unable to sufficiently offset the decline in private demand, so the
effect of increases in private sector net savings predominate in the analysis.
The implication is that some agreement for a temporary fiscal “relent” might
enable fiscal policy to provide a tailwind to growth relative to trend, if political
obstacles make public sector asset purchases a non-starter.
Page 14
Deutsche Bank AG/London
17 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
alex-g.li@db.com steven.zeng@db.com
Treasuries

Foreign investors purchased $26 billion of long-term Treasuries in August.
Latin America was the largest buyer with $15 billion of investments
whereas Asia and Europe added $13 billion and $10 billion, respectively.

Net foreign purchases of long-term Treasuries have totaled $133 billion so
far this year. Foreigners divested $31 billion of securities in the first eight
months last year; they added $368 billion of paper during the same period
in 2012.

Treasury two-year floaters have been well received by investors since their
introduction in January 2014. We analyze auction data and total return
performance. Treasury auction allotment figures show that foreign
investors have been a consistent demand source for floaters at auctions
this year.
Foreign Treasury purchases rebound in August
Foreign investors purchased a net $29 billion long term U.S. Treasury, agency
and corporate bonds in August, the most since February. August’s additions
were preceded by net reductions of $21 billion in June and a small $0.4 billion
in July. Asia based investors led the purchases in August with $18 billion in
investments, followed by those in UK and the Latin America who added,
respectively, $16 billion and $14 billion of securities. Europe ex-UK however
offloaded $13 billion of securities, taking its net divestments to $68 billion
since the beginning of the year.
Foreign purchases of US bonds by month, vs. 10Y yield level
Net Purchase of US Bonds
Tsy 10Y (rhs)
90
3.0
60
$bn
3.5
2.5
30
2.0
0
1.5
-30
-60
Feb-12
Tsy 10Y
120
1.0
Aug-12
Feb-13
Aug-13
Feb-14
Aug-14
Source: US Treasury; Deutsche Bank
In Treasuries, Latin America was the largest buyer of notes and bonds, adding
$15 billion of securities during the month. Asia purchased $13 billion of paper
as well, offsetting its net divestments in July. Europe was a net buyer of $10
billion of securities for the second straight month. However, investors based in
Deutsche Bank AG/London
Page 15
17 October 2014
Global Fixed Income Weekly
Canada offloaded $9 billion. Overall, the net foreign investments totaled $26
billion in August, of which $4 billion were attributed to foreign official
institutions.
UK’s net purchase of Treasury notes and bonds
80
UK
60
Monthly, $ Billions
40
20
0
-20
-40
-60
-80
Aug-04
Aug-06
Aug-08
Aug-10
Aug-12
Aug-14
Aug-12
Aug-14
Source: U.S Treasury Department
China’s net purchase of Treasury notes and bonds
50
China
40
30
Monthly, $ Billions
20
10
0
-10
-20
-30
-40
-50
Aug-04
Aug-06
Aug-08
Aug-10
Source: U.S Treasury Department
Foreigners were net buyers of $10 billion in agency and mortgage-backed
securities in August. Europe led the purchases with $5 billion of investments
whereas the Asia was a close second at $4 billion. However, they divested $7
billion from the corporate paper for the second consecutive month.
Treasury floaters update
Treasury two-year floaters have been well received by investors since their
January introduction. In the September auction, $13bn floaters were sold at a
high discount margin of 0.041%, the lowest on record. Indirect bidders made
up 54% of the purchase, an indication that client demand for these securities
Page 16
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
remains strong. Treasury auction allotment figures show that foreign investors
have been a consistent demand source for floaters at auctions this year.
Record low discount margin at the last FRN auction
Foreign investor allotments
0.075%
45%
Auction high discount margin
0.070%
40%
0.065%
35%
0.060%
30%
0.055%
25%
0.050%
20%
0.045%
15%
0.040%
10%
0.035%
5%
0.030%
Treasury 2-Year FRN
Auction Allotment:
Foreign & International
(Bil.$)
0%
Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14
Source: Treasury and Deutsche Bank
1/1/14
4/1/14
7/1/14
Source: Treasury and Deutsche Bank
Despite the increase in short rates this year, on a total return basis 2y floaters
have underperformed 2y fixed coupon notes. The Bloomberg Treasury Floating
Rate Bond Index returned 0.08% from January 31 through September 30,
compared to a 0.28% return on the Treasury 1-3 Year Index. The
underperformance is not a surprise, given the higher yield and longer duration
on the Treasury 1-3 Year Index, whereas floaters are considered a short term
investment vehicle.
Regression of floater vs. fixed excess returns on daily 2y
yields
yield changes
100.5
0.70
100.4
100.3
0.60
100.2
100.1
0.50
100.0
99.9
0.40
99.8
99.7
99.6
99.5
Feb-14 Mar-14 Apr-14 May-14 Jun-14
Source: Bloomberg Finance LP and Deutsche Bank
1-3Y Treasury Index
Treasury FRN Index
2y yiel d (%, rhs)
0.30
0.20
Jul-14
Aug-14 Sep-14
Daily excess return of 2y FRN Index over
1-3Y Tsy Index (bp)
Treasury floater and 1-3y fixed coupon indexes vs. 2y
20
15
10
5
0
(5)
y = 1.7154x - 0.3467
R² = 0.7088
(10)
(15)
-10
-5
0
Daily change in 2y yields (bp)
5
10
Source: Bloomberg Finance LP and Deutsche Bank
A regression1 of the difference in daily returns by these two indexes on daily 2y
yield changes suggests that for 2y floating and 2y fixed coupon notes to return
the same to investors, yields in the 2y sector would have to rise by 0.21bp per
day, or 37bp total, between February 2014 and September 2014. 2y yields
increased just 25bp during this period.
1
The regression has a constant of -0.37% and a beta coefficient of 0.017%, the former can be interpreted
as the opportunity cost of unearned carry from holding floaters versus fixed rate note, and the latter
implies the percentage excess return over a fixed rate note portfolio for every basis point rise in yields.
Deutsche Bank AG/London
Page 17
17 October 2014
Global Fixed Income Weekly
Two-year floating rate note (FRN) auction allotments
Settle Date
Total
(less Fed)
$bn
1 Yr Avg
9/26/2014
8/29/2014
7/31/2014
6/27/2014
5/30/2014
4/30/2014
3/28/2014
2/28/2014
14
13
13
15
13
13
15
13
13
Federal Reserve
$bn
%*
0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
Dealers and Brokers
$bn
%
0%
0%
0%
0%
0%
0%
0%
0%
0%
7.9
5.9
6.9
8.6
7.8
7.6
9.8
8.7
7.8
58%
46%
53%
57%
60%
58%
65%
67%
60%
Investment
Funds
$bn
Foreign and
International
$bn
$bn
%*
$bn
1.8
0.1
0.4
0.9
1.2
1.5
2.5
2.9
4.0
3.4
4.0
5.5
5.0
4.0
3.6
2.2
1.3
1.0
0.5
3.0
0.1
0.5
0.1
0.3
0.5
0.0
0.2
4.0%
23.2%
0.6%
3.4%
0.5%
2.3%
3.5%
0.1%
1.3%
13.2%
0.6%
3.5%
6.1%
8.9%
11.5%
16.5%
22.7%
30.8%
Other
24.8%
30.6%
42.6%
33.4%
30.8%
28.0%
14.5%
10.0%
7.7%
* Percentage as of total less Fed SOMA
Source: US Treasury and Deutsche Bank
Fed buyback
Next week’s three buyback operations are worth about $4 billion in notional
and $3 billion in ten-year equivalents. Monday and Tuesday’s operations are
targeted at the 4.8-5.75 and 7-10 year sectors of the curve whereas the 5.8-7
year segment will be in focus on Thursday.
Fed buyback schedule for October 20-24
Date
Operation type
20-Oct
21-Oct
23-Oct
Treasury
Treasury
Treasury
Maturity range
7/31/2019
11/15/2021
7/31/2020
Total
6/30/2020
8/15/2024
9/30/2021
Expected
Avg.
par ($bn) Duration
Avg.
DV01
10yr Equiv Sub/cover
($bn)
(Last 4 avg)
1.125
1.550
1.500
4.85
7.30
5.80
5.16
8.15
6.32
0.65
1.42
1.06
4.18
6.08
6.69
3.13
5.14
3.13
3.70
Source: Deutsche Bank, New York Fed.
Page 18
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
United States
Rates
Gov. Bonds & Swaps
Rates Volatility
Aleksandar Kocic
Research Analyst
(+1) 212 250-0376
aleksandar.kocic@db.com
Derivatives

Vol has returned to the markets with the last week’s developments likely
to set the template for future market corrections. The unprecedented
realized move in rates, about seven standard deviations intraday, has been
to a large extent a function of positioning and is unlikely to resurface with
the same force.

The most troubling fact after the last week is the transient nature of the
entire episode. Only two days after the event, we were seeing attempts to
undo the correction -- as if the market is using this as an opportunity to
reload on the same trades that led to it. Such a quick reversal of volatility
spike reaffirms both our concerns that such episodes are likely to resurface
in the near term, as well as our conviction that risky assets would be the
epicenter of future turbulence.

While at these vol levels it might be tempting to go back to selling
strangles and reload on risky assets, an outright gamma short could be
premature as the market could experience additional turbulence in the near
term. We believe that selling vol in an RV context or though contingent
structures is a safer option. We recommend the following vol trades:

Sell $195mn 3M5Y vs. buy $100mn 3M10Y straddles at zero cost.

Sell $100mn 6M5Y vs. buy $100mn 18M5Y straddles, offer 184c

In rates, our core position is bull steepeners in 5s/10s. This is the mode
that could persist beyond 2014. We would express this view through
contingent curve caps:

6M 5s/10s ATMF curve cap subject to 5Y CMS < Fwd-25bp (at expiry),
offer 4.5c, a 58% discount to vanilla at 10.75bp

The repricing of risky assets might not be over yet. In the near-term,
accommodative Fed and delayed rate hikes is a bull stepener with reduced
vol and a possible rebound in risky assets. A delayed response or nondovish rhetoric, on the other hand, could trigger another leg of risk off
trade and further sell off in risky assets lower, which might rebound only
after that. The following trades capture the two scenarios:

3M SPX ATM (1890) call subject to 5s < Fwd-10bp at expiry, offer 1.00%,
a 70% discount to vanilla at 3.25%

3M SPX ATM (1890) call subject to KO at 1950 (103%) during the first
month, offer 1.15%, a 66% discount to vanilla at 3.25%
Everything is moving, but nothing is changing
Vol has returned to the markets with the last week’s developments likely to set
the template for future market corrections. For rates, the magnitude of realized
move was unprecedented. Large daily swings, in excess of 20bp, used to be a
regular occurrence 10-15 year ago, but this was primarily an effect of negative
convexity of the market. This time around, the magnitude of the move,
although not surprising in the context of market positioning, has caused a
temporary sense of panic. What made things especially uncomfortable was the
large intraday whipsaw. Rates led the way with as much as 35bp rally in the
morning trading hours (about 7-sigma move), and closing only 6bp lower for
Deutsche Bank AG/London
Page 19
17 October 2014
Global Fixed Income Weekly
the day. In contrast, max S&P move remain within two standard deviations.
Such a large whipsaw made it very uncomfortable for liquidity providers which
largely distorted the pricing. To put things in perspective, for the current
market calibrated to 3M10Y vol around 4.5bp/day a 35bp daily move exceeds
seven standard deviations. In units of 2001-2005 markets, when 3M10Y was
trading north of 8+bp/day, this would correspond to a 50+bp move. For
comparison, the largest one-day move in rates has been a 47bp rally in 10Y
UST on 18-Mar-2009.
The discomfort caused by such an outlier is something that is justified in the
context of existing market complacency. Low volatility and excessive
determinism, fostered by the Fed transparency, created positions which
became vulnerable to minor instabilities. A buildup of rates shorts, which have
seen a capitulation in the last week, has been partly “subsidized” by the dollar
strength, which in itself began to expose vulnerability of the US economy to
deflationary risks and further reduced a likelihood of rate hikes.
While weakness in Europe and anticipation of policy response there was
encouraging for the US shorts, it went against the equity market’s pricing as
ECB disappointed. The explosion of vol across the board was announced by
the dramatic rise in VIX, which started gradually in mid-September from 12%
reaching 15% by the end of the month, and soared to 26% in the second week
of October. This was largely a function of both market complacency and
caution of equity investors. With S&P on the way to new highs as of late
August, the risk/reward profile looked like a high probability of small gains and
a low probability of big losses. This meant a long equity position overlaid with
OTM puts. At the same time, high degree of complacency encouraged short
gamma as a carry position with multiple implementations either through VIX
puts or futures. This made both street short convexity in a sell off and investors
short VIX and when equities sold off and street hedging exacerbated the move,
the first leg of rise in VIX was multiplied by short covering of VIX positions. All
of this was helped by strong USD and weakness in Europe together with less
optimistic outlook in the US. At the end, what had been the strongest points
for US equities, (e.g. growth prospects, liquidity and response to
accommodation), turned out to be their biggest curse. The need to deleverage
meant that losses would have to be covered by the best performers, which
meant either credit or equities, but, because of relatively pore liquidity, equities
had to pay the price. In fact, in the metric of different risk premia, reaction of
credit has been relatively mild. Compared to the move in VIX, IG widening has
been twice as strong as post-2008 history suggests.
Figure 1: S&P and VIX: a perfect storm
2050
30
SPX
VIX (right)
2000
25
1950
20
1900
15
1850
10
1800
5
Jul
Aug
Sep
Oct
Source: Deutsche Bank
Page 20
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Extremely low volatility has been one of the main concerns of the Fed. In our
view, their intention was to shake things up so that risky assets reprice close
to fundamentals, but not to shake them up too much, as one sided positioning
could trigger possible liquidity problems and cause positive feedback in the
market. The absence of particular theme on Wednesday suggested that
volatility has reached uncomfortable levels and that its further rise could be
counterproductive. It is not unlikely to see an effort on the Fed side to smooth
things out if we see further turbulence.
To a large extent, last week’s rise in rates vol reflects the magnitude of realized
move due to capitulation of the shorts. Open interest indicates that about 2/3
of this trade is done, so, we do not expect to see another leg of vol increase.
Risky assets, opn the other hand are potential source of risk. For some time,
our contention has been that return of volatility would take place through risky
assets. This is what happened this time, as equities vol led the way. Fig 2
shows the recent history of the ratio between VIX and rates vol.
Figure 2: Equity vs. rates vol
0.35
VIX / 3M10Y
0.3
0.25
0.2
0.15
Jul
Aug
Sep
Oct
Source: Deutsche Bank
Perhaps the most troubling fact after the last week is the transient nature of
the entire episode. Only two days after the event, we were seeing attempts to
undo the correction -- as if the market is using this as an opportunity to reload
on the same trades that led to it. Such a quick disappearance of the spike in
volatility reaffirms both our concerns that such episodes are likely to resurface
in the near term, as well as our conviction that risky assets would be the
epicenter of future turbulence.
Trades: Go faster, but go where?
While at these vol levels it might be tempting to go back to selling strangles
and reload on risky assets, an outright gamma short could be premature as the
market could experience additional turbulence in the near term. We are not
against fading the last week’s turbulence, but would exercise caution in this
context. We believe that selling vol in an RV context or though contingent
structures is a safer option.
Vol
If rates vol spikes again in sympathy to risky assets vol and another episode of
the risk off trade, it is unlikely to see a move of the same magnitude in the
Deutsche Bank AG/London
Page 21
17 October 2014
Global Fixed Income Weekly
belly as most of positions have been cleared there. In the near term, rebuilding
of rates short is unlikely, especially of the magnitude that led to the last week’s
unwinds. At current levels, we would finance a long gamma position in 10Y
tenors through short 5Y gamma:

Sell $195mn 3M5Y vs. buy $100mn 3M10Y straddles at zero cost.
If the market recovers in the sense that sentiment returns to pre-October
correction, but rate hikes are pushed into 2016, 5Y gamma could remained
somewhat constrained while bid for forward vol in the belly would resurface
with calendar spreads opening up. Current pricing offers attractive entry levels
for this trade:

Sell $100mn 6M5Y vs. buy $100mn 18M5Y straddles, offer 184c
Both trades are vulnerable to unilateral rise in 5Y gamma with potentially
unlimited downside.
Rates, risky assets and curve modes
Going forward, the strategies are likely to be a function of the policy response
and any unconditional trades remain risky. In rates, our core position is 5s/10s
steepener. With the unwind of shorts on the Eurodollar strip and repricing of
delayed rate hikes, the belly is likely to outperform with 5Y UST ending up
below 1.25% if rate hikes are pushed into 2016, while 10s could stay at current
levels or even rebound higher. This is the mode that could persist beyond 2014.
We would express this view through contingent curve caps:

6M 5s/10s ATMF curve cap subject to 5Y CMS < Fwd-25bp (at expiry),
offer 4.5c, a 58% discount to vanilla at 10.75bp
Ref. fwd 66.25bp, 6M5Y fwd 1.89%. The barrier at 1.64% reflects the view that
5s would return to their pre-taper-tantrum levels, Fig 3.
Figure 3: 5Y swaps rate and 5s/10s since 2013
160
2.5
150
5s/10s
2.25
140
5s (right)
2
130
1.75
120
1.5
110
1.25
100
1
90
0.75
80
0.5
70
0.25
60
0
J F M A M J J A S O N D J F M A M J J A S O
Source: Deutsche Bank
The repricing of risky assets might not be over yet. In the near-term,
accommodative Fed and delayed rate hikes is a bull stepener with reduced vol
and a possible rebound in risky assets. A delayed response or non-dovish
rhetoric, on the other hand, could trigger another leg of risk off trade and
further sell off in risky assets lower, which might rebound only after that. If
there is a forced deleveraging, it is likely that risky assets will “finance” that
process as they have had the most impressive gains in the last year. Given the
Page 22
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
liquidity problems in credit, equities might be the first frontier in that process,
which should be bearish for stocks and supportive for vol. So, while the word
“rebound” of risky assets is in both scenarios, the initial conditions would be
very different. We recommend two trades that capture these two policy
response modes.
Dovish: Equities rise while Fed hikes are pushed out (Contingent equity calls)

3M SPX ATM (1890) call subject to 5s < Fwd-10bp at expiry, offer 1.00%,
a 70% discount to vanilla at 3.25%
Hawkish: Equities decline before they bounce back (Up & out calls)

3M SPX ATM (1890) call subject to KO at 1950 (103%) during the first
month, offer 1.15%, a 66% discount to vanilla at 3.25%
Both trades are offered at a substantial discount to vanilla. Even when
combined to proxy for an “unconditional” strategy (equities rebound one way
or another), at total price of 2.15%, they still look attractive relative to vanilla at
3.35%. All trades have a limited downside with maximum losses equal to the
options premium.
Deutsche Bank AG/London
Page 23
17 October 2014
Global Fixed Income Weekly
Europe
Credit
Covered Bonds
Securitisation
Conor O'Toole
Research Analyst
(+44) 20 754-59652
conor.o-toole@db.com
European ABS update
This is an excerpt from the European Asset Backed Barometer
Despite central bank purchases set to start at some point in Q4, European ABS
pricing has by no means been immune to the broader market correction.
Following the sovereign lead, pricing in peripheral ABS has been most volatile
– with senior paper from Italy, Portugal and Spain off ca. 10-15 bps in ABS PP
eligible names. Non ABS PP eligible peripheral bonds have fared worse still –
IMPAS 4 A for example is off c.3 ppts, while holding up better in CLOs, CMBS
and core RMBS/ABS. Although these moves are large for the sectors in
question, in the context of the recent ABS PP aggressive tightening, they are
understandable. A contrast also exists between the sector and the subdued
price action in Covered Bond markets, where ECB purchases are due
imminently. We see actual CBPP3 purchases as a potential catalyst to the
establishment of firmer ABS support levels and a potential sector relief rally.
Amid this past week’s volatility, new issue ABS markets have held up well with
six deals issued and a reasonable pipeline maintained – see page 4, however
importantly all transactions were from core. Of this issuance some GBP 2.9 bn
of issuance was from 2 deals backed by the recently acquired UKAR mortgage
portfolio which priced well back of secondary comparables. The quick turnaround into a securitisation exit along with the quantum of issuance speaks to
the ability of the European ABS market to readily absorb well priced supply.
Away from macro volatility, an EBA consultation paper on High Quality
Securitisation published on Tuesday continues the regulatory flurry of the past
week. We published standalone reports on both LCR and Solvency II
Delegated Acts this past week – where we argue that while there has been
some positive movement on ABS (including a broader spectrum for LCR and
lowering capital charges for certain senior bonds for Solvency II) the
concession in ABS are not sufficient. This is particularly so when one analyses
the treatment securitisation versus covered and corporate bonds, and relatively
disappointing therefore in the context of recent policymaker debate.
CMBS pricing has remained relatively resolute over the past week, with bids
down c.¼ pts in CMBS 2.0 on thin trading activity. Outside this, we think the
sale of a portfolio of 10 properties in WINDM 11 is broadly positive compared
to pre-announcement pricing, where we understand the Class B was trading in
the mid-high 60s (a correction versus the high 80s seen in June). We think
recoveries on the Class B will ultimately fall somewhere in the mid 70% range,
when the residual 3 properties are sold, most likely in the next 6 months.
1 week Spread widening (bp)
Chart of the week- – Spread widening in the last one week
Sovereign 5y
50
RMBS
Covered bonds
40
30
20
10
0
-10
-20
-30
Spain
Italy
Portugal
Ireland
UK
Netherlands
Source: : Deutsche Bank, Indicative spread widening for the sectors. RMBS and covered bonds spread widening based on trader inputs
Page 24
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Global
Credit
Covered Bonds
Bernd Volk
Strategist
(+41) 44 227-3710
bernd.volk@db.com
Covered Bond and Agency Update

The ECB published an act that officially establishes CBPP3, coming into
force tomorrow. The market expects CBPP3 to start next week, which was
the reason for peripheral covered bonds widening only marginally while
peripheral sovereigns widened significantly this week. Spreads of core
covered bonds traded unchanged.

The ECB said CBPP3 should be implemented in a uniform and
decentralized manner, suggesting that risk is borne according to capital
keys. While supportive for spreads of Italian and Spanish covered bonds,
buying of core country covered bonds should be disappointing from an
ECB balance sheet perspective.

With EUR 33bn of negative net supply ytd, the primary market of EUR
benchmark covered bonds remains supportive on top of CBPP3, also
confirmed by a share of iBoxx EUR Covered in iBoxx EUR Bonds of 9.5%
as of Oct, the lowest level since recording in 2004.

Only Caisse Centrale Desjardins du Quebec tapped the primary market this
week with a EUR 1bn 5Y issue at ms+2bp. Banks buying 53% (SSA 25%,
asset managers 12%, insurance/pension funds 7%, corporates 3%)
suggests that the confirmed LCR Level 2A status for non-EU covered
bonds in the EU supports demand.

The EU LCR rules deviate from Basel III, strongly softening the treatment
of covered bonds. Moreover, the eligibility in banks' Level 2B buffer of
credit lines that EU national central banks and the ECB could extend under
some conditions and the lack of restrictions on EU government bonds are
further differences compared to Basel III.

The EU rules do also not impose the public disclosures that Basel
recommended in Jan 2014. Moreover, the EU regulation will not be
enforced on 1 Jan 2015, but in Oct 2015, when the minimum threshold is
set at 60%. Full compliance (100%) is required in Jan 2018.

In our view, EU rules regarding LCR are complex but very supportive for
covered bonds and agencies. Even unrated covered bonds and covered
bonds rated below A- qualify for Level 2B. Minimum OC for covered bonds
to qualify for Level 1 (2%), Level 2A (7%) and Level 2B (10%) do not need
to be based on legal frameworks for covered bonds. By far most euro area
covered bonds will qualify for LCR and non-LCR eligible covered bonds by
euro area banks and Multi-Cedulas typically qualify for CBPP3.

In our understanding, supras, agencies guaranteed by Member States (and
0% risk weighted regional governments), 0% risk weighted sub-sovereigns,
wind-down entities guaranteed by Member States and crisis inspired state
guaranteed bank bonds qualify for Level 1. While there is uncertainty
regarding agencies with a 20% risk weight, we expected a generous
interpretation. In numerous cases, e.g. Dutch BNG and NEDWBK, we
expect Level 1 status to apply.
Besides some weakness in EFSF and ESM, core European supras and agencies
held up very well with little spread widening versus swaps, also supported by
Level 1 LCR status. Besides in case of significant further weakness in the
periphery, we expect ongoing tight spreads of core supras and agencies,
supported by flattish net supply.
Deutsche Bank AG/London
Page 25
17 October 2014
Global Fixed Income Weekly
United Kingdom
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Soniya Sadeesh
Strategist
(+44) 0 207 547 3091
soniya.sadeesh@db.com
UK Strategy
A very sharp move lower in core yields this week, as volatility returned, with
risky assets selling off alongside. Broader concerns over the strength of the
global recovery, alongside idiosyncratic domestic factors (local politics in EZ
for example triggering some weakness in periphery) contributed. We stop out
of the short front end positions.
One of the largest daily volumes in short sterling in the last 5Y
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Total Volum e
Date
# Contracts L Z6 change
13-Jun-14
2894257
-10
15-Oct-14
2045690
22
12-Feb-14
2043884
-19
22-Jan-14
1985457
-10.5
15-Jun-12
1774039
15
24-Jan-14
1735895
7
11-Jun-13
1706709
-18
07-Aug-13
1632952
-11
14-May-14
1630268
14
16-Apr-14
1555487
-5
18-Dec-13
1527959
-10
25-Jan-11
1491967
9
24-Jun-13
1484442
-20
13-Nov-13
1470628
-3
18-Sep-14
1456193
-6
Trigger/Event
Mansion House speech
Global grow th/inflation fears
Feb 14 IR
Labour market report
Mansion House speech
Governor speech
Taper fears
Aug 13 IR
May 14 IR
Labour market report
Labour market report
First estimate Q410 GDP
Taper fears
Nov 13 IR
Scotland referendum
Source: Deutsche Bank, Bloomberg Finance LP, Liffe
Central banks have been discussing/warning that benign market conditions did
not reflect existing risks. The Governor recently referred to the FSB statement
in mid Sept which concluded: “there are increased signs of complacency in
financial markets, in part reflecting search for yield amidst exceptionally
accommodative monetary policies. Volatility has become compressed and asset
valuations stretched across a growing number of markets, increasing the risk of
a sharp reversal.” To some extent this might be viewed as valuations catching
up, however central bank speakers have been changing tack this week to calm
conditions.
The FPC has also noted that secondary market liquidity could be impacted in
such an unwind, as market-making capacities in some sectors have been
structurally reduced – this is said to have played a role in this week’s move.
Domestic data played a secondary role, despite two important releases. The
September CPI print was softer than expected, food and fuel were expected to
contribute negatively – this should be seen as a positive development for
consumers, however the decline was more broad-based than just that. The
wage data however was more positive; whilst acknowledging levels are still
not especially strong, the trend in recent months has been positive, and a
clearer indicator of domestic price pressures than CPI.
Page 26
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
BoE’s Haldane acknowledged recent dynamics, saying that it meant that rates
could remain lower than he had expected at his last speech in June, indicating
that market expectations for “mid 2015” seemed reasonable.
Underlying trends do matter
Real wages recovering slowly
9.0
4
RPIx-Target(2.5)
7.0
mm changes in Base Rate
3
5.0
CPI-Target (2)
3.0
2
1.0
1
-1.0
0
-1
-3.0
Real Wages
-5.0
Real Wages, 3mma yy%
-7.0
-9.0
-2
00
01
02
03
04
05
06
07
08
09
Source: Deutsche Bank
10
11
12
13
02
14
03
04
05
06
07
08
09
10
11
12
13
14
Source: Deutsche Bank
Rate pricing has moved back to August 15 where the first hike is fully priced.
Assuming that the MPC will time the first hike to coincide with an Inflation
Report (this seems reasonable at least for the first hike, not necessarily the
entire cycle), then May or August are the mid year meetings, with the latter
complicated by the timing of the general election. The pace however has
slumped significantly, with some 37bp in 2016, and 28bp in 2016, ie Dec 16
OIS implying around three and a quarter hikes.
Libor OIS forward bases have widened, which appears overdone. Access to
liquidity at least should not be an issue - the FPC minutes record preparations
ahead of the referendum, and note that UK banks were said to have stable
wholesale funding positions, significant asset buffers alongside “substantial”
prepositioned collateral at the DWF.
Starting point vs pace
4.50
Live
4.00
100bp/year
3.50
50bp/year
3.00
Terminal Rate 2.5%
Yest
2.50
2.00
1.50
1.00
Fwd basis back to referendum levels
35
USD L/OIS Basis
GBP L/OIS Basis
30
25
20
15
0.50
Source: Deutsche Bank
Oct-14
Sep-14
Jul-14
Aug-14
Jun-14
Apr-14
May-14
Mar-14
Jan-14
Feb-14
Dec-13
Oct-13
Nov-13
Sep-13
10
Aug-13
0.00
Source: Deutsche Bank, Bloomberg Finance LP
GBP rates have unwound part of the rally, largely tracked the US move, though
have outperformed US long forwards.
Looking at latest (Thurs close) valuations on a 2Y horizon, several points stand
out as being particularly stretched – long dated forwards and front end
breakevens.
Deutsche Bank AG/London
Page 27
17 October 2014
Global Fixed Income Weekly
Weekly change(Thurs close)
GBP
-9.0
-15.8
-14.1
-14.5
GBP
-18.4
-22.9
-10.9
-16.2
2Y
5Y
10Y
30Y
1Y1Y OIS
2Y2Y
5Y5Y
15Y15Y
USD
-7.7
-14.8
-10.7
-6.2
USD
-20.1
-25.7
-7.1
-3.1
How stretched?
EUR
2.2
1.2
-3.5
-9.1
EUR
0.2
1.0
-8.6
-13.6
Source: Deutsche Bank, Bloomberg Finance LP
Z-Scores 2Y Basis
Nominal Fwds
2Y2Y
GBP
-0.03
USD
0.51
EUR
-1.87
Inflation Swap
5Y
GBP
-1.95
USD
-2.63
EUR
-2.36
5Y5Y
-1.51
-0.90
-2.46
10Y
-1.18
-2.55
-2.89
15Y15Y
-2.95
-1.31
-2.50
5Y5Y
-0.22
-2.05
-3.80
Source: Deutsche Bank, Bloomberg Finance LP
The DMO has announced the UKT 3h68 will be syndicated in the week of 27
Oct. There is another GBP 4 bn remaining under nominal syndication
programme; the next nominal syndication in the next issuance year as the one
in Q115 will be the remaining linker. The index extension impact ranges from
0.064Y-0.072Y depending on the issuance size.
Whilst outright levels have been dragged along with global rates, the sector
has been cheapening relative to 30Y in recent weeks, which can be seen both
on the slope and when looking at swap spreads.
Index extension estimates
Index Extension Estimates
Size, bn
3h68
4.00
3h68
4.25
3h68
4.50
Sector impact
0
All
0.064
0.068
0.072
15Y+
0.089
0.095
0.100
UKT 44-68
3
UKT 60-68
-1
2.5
-2
2
-3
1.5
-4
1
-5
Source: Deutsche Bank
-6
0.5
-7
0
Source: Deutsche Bank, Bloomberg Finance LP
ASW Box
10Y30Y fitted
0.0
35.0
60
-1.0
30.0
50
25.0
40
20.0
30
15.0
20
-2.0
-3.0
-4.0
10.0
-5.0
3Q44-3H68 ASW (rhs)
-6.0
Oct-13
Source: Deutsche Bank
Page 28
2Q23-3H68 ASW
5.0
0.0
Apr-14
Fitted
Residual
10Y30Y
10
0
-10
Oct-14
Source: Deutsche Bank
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Japan
Rates
Gov. Bonds & Swaps
Makoto Yamashita, CMA
Strategist
(+81) 3 5156-6622
makoto.yamashita@db.com
Japan Strategy
Overview

Oil prices have plunged during the recent "risk off" phase. If crude oil
remains somewhere near USD80/barrel, then lower petroleum prices alone
will subtract around 0.3% from Japan's CPI. Second-round effects are also
likely to have a non-negligible impact, thereby making it even harder for
the BOJ to achieve its +2% "price stability target". However, the central
bank is unlikely to deploy additional monetary easing in the near term
given that yen depreciation last month sparked political and public
criticism of import inflation. That said, the possibility of further BOJ action
is liable to remain in the minds of JGB market participants if the world
stays in "risk off" mode, in which case domestic interest rates could hover
somewhere around their current levels for longer than we had previously
thought.

The limited capacity of most major nations to deploy further policy
stimulus is perhaps one factor behind the recent shift in market sentiment,
with most central banks having cut interest rates to around zero and many
already deploying quantitative easing measures. However, the Abe
administration has room to temporarily loosen the fiscal purse strings
given that a final decision on the October 2015 consumption tax increase
must be made before the end of December. With the hike to 10%
seemingly a done deal, we see ample potential for a substantial
supplementary budget aimed at bolstering the cabinet's approval rating.
Inflation expectations receding as oil prices plunge
"Risk on" positions have been rapidly unwound amid growing concerns over
the global economic outlook. Oil prices have plunged during the latest derisking phase, with NYMEX crude down some 10% from end-September and
20% from July at just above USD80/barrel. Contributing factors would appear
to include (1) downside risk to the world economy, (2) concerns over the
prospect of Fed rate hikes, (3) increased global supply, including the growth of
US shale oil, and (4) OPEC's recent emphasis on maintaining market share
rather than price. Market attitudes vis-à-vis (1) could change if economic
indicators take a turn for the better, and a temporary fall in oil prices could
generate cyclical upward pressure at some point in the future by boosting the
purchasing power of oil-consuming nations. However, (3) and (4) might
reasonably be considered structural factors, making this an opportune time to
consider the potential ramifications of lower oil prices for Japanese interest
rates.
Japan is a massive energy importer, as a result of which its CPI is quite
sensitive to movements in international energy prices. The BOJ bases its
inflation forecasts on the core CPI, which excludes fresh foods but does
include energy products. Assuming that oil prices and USD/JPY maintain their
current levels (and the usual roughly one-month time lag), prices of petroleum
products (gasoline, kerosene, and liquefied propane) can be expected to fall
around 9% from their August levels. Given their 3.6% weight within the index,
this would translate into a roughly 0.3% decline in the CPI. Prices are also
likely to decline for certain other items due to second-round effects, thereby
lowering the index even further.
Deutsche Bank AG/London
Page 29
17 October 2014
Global Fixed Income Weekly
Figure 1: Japan's petroleum products CPI vs. the price of crude oil
Crude oil price
Petroleum productions CPI (rhs)
($/bbl)
(Index)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14
140
130
120
110
100
90
80
70
60
Source: Ministry of Internal Affairs and Communications (Statistics Bureau), Deutsche Securities
Figure 2: Contribution of petroleum product prices to Japan's core CPI
inflation rate
Contribution of petroleum product prices
Core CPI
(year-on-year, %)
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13
Jan-14
Jul-14
Source: Bloomberg Finance LP, Ministry of Internal Affairs and Communications (Statistics Bureau), Deutsche Securities
This may force the BOJ to lower its inflation forecasts and consider the need
for additional monetary easing measures. However, such action is likely to be
politically difficult at this juncture given that last month's depreciation of the
yen sparked somewhat of an outcry over the impact of import inflation. It is
therefore possible that the BOJ will leave its forecasts unchanged and hold off
on further easing for at least the time being. That said, the possibility of further
BOJ action is liable to remain in the minds of JGB market participants under
this scenario, in which case domestic interest rates could hover somewhere
around their current levels for longer than we had previously thought. We do
not recommend buying JGBs at current (historically low) yield levels given that
exchange rates, equities, and commodities have all turned more volatile, but
we may need to rethink our forecast of a rise in JGB yields if oil prices remain
low and USD shows no signs of resuming its uptrend.
Japan could draft a larger supplementary budget if the
global economy slows
The limited capacity (or willingness) of most major nations to deploy further
fiscal or monetary stimulus is perhaps one factor behind the recent shift into
"risk off" mode. For example, Germany—which continues to run a current
account surplus—was reportedly exhorted at last week's G20 meeting to step
up its fiscal spending, but looks unlikely to alter its stance on the need for
Page 30
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
discipline even if it does loosen its purse strings slightly in response to an
economic slowdown. However, Japan appears uniquely placed to deploy
significant fiscal stimulus measures ahead of a December decision to proceed
with the planned October 2015 consumption tax hike from 8% to 10%
(following the release of GDP figures for 3Q). 66% of respondents in a
September Nikkei poll indicated that they are opposed to the tax increase, and
it is also important to recognize that the cabinet's approval rating tends to be
quite sensitive to domestic stock prices (which are in turn sensitive to global
stock price movements). The Abe administration is thus at risk of seeing its
approval rating (currently 53%) drop below the 40% threshold considered
necessary to maintain a stable government.
A temporary increase in fiscal spending may thus be considered quite an
attractive option. Whereas the Obama government continues to be constrained
by the Republican-controlled House, the Abe government's control of both
houses gives it the ability to pass legislation virtually at will. The ruling Liberal
Democratic Party often resorts to pump-priming measures when the economy
appears to be at risk of a slowdown, and should face no major obstacles in the
current political climate. We therefore expect the prospect of a large
supplementary budget to become a key theme in 4Q if financial markets
remain in "risk off" mode.
Figure 3: Cabinet approval rating vs. Nikkei 225
(JPY)
Nikkei 225
Cabinet approval rating (rhs)
LDP government → DPJ government
→ LDP
government
20000
18000
(%)
80
70
60
16000
50
14000
40
12000
30
10000
20
8000
10
6000
0
06
07
08
09
10
11
12
13
14
Note: Vertical lines denote changes of Cabinet
Source: Nikkei Research website, Bloomberg Finance LP, Deutsche Securities
Deutsche Bank AG/London
Page 31
17 October 2014
Global Fixed Income Weekly
Asia
Rates
Gov. Bonds & Swaps
Rates Volatility
Sameer Goel
Strategist
(+65 )
64236973
sameer.goel@db.com
Asia
Swapnil Kalbande
Strategist
(+65) 6423 5925
swapnil.kalbande@db.com
Resetting to 2% yields
Linan Liu
The absolute scale of drop in global yields in some sense does not do justice to
the intensity of the moves over the last few days. The spike in interest rate
volatility is probably more illustrative of the turbulence in markets as they reset
to the new thematic of disinflation led by lower energy prices, and the growing
expectations of push back in tightening by the Fed.
Strategist
(+852) 2203 8709
linan.liu@db.com
Kiyong Seong
Strategist
Asia has reacted, as can be expected, with a beta of less than one to the
moves in global yields, given in particular the cross currents between the
disinflationary impulse from lower energy prices versus the potential fallout for
capital flows into the region from the increasing negativity towards risk assets.
Rates volatility has spiked harder than FX vol
kiyong.seong@db.com
Month to date moves in Asian yields versus US
180
18
interest rate volatility*
160
(+852) 2203 5932
16
currency volatility**
0
-5
-10
140
14
120
12
-20
100
10
-25
80
8
60
6
-15
-30
10Y bonds
-35
40
Oct-09
Aug-10
Jun-11
Apr-12
Feb-13
Dec-13
4
Oct-14
Source: Deutsche Bank, Bloomberg Finance LP *Index of normalized implied volatility on 1-mth
Treasury options ** Index of 3-mth implied volatility of 9 major currency pairs
-40
5Y swaps
bp
-45
US
SG
TH
CH
Source: Deutsche Bank, Bloomberg Finance LP
ID
IN
TA
KR
MY
*NDIRS where applicable
Have we reset then to a world with Treasuries in the low-2% handle? Away
from the idiosyncrasies of the local rates markets, one way to contextualize
this is to compare the levels today with those from before the first Taper
Tantrum in summer of 2013, and from when the Fed’s commitment to keeping
rates low for an extended period of time was still unquestioned. We look
below at 10Y government bond yields in Asia (and the US) versus their range
over the past couple of years.
Page 32
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Asia 10Y bond yields versus their 2-year history
10
10Y Yields (%)
2Y Range
Current
Average
9
8
7
6
5
4
3
2
1
0
IDR PHP SGD TWD MYR INR CNY HKD USD THB KRW
Source: Deutsche Bank, Bloomberg Finance LP
What stands out is the scope for further retracement in several markets in the
region, and in particular the high yielders, if the disinflation thematic were to
stick. India we believe mostly gains from a combination of lower US yields and
lower energy prices, with the latter feeding ultimately into expectations of
monetary easing down the line. Indonesia is a less obvious case, though, with
the jury still out on potential fuel price adjustment by the incoming
administration, and given the historically high sensitivity to risk sentiment.
Among the more cyclical markets, while Thailand and Korea appear at first
glance to be on the richer side of their 2Y ranges, we need to adjust for the
75bp easing in policy rates in both economies over this period. We argue
below for further downside in yields in both these markets. Less so, we feel, in
Malaysia.
And finally, in China, the cuts in 14D repo rates by the PBoC, including this
week, herald a shift in monetary policy direction towards further easing in the
months to come, particularly given the weakness in property sales and
investment. Together with the impulse from lower global yields, we look for
further flattening in the CGB curve (see later).
Korea: Pain trade
The pain trade for local institutional investors such as insurers we suspect is
still for lower yields. We see 10Y KTB yields moving lower still to 2.50%, and
are overweight on duration in this market.
The on-the-run 10Y KTB now trades at 2.738% (MTD -15bp vs. -50bp in the
10Y UST). As a result, the yield differential between 10Y KTB and UST yields
has widened again to +75bp from the recent low of +40bp. We believe this
differential will narrow in the days ahead, and will press 10Y KTB yields to
nearer 2.50%.
Deutsche Bank AG/London
Page 33
17 October 2014
Global Fixed Income Weekly
Yield differential and foreign bond holdings
RMB deposits are not attractive at these levels
10Y KTB - 10Y UST, bp
Foreign bond holdings, KRWtn, RHS
140
103
120
400
101
99
100
Premium on RMB deposit aginst 1Y KRW
deposit, bp, LHS
1Y CCS basis, inversed, bp, RHS
500
105
-120
300
-110
200
95
60
100
91
89
20
0
Jan-13
-100
-90
93
40
-80
-70
0
-60
87
-100
Oct-12
85
May-13
Sep-13
Jan-14
May-14
-140
-130
97
80
-150
Sep-14
Source: Deutsche Bank, FSS, Bloomberg Finance LP
Apr-13
Oct-13
Apr-14
-50
Oct-14
Source: Deutsche Bank, Bloomberg Finance LP
Local long-term investors who have waited for a correction in global rates with
the end of QE will likely have to start buying KTBs given the lack of alternative
investment opportunities. They have been diversifying their investments into
RMB deposits and overseas bonds, which however are not particularly
attractive at these levels.
The market we feel is yet to be convinced that the recent rate cut by BoK
would be the last one in this cycle. To be sure, the Governor’s comments after
the latest round of easing, and the scale of downward revisions in forecasts,
are not necessarily dovish enough to imply another rate cut. But it also true
that the BOK has repeatedly revised down its forecasts and in turn cut policy
rates in this cycle. We would expect the market to gradually price back in
another rate cut into the front end, particularly as the downward pressure on
inflation intensifies with the recent collapse in global commodity prices. Any
upward pressure on inflation due to hike on tobacco tax – by as much as
0.6%ppt on CPI – will likely be seen as a supply led factor, and not a reflection
of demand pressures.
5Y swaps have outperformed other segments of the IRS curve, resulting in the
2Y/5Y/10Y fly moving lower to -8.7bp, the lowest level since June 2013. The
2Y/5Y IRS spread stands at 17bp. To be sure, the curve has inverted in the past,
but only when the central bank was in a tightening mode. Such a scale of
flattening is unlikely to happen given the residual hopes of another rate cut.
KRW IRS 2Y/5Y and the policy rate
150.0
IRS 2Y/5Y spread
Policy rate, RHS
5.5
5.0
100.0
4.5
4.0
50.0
3.5
3.0
0.0
2.5
2.0
-50.0
1.5
-100.0
Jun-01
1.0
Jun-03
Jun-05
Jun-07
Jun-09
Jun-11
Jun-13
Source: Deutsche Bank, Bloomberg Finance LP
Page 34
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Malaysia: Limited value
The government has reiterated its commitment to fiscal consolidation in the
2015 Budget presented last Friday. The Budget deficit is expected to fall from
3.9% of GDP last year to 3.5% this year before it approaches 3% in 2015.
That said, supply has not been the problem for Malaysian rates. It is demand
that remains crucial in driving the market. Domestic accounts have been
diversifying out of MGS into GII for yield pick-up. That leaves offshore as the
sole taker of the MGS supply, and although their holding of GII is miniscule,
they now appear to be buying relatively more GIIs than they did in the past.
Markets will have to digest an estimated MYR16.5bn of supply for the
remainder of 2014, and majority of this will be MGS (MGS: 10.5bn gross & net,
GII: 5.5bn gross & 1bn net). The onshore community (local real money and
banks/PDs) are unlikely to find current levels as particularly compelling. As
such, the onus remains on the offshore community to keep the market
supported at these levels.
With developed market yields making new lows, we see little immediate risk
for MGS to sell off either. Looking at relative valuations, we prefer 10Y GII over
10Y MGS which offers over 30bp pick-up and see a scope for this spread to
compress. Also, importantly the 10Y MGS appears to be the most expensive
on entire MGS curve, based on our fitted spline model, and we recommend
switching out of the benchmark 10Y to maximize gains. We like 7Y MGS and
back-end of the curve, especially the 30Y.
10Y MGS vs 3M Klibor
Source: Deutsche Bank, FSS, Bloomberg Finance LP
Deutsche Bank AG/London
10Y GII appears attractive over 10Y MGS
Source: Deutsche Bank, Bloomberg Finance LP
Page 35
17 October 2014
Global Fixed Income Weekly
MGS Yield Curve: Actual versus smooth Spline
5.00%
ExpSpline Yield
Market yield
Yield
4.80%
4.60%
4.40%
4.20%
4.00%
3.80%
3.60%
3.40%
3.20%
Maturity
3.00%
0
2
4
6
8
10 12 14 16 18 20 22 24 26 28 30 32
Source: Deutsche Bank
Thailand: Stay long, stay strong
With the old 10Y (LB236A) now at 3.20%, and the new 10Y (LB25DA) at
3.40%; spread to policy rates is similar to when 10Y yield was near 3% in Oct2010 (and policy rate at 1.75%). Is the rally over? We don’t think so. Back in
Oct-2010, inflation was at 2.90% and subsequently pushed higher to 4.50%
over the following 10 months, and BoT was already in a hiking cycle (starting
July 2010). In contrast, inflation now is at 1.75%, and BoT's forecasts put CPI
next year at an average of 2.1%. BoT's latest proposal to switch its policy
target from core to headline inflation adds to a firmly accommodative bias for
an extended period. Meanwhile, growth is anemic; supply outlook for Loan
Bonds in FY15 is supportive and the demand outlook is fairly robust, with flush
onshore liquidity and given that offshore buying has more to catch-up. As such
the Thai curve remains sufficiently steep, especially in the context of a central
bank with an accommodating bias for longer. We thus remain constructive on
ThaiGBs and maintain our overweight stance on duration.
ThaiGB now, versus in 2010
Source: Deutsche Bank, Bloomberg Finance LP
China: Easing signals
The PBoC cut the 14D repo rate in the open market by another 10bps this
week to 3.4%, the third cut in this rate this year and bringing the total cut in
the 14D repo rate by 40bps. We believe there are three policy implications of
the cut this week
Page 36
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly

Realign PBoC’s OMO rates with the money market rates. While the PBoC
manages liquidity in the open market by primarily tracking a quantitative
target (ie. money supply growth, this year at 13%), it also uses interest
rates of its open market operations (PBoC bill yields and repo/reverse repo
rates) to signal its monetary policy bias. Over the past few weeks, the
PBoC took two important steps to ease monetary condition, albeit still on a
targeted basis – the RMB500bn SLF to large commercial banks around
September 18th and mortgage policy relaxation on September 30th. Policy
induced liquidity injection has led to lower money market rates, for
example the 7D repo rate fell to around 3% and 14D repo rate to 3.25%.
The move in the money market rates widened its gap to the 14D OMO
repo rate, and considering these two rates are large commercial banks
short term lending rates to either the central bank (OMO repo rate) or
borrowers in the interbank market, they should naturally converge. As
such we believe the cut reflects PBoC’s willingness to realign its open
market rates with money market rates;

Guide the market expectation on liquidity and money market rates. As the
OMO rates are PBoC’s policy rates, they do not fluctuate frequently and
each move carries PBoC’s policy intention. In our view, the cut clearly
signals that PBoC wants to keep money market rates low, interbank
liquidity condition flush and low volatilities of money market rates for
some time. The purpose is to help lower corporate financing costs through
money policy transmission either in the corporate bond market as lower
benchmark CGB yield curve will drive lower corporate bond yields ; or in
the bank loan market as financial institutions can borrow in the interbank
market relatively cheaply to make corporate loans.

Prepare for further policy easing in the coming months. We believe the
three cuts in the 14D repo rate this year indicates that PBoC’s monetary
policy direction will shift towards further easing in the months to come,
particularly given the weakness in property sales and investment. With the
recent correction in commodity prices, and September money supply
growth (12.9% YoY) within the 2014 full year (13% YoY) pointing to benign
inflation outlook, we see room for the PBoC to lower the 14D OMO repo
rate towards 3-3.2% towards the year end.
Realigning 14D OMO repo rate with the money market 14D repo rate (%)
8
7
14D repo rate
14D OMO repo rate
6
5
4
3
2
Source: Deutsche Bank
Deutsche Bank AG/London
Page 37
17 October 2014
Global Fixed Income Weekly
Pacific
Australia
New Zealand
Rates
Gov. Bonds & Swaps
David Plank
Macro strategist
(+61) 2 8258-1475
david.plank@db.com
Dollar Bloc Strategy
Ken Crompton
Strategist
(+61) 2 8258-1361
kenneth.crompton@db.com

The extreme volatility in bond markets over the past week has seen the
market trade to the stop in our 10Y ACGB short, if only briefly. We have
remained in the trade, however. We also recommend that longer-term
investors remain underweight duration. At close to 3% we simply don’t
see any long-term value in the 10Y ACGB.

One could argue that from an Australian perspective the current economic
dynamics are worse now than in 2012, when the 10Y ACGB did trade
under 3%, because China is in a weaker position. In our view this reality is
priced to some extent in the form of a lower AUD and a tighter 10Y
ACGB/UST spread. We think both have further to fall.

A tighter 10Y ACGB/UST spread could happen in a bullish fashion, of
course. If the 10Y spread reaches the lower end of our forecast range of
50bp and the 10Y UST sells-off by less than 50bp from this point then we
end up with a 10Y ACGB yield of 3% or lower. And if the spread
compression happens as the 10Y UST is rallying then the 10Y ACGB could
end up much lower than 3%.

But a bullish spread compression toward 50bp will require the AUD frontend to price a sub-2% cash rate, in our view. We struggle to see this
happening without explicit endorsement from the RBA and we think it will
take a considerable evolution of the domestic data to push the RBA to an
easing bias. This may happen in time, but not before February at the
earliest in our view.

Is there an alternative path to front-end AUD curve steepening than via a
long-end sell-off? To be specific, might an aggressive easing cycle by the
RBA, or the expectation of such, steepen the front of the curve? The
answer to this is that it depends.

for the front of the curve to bull steepen in coming months we would need
any easing or the pricing of an easing to be accompanied by the
expectation that on a two year, or thereabouts, horizon rates would be
rising again. We aren’t confident this would be the case in the current
environment. Hence we would not recommend that investors looking for
the AUD front-end to price easings implement this trade via a front-end
curve steepener. Rather we suggest they simply go long the front of the
AUD curve.
Bond rally continues as concern about the global growth outlook increases and
market volatility spikes
Bond markets have rallied strongly this week, with extreme volatility a key
feature of the price action. The 10Y UST yield is at 2.15% as we write, down
from 2.28% at the close of last week. The discussion of end of day levels
massively understates the degree of volatility over the week, however. At one
point on Wednesday the 10Y UST very briefly traded as low as 1.86%, a rally
of some 35bp from the open, before closing the day at 2.13%. It then traded
below 2% again on Thursday, before finishing the day at 2.16%.
Page 38
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
$-bloc 10Y bond yields
5.0
10Y NZGB (LHS)
10Y ACGB (LHS)
10Y UST (RHS)
10Y CAN (RHS)
4.8
3.2
3.0
4.6
2.8
4.4
2.6
4.2
4.0
2.4
3.8
2.2
3.6
2.0
3.4
1.8
3.2
3.0
Jan-13
1.6
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Oct-14
Source: Deutsche Bank, Datastream
Putting to one side the extreme price action of the past few days, we think the
rally since the later part of September has been largely driven by concerns
about the global growth outlook and the rise in market volatility that seems to
be related to both this and the impending end of the Fed’s QE program. No
doubt market positioning has played a key role as well, as perhaps have
concerns over the impact of a stronger currency on the US growth outlook and
also perhaps the impact of the spread of Ebola. The net result is that the
market has lost confidence in its expectation that the Fed will tighten in 2015.
From pricing a series of rate hikes in 2015 as recently as the end of September,
the market now has just one 25bp hike fully priced for that year. And the
market has pulled back from expecting a Fed funds rate of close to 2% by the
end of 2016 to now something closer to 1.25%.
End 2016 market expectations for the Fed
2.1
Dec-16 Fed funds
rate priced by
market
2.0
1.9
1.8
1.7
1.6
1.5
1.4
1.3
1.2
1.1
Mar-14 Apr-14 May-14 Jun-14
Jul-14
Aug-14 Sep-14 Oct-14
Source: Deutsche Bank, Bloomberg Finance LP
There has also been a reassessment by the market of where the Fed will end
up in the long-term. This matters more for the 10Y UST than near-term
expectations for the Fed, in our view.
Deutsche Bank AG/London
Page 39
17 October 2014
Global Fixed Income Weekly
Long-term Fed expectations and the 10Y UST
6.0
10Y UST
5.5
5.0
3M rate implied by 12th
Eurodollar contract
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Jan-05
Apr-07
Jul-09
Oct-11
Jan-14
Source: Deutsche Bank, Bloomberg Finance LP
In total the 10Y UST has now rallied by close to 50bp since its recent high on
18 September. Over the same effective period the 10Y ACGB has also rallied
by close to 50bp. That is, the 10Y ACGB/UST spread is essentially unchanged
from 19 September until now, even though the AUD front-end has not quite
managed to keep pace with the US front-end rally.
10Y ACGB/UST spread vs relative front-end pricing
10Y ACGB/UST spread, bp (LHS)
170
4th AUD bank bill/Eurodollar futures spread, bp (RHS)
270
160
150
250
140
130
230
120
210
110
100
190
90
80
Jan-13
170
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Oct-14
Source: Deutsche Bank, Bloomberg Finance LP, Reuters
In saying this we would note that the AUD front-end only began to
underperform the US front-end in late September after a period of
outperformance that was also reflected in a narrowing in the 10Y ACGB/UST
spread. All up we would say that the 10Y ACGB/UST spread is broadly where
we might expect it to be given the recent relative front-end performance, give
or take a few basis points.
Remain in trading short and continue to recommend long-term investors
remain underweight
The price action over the past few days took the 10Y ACGB futures to the stop
we established for our short 10Y ACGB position last week, if only briefly. We
have, however, remained in the trade as we think the price action in the past
few days is as much a reflection of positioning as reality. As far as our duration
recommendation for real money is concerned, we want to take a longer-term
view that is less vulnerable to the sort of volatility seen over the past few days.
From a long-term perspective we don’t see a lot of value in the 10Y ACGB this
Page 40
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
close to 3%. Even in the depths of the European debt crisis in mid-2012 the
10Y ACGB yield only briefly fell below 3%. Consistent with this we recommend
that long-term investors remain underweight duration.
10Y ACGB over the long-term
7.0
6.5
10Y ACGB
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
Jan-08
Oct-08
Jul-09
Apr-10
Jan-11
Oct-11
Jul-12
Apr-13
Jan-14
Oct-14
Source: Deutsche Bank, Datastream
One could argue that from an Australian perspective the current economic
dynamics are worse now than in 2012 because China is in a weaker position.
In our view this reality is priced to some extent in the form of a lower AUD and
a tighter 10Y ACGB/UST spread. We think both have further to fall.
A tighter 10Y ACGB/UST spread could happen in a bullish fashion, of course. If
the 10Y spread reaches the lower end of our forecast range of 50bp and the
10Y UST sells-off by less than 50bp from this point then we end up with a 10Y
ACGB yield of 3% or lower. And if the spread compression happens as the 10Y
UST is rallying then the 10Y ACGB could end up much lower than 3%.
What will it take for the 10Y spread to compress in a bullish fashion? If our
model of the spread remains broadly intact then we can only get material
spread compression in a rally if the AUD front-end rallies by more than the US
front-end. On a 12M ahead basis the AUD front-end is currently pricing about
half a rate cut from the existing cash rate of 2.5%. As the following chart
shows this is still somewhat less than the front-end was pricing as recently as
early August and a reasonable amount less than the market was pricing in
mid-2013.
But even if the front-end rallied back to its mid-2013 low we don’t think this
would be enough to compress the 10Y ACGB/UST spread all that far below
100bp. For the spread to narrow toward 50bp purely on the back of a rally in
the AUD front-end we think that the market would need to be pricing an RBA
cash rate well below 2%.
Deutsche Bank AG/London
Page 41
17 October 2014
Global Fixed Income Weekly
AUD front-end pricing vs RBA cash rate
4.50
Cash rate implied by 12th IB contract
4.25
RBA cash rate
4.00
3.75
3.50
3.25
3.00
2.75
2.50
2.25
2.00
Jan-12
Jun-12
Nov-12
Apr-13
Sep-13
Feb-14
Jul-14
Source: Deutsche Bank, Bloomberg Finance LP
While we don’t think it is much of a stretch to imagine the AUD front-end
pricing a cash rate of 2% if the current volatile conditions continue, we do
think a sub-2% cash rate will be difficult to price absent another global turn for
the worse and/or an explicit move to an easing bias by the RBA.
What would it take for the RBA to shift to an easing bias? We think we would
need to see clear evidence of a rising unemployment rate and markedly slower
house price inflation for the RBA to make such a shift. While clearly possible
in a world of weak global growth and falling commodity prices it would take
some time for these to develop, in our view. Hence we see a scenario in which
the RBA moves to an easing bias before next February as reasonably unlikely
(absent a negative global shock of some magnitude).
Alternatively, the market could simply take the view that the RBA’s outlook is
wrong and price in an easing cycle regardless. The market was prepared to do
this to spectacular effect in the later part of 2011 even ahead of a major lift in
Australia’s unemployment rate (which didn’t start to clearly trend higher until
mid-2012). One critical difference between now and then is the level of the
cash rate – 4.75% then versus 2.5% now. Compared to global rates the AUD
rate structure stood out more in 2011 than it does now, with consequent
implications for the currency (the AUD hit 1.10 in July 2011).
Again this is clearly possible and the events of mid-2011 highlight to us that
market sentiment can shift very quickly. Our central scenario, however, is one
in which the unemployment rate only gradually trends higher and house price
inflation slows over time. This is an environment in which we think it will be
difficult for the AUD front-end to price much below a sub-2.25% cash rate
without explicit endorsement of such a move by the RBA. This is more than it
has priced now, so we see scope for the front-end to rally from here if global
sentiment continues to be supportive – but only to a modest extent.
The front of the AUD curve and an easing cycle
A long-standing expectation of ours has been that the front of the curve will
finish the year much steeper than currently. The key driver of this view has
been our bearish outlook for the market. The front of the curve is currently
much flatter than we thought it would be because bond yields are lower than
expected.
Is there an alternative path to front-end curve steepening than via a long-end
sell-off? To be specific, might an aggressive easing cycle by the RBA, or the
Page 42
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
expectation of such, steepen the front of the curve? The answer to this is that
it depends. The following chart tells the story.
The front of the curve and the RBA cash rate
250
2.0
2nd bank bill future/3Y ACGB spread, bp (LHS)
200
RBA cash rate, inverted (RHS)
3.0
150
100
4.0
50
5.0
0
-50
6.0
-100
7.0
-150
-200
Jan-94 Mar-96 May-98 Jul-00
8.0
Sep-02 Nov-04 Jan-07 Mar-09 May-11 Jul-13
Source: Deutsche Bank, Bloomberg Finance LP
There have been 4 easing cycles by the RBA over the past 20 years. In the first
three the front of the curve started steepening ahead of the first rate cut.
Indeed, the steepening began almost as soon as the last rate hike was
completed. The cycle that started in 2011 was very different, however.
The front of the curve, at least as measured in the above chart, steepened in
initially ahead of the last rate hike in 2010 and continued doing so for a the first
few months of 2011. However, the front of the curve returned to a flattening
trend in April 2011 and continued flattening until well into 2012 – by which
time the RBA was well into its easing cycle. The following chart focuses on
the 2011/2012 period in detail and shifts the front curve slope somewhat to
that between the 4th AUD bill future and the 3Y bond.
Front of the curve and the RBA cash rate in 2011/12
4th bill future/3Y bond spread, bp (LHS)
20
3.00
RBA cash rate, inverted (RHS)
10
3.25
0
3.50
-10
3.75
-20
-30
4.00
-40
4.25
-50
4.50
-60
4.75
-70
-80
Jan-11
5.00
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Source: Deutsche Bank, Bloomberg Finance LP
We can see that the front of the curve steepened sharply in early August when
the market first moved to price RBA rate cuts (in what was a very sharp rally
over the course of a few days). The front of the curve then proceeded to
flatten aggressively, with this flattening continuing even as the RBA eased
rates. It wasn’t until well into the easing cycle after the middle of 2012 that
the curve started to resteepen.
Deutsche Bank AG/London
Page 43
17 October 2014
Global Fixed Income Weekly
The issue here, in our view, is that the start of the easing cycle by the RBA did
not trigger the expectation that there would eventually be a tightening cycle
some time down the track. It is this expectation that has been responsible for
the front-end curve steepening in the past. This time around the strong rally in
global rates and the expectation that the Fed would remain in zero for a
number of years precluded the AUD front-end from pricing a return to a
‘normal’ cash rate on a horizon that would steepen the front of the curve.
Thus for the front of the curve to bull steepen in coming months we would
need any easing or the pricing of an easing to be accompanied by the
expectation that on a two year, or thereabouts, horizon rates would be rising
again. We aren’t confident this would be the case in the current environment.
Hence we would not recommend that investors looking for the AUD front-end
to price easings implement this trade via a front-end curve steepener. Rather
we suggest they simply go long the front of the AUD curve.
David Plank +61 2 8258 1475
Page 44
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Dollar Bloc Relative Value

The AOFM priced the ACGB Apr-37 bookbuild on 15 October.

Previous ultra long dated ACGB issues have tended to issue on the cheap
side of fair value but, despite a large initial issue sze of $7bn, the Apr-37
has priced near fair value in our view.

With very little cheapness in the issue at launch we don’t expect to see
significant swap spread widening on the new bond. The steep 10Y/30Y
swap curve may be one reason behind this, and we continue to
recommend paying the 5Y/10Y/30Y swap butterfly to capture a flattening.

Domestic 0Y+ bond indices will lengthen significantly due to the
combination of the Oct-14 ACGB maturity and the entry of the new bond
at the month-end rebalancing. We estimate a total widening of 0.17.
The AOFM priced $7bn of a new 3.75% 21 April 2037 benchmark ACGB on 15
October. The bond priced at a yield of 3.945%, or a 10Y EFP spread of 62bp to
the December bond futures.
In a Reuters story the AOFM reported a breakdown of investor location and
type. 50% of the issue was placed domestically and 25% placed in the UK.
The high UK participation is interesting, possibly reflecting the attractiveness of
high nominal Australian yields – the UK market has strong demand for long
dated assets. The AGCB Apr-37 yields about 120bp over similar maturity Gilts.
Tender geographical and investor breakdown
Australia
Britain
Asia
Other (ex-US)
Fund managers
Banks
Hedge funds
Central banks
Other
Source: AOFM, Reuters
US domestic investors cannot buy the bond until it has been seasoned under
SEC Regulation S – forty days after the issue’s 21 October initial settlement, or
30 November.
Pricing was close to fair value
The ultra long end of the Australian curve has historically been very illiquid.
Prior to 2011 there was very little activity in the 15Y+ part of the curve outside
of structured product hedging.
The AOFM’s efforts in extending the
Government yield curve to fifteen, twenty and now twenty-three years have
significantly improved liquidity, but it has also has resulted in a significant
repricing of the ultra long end.
Deutsche Bank AG/London
Page 45
17 October 2014
Global Fixed Income Weekly
Bonds weakened shortly after pricing was announced
2.64
3.39
3Y Dec futures intraday yield
2.62
3.37
10Y Dec futures intraday yield
2.60
3.35
2.58
3.33
2.56
3.31
2.54
3.29
2.52
3.27
~3:14pm: AOFM pricing e-mail
2.50
8:30
9:30
10:30
11:30
12:30
13:30
14:30
15:30
3.25
16:30
Intraday trading 15 October 2014
Source: Bloomberg Finance LP
The Apr-37 priced at a yield spread of about 15.5bp to the Apr-33 ACGB.
Immediately after pricing of the deal was announced, bonds across the curve
weakened materially, with 3Y and 10Y bond futures both selling off 5bp over
remainder of the afternoon session. The Apr-37 itself, however, saw its spread
to the ACGB Apr-33 marked near +14bp at close on 15 October, although it
widened +0.5bp the following day.
Long end ACGB asset swap spreads
0
-10
-20
-30
-40
-50
-60
Apr-27
-70
Apr-29
-80
Apr-33
-90
Aug-12
Apr-37
Dec-12
Apr-13
Aug-13
Dec-13
Apr-14
Aug-14
Source: AOFM, Reuters
The swap spread differential between the Apr-37 and Apr-33 at issue was six
basis points. In comparison, the Apr-33 priced nearly 16bp wider than the Apr29 when it launched whilst the Apr-29 was launched about 14bp cheaper than
the Apr-27. As the graph above shows long end bonds had tended to cheapen
overall on a swap spread basis prior to issue of the new line and then richen.
As the graph below shows, swap spread differentials to the shorter bonds also
closed.
Page 46
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Long end ACGB asset swap spreads
Apr-29 / Apr-27 swap spread (bp)
18.0
Apr-33 / Apr-29 swap spread
16.0
Apr-37 / Apr-33 swap spread
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
0 10 20 30 40 50 60 70 80 90 100110120130140150160170180
Business days since issue of longer bond
Source: AOFM, Reuters
The Apr-37, however, at only a 6bp swap spread discount to the Apr-33 does
not offer a significant potential for outperformance, in our view. Although the
market did appear to make a material concession to the supply after pricing
was announced the Apr-37 has not, in our view, despite the very large size of
the tender, been priced at a significantly cheap level. .
Steep swap curve could have been a factor
The relative steepness of the AUD swap curve could be one factor that has
prevented the new bond pricing at a substantially cheap swap spread.
ACGB and AUD swap curves
4.3
4.1
3.9
3.7
Apr-37
3.5
3.3
3.1
2.9
2.7
2.5
2.3
Sep-14
Apr-33
Apr-29
Apr-27
Apr-26
Apr-25
Apr-24
Apr-23
Jul-22
May-21
Apr-20
Oct-19
Mar-19
Oct-18
Jan-18
Feb-20
Aug-25
AUD swap
ACGB
Feb-31
Jul-36
Source: AOFM, Reuters
We noted in the September Australian RV Monthly that the long end of the
AUD swap curve was steep in outright terms and recommended paying the
AUD 5Y/10Y/30Y swap butterfly. The launch of the Apr-37 was a small risk to
the trade but rather than repricing the swap curve substantially steeper, we
think the already steep swap curve has put pressure on the bond to price at a
relatively fair spread to the existing ACGBs. The AUD 10Y/30Y swap slope is
now trading slightly flatter than when the Apr-37 bookbuild was announced.
Deutsche Bank AG/London
Page 47
17 October 2014
Global Fixed Income Weekly
ACGB and AUD swap curves
70
60
AUD 10Y/30Y swap slope
Apr-29 minus Apr-27 swap spread (RHS)
Apr-33 minus Apr-29 swap spread (RHS)
0
2
50
4
40
6
30
8
20
10
10
12
0
14
-10
16
-20
Jan-12
18
Jun-12
Nov-12
Apr-13
Sep-13
Feb-14
Jul-14
Source: AOFM, Reuters
As a result, although we don’t see significant value in the new bond from a
relative value perspective we continue to look for flattening of the long end of
the Australian curve.
Index impacts
Domestic investor participation in the syndication, at 50%, was relatively high.
Index impacts might have played a role in this as domestic investors prepared
for the upcoming month-end rebalancing.
Bloomberg Composite 0+ index modified duration, with estimated 1
November duration
4.7
4.5
4.3
4.1
3.9
3.7
3.5
Jan-12
Jun-12
Nov-12
Apr-13
Sep-13
Feb-14
Jul-14
Source: Bloomberg Finance LP
Domestically, many benchmarked investors follow 0Y+ bond indices such as
the Bloomberg AusBond Composite Index. Between 14 October and month
end this index sees $16.3bn of maturities, mostly due to the ACGB Oct-14
maturity on 21 October. These bonds exit the index upon maturity (the $3bn
TCV Oct-14 has already been removed) and the new Apr-37 will enter the index
after the month-end rebalancing. We estimate a total modified duration
extension of 0.17 for the index. 0.09 of this will occur at the end of the month,
one of the larger month-end extensions that have occurred.
Page 48
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Distribution of month-end modified duration change since 2000, Bloomberg
AusBond Composite 0+ Yr Indx
80
70
Frequency
60
50
40
30
20
10
0
-0.04 -0.02 0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14
Month-End Mod Durn Change
Source: Deutsche Bank, Bloomberg Finance LP
Most major global bond indices are 1Y+ indices, so the October 2014
maturities do not have an impact but the Australian portion of those indices
will see a duration increase from 1 November. Combining this with the
seasoning of the bond opening it to US investors at the end of November and
the AOFM’s statement that there will be no further supply into the line until at
least January 2015 means that we think that pricing will tend to remain fair.
Kenneth Crompton +61 2 8258 1361
Deutsche Bank AG/London
Page 49
17 October 2014
Global Fixed Income Weekly
Global
Economics
Rates
Gov. Bonds & Swaps
Inflation
Markus Heider
Strategist
(+44) 20 754-52167
markus.heider@db.com
Global Inflation Update
Global
1. Lower oil, rising risk aversion…
B/Es globally continued to slide this week, as commodities fell further and risk
aversion rose (chart 1). The slump in oil prices—brent has fallen more than
15% since end-August—has significantly reduced near-term CPI forecasts and
ILB carry prospects. Headline inflation could approach 1% y/y in Q1 2015 in
the US, and stay around 0.3/0.4% in Q4 in the euro area. With risk aversion
rising at the same time, the deterioration in market conditions for B/Es has
been unusually quick, as summarized by our B/E momentum scores (chart 2).
With global B/E drivers dominating, the cross-market correlation has picked up
(chart 3). Economic data trends on the other have been uneven, disappointing
in the euro area, but strong in the US. Indeed, trends in capacity utilization or
jobless claims appear consistent with expectations of rising domestic inflation
and similar momentum in the past has typically benefited B/Es (chart 4). In any
case, B/E valuations are now at least two standard-deviations below 3m to 2y
averages (chart 5). The sell-off has been strongest in 5y GBP as well as longend EUR B/Es, (1y z-scores -4 to -5; chart 5). 5y RPI or 30y TIPS B/Es in
particular look cheap against or models. Given this week’s steepening, 5y5y
TIPS B/Es have proved more resilient and TIPS/EUR spreads widened (chart 6).
2.0%
10.0
1.0%
5.0
0.0%
0.0
-1.0%
-5.0
-2.0%
-10.0
-3.0%
-15.0
1w change, % (lhs)
-4.0%
-20.0
1w change, pts/bp (rhs)
-5.0%
-25.0
-6.0%
-30.0
brent metals food
DXY
SPX
VIX
(rhs)
10y
UST
(rhs)
10y
Bund
(rhs)
Source: Deutsche Bank
2. …weigh on B/Es
0.7
3
10y B/E, TIPS, 4w chge (lhs)
Momentum Score (rhs)
0.5
2
0.3
3. Cross market correlation picks up
1.0
USD/EUR
0.8
USD/GBP
1
4. US jobless claims strong
0.1
200
-40
150
-30
100
-20
50
-10
0
-0.1
-1
0.6
0.4
0
-0.3
-2
-0.5
0
0.2
-50
10
-100
20
-0.7
Jan-10
-3
Sep-10
May-11
Jan-12
Sep-12
May-13
Jan-14
Sep-14
0.0
-0.2
-0.4
-150
-0.6
Jan-13
May-13
Source: Deutsche Bank
30
10y TIPS B/E 20w change
6m rolling correlation
between 10y CPI swaps
-200
Sep-13
Jan-14
May-14
Sep-14
Source: Deutsche Bank
-250
1999
40
jobless claims (rhs) 20w change
50
2001
2003
2005
2007
2009
2011
2013
Source: Deutsche Bank
5. B/Es well below averages
USD
6. 5y5y TIPS/EUR B/E spread widens
EUR
GBP
1.1
0.8
0.0
5y5y USD - EUR, swaps
1.0
0.7
5y5y USD - EUR, cash (rhs)
-1.0
0.9
0.6
-2.0
0.8
0.5
-3.0
0.7
0.4
0.6
0.3
0.5
0.2
0.4
0.1
-4.0
-5.0
3m
6M
1Y
2Y
CPI swap s: z-scores
-6.0
2Y 5Y 10Y 20Y 30Y
Source: Deutsche Bank
Page 50
2Y 5Y 10Y 20Y 30Y
2Y 5Y 10Y 20Y 30Y
0.3
Jan-13
0.0
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Oct-14
Source: Deutsche Bank
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
EUR
EUR B/Es mostly declined again this week; curves moved lower in parallel and
in cash even flattened somewhat. As a result, forward B/Es were down
strongly, with 5y5y reaching new lows of just above 1.7% in swaps, and below
1.6% in cash. This will maintain the pressure on the ECB. September HICP was
revised marginally higher from the flash estimate, and EUR ILBs will see
inflation accrual of about 0.44% through November. Carry prospects for
December and January have however deteriorated again as falling oil prices
have pushed HICP forecasts for October and November lower.
HICP prints have tended to surprise to the downside since early last year (chart
3), and this has been an ongoing negative for B/Es. With some signs of
normalization in fresh food prices and a weaker exchange rate we were
expecting more balanced surprises from this summer and the HICP flash
estimate has now been in line with consensus estimates two months in a row.
The sharp drop in oil prices has however increased downside risks again for
the coming months.
While momentum remains negative, B/E valuations are low. 10y HICP has
fallen to just over 1.3% (which is some 15bp below the 2008 trough) and the
DBRei23 B/Es has been approaching 1% (in seasonally-adjusted terms). While
this remains (around 35bp) above the average 10y JGBi B/E recorded between
2004 and 2007, inflation trends in the euro area also remain well above
averages recorded in Japan (chart 1). Headline inflation, at 0.3% y/y, is close to
the 2004-2007 Japan average of 0.0%, but global inflation was contributing
more at that time, so that core CPI was lower than headline CPI and GDP
deflator inflation was significantly below core CPI and some 1.9% below
current levels in the euro area (chart 1).
Despite the strong declines in B/Es, the value of the embedded deflation floors
remains relatively low (chart 4). This is because implied inflation volatility has
decreased markedly in recent quarters and most of the shorter-dated ILBs
(where B/E valuations are lowest) are relatively seasoned issues with floor
strikes significantly out of the money. Should B/Es continue to decline or
volatility pick up, issues such as the BTPei18 or SPGei19 would benefit most.
1. EUR now v JPY in 2000s
J P Y 2004- 2007
E UR
av erag e
cu rren t
CPI
0.0
0.3
Core CPI
-0.4
0.8
GDP deflator
-1.2
0.7
10y JGBi BEI
0.66
1.01
Source: Deutsche Bank
2. Swap-cash B/E spreads
35
swap - bond B/E spread
30
DEM
FRF
25
ITL
ESP
20
15
10
5
0
2014
2020
2025
2031
2036
2042
Source: Deutsche Bank
There have been some significant moves in relative valuations in recent weeks.
Long-end OATei have cheapened and long-end BTPei richened, and the latter
are now richer against swaps than the former (chart 2). While the SPGei24 has
caught up with German ILBs, in 5y BTPei as well as the new SPGei19 remain
10bp or so cheaper than core issues (chart 2). This means that on ASW, only
5y BTPei offer a significant pick-up over nominal BTP.
3. HICP forecast error v oil, fresh food and FX
0.30
4. Embedded floors: strikes & values
HICP flash forecast error, 3mma
DBRei16
OBLei18
DBRei20
DBRei23
DBRei30
OA Tei15
OA Tei18
OA Tei20
OA Tei22
OA Tei24
OA Tei27
OA Tei30
OA Tei32
OA Tei40
fitted, f(oil, fresh food, FX)
0.20
0.10
0.00
-0.10
-0.20
Source: Deutsche Bank
Deutsche Bank AG/London
BTPei16
BTPei17
BTPei18
BTPei19
BTPei21
BTPei23
BTPei24
BTPei26
BTPei35
BTPei41
SPGei19
SPGei24
Di st an ce f rom f l oor Fl oor v al u e
cu mu l .
an n u al .
bp
-6.3%
-3.3%
0.0
-13.7%
-4.9%
0.0
-0.8%
-0.2%
2.8
-9.4%
-2.0%
0.0
-7.4%
-1.1%
0.2
-12.1%
-1.4%
0.1
-0.2%
0.0%
2.6
-5.4%
-0.5%
1.0
-16.1%
-0.8%
0.8
-7.7%
-0.3%
1.6
0.2%
0.2%
0.0%
0.0%
3.6
2.8
Jul-14
Feb-14
Apr-13
Sep-13
Nov-12
Jan-12
Jun-12
Aug-11
Oct-10
Mar-11
May-10
Jul-09
Dec-09
Feb-09
Apr-08
Sep-08
Nov-07
Jan-07
Jun-07
-0.30
Di st an ce f rom f l oor Fl oor v al u e
cu mu l .
an n u al .
bp
-13.7%
-9.3%
0.0
-5.6%
-1.6%
0.8
-8.4%
-1.6%
0.1
-3.1%
-0.4%
1.6
-0.7%
0.0%
2.6
-16.1%
-20.3%
0.0
-3.5%
-0.9%
0.6
-17.8%
-3.3%
0.0
-7.5%
-1.0%
0.3
-1.2%
-0.1%
1.9
-6.1%
-0.5%
0.9
0.1%
0.0%
2.4
-18.9%
-1.2%
0.4
-12.4%
-0.5%
1.1
Source: Deutsche Bank
Page 51
17 October 2014
Global Fixed Income Weekly
GBP
3. Wage growth to rise
7.0
0
-4
-8
-12
-16
BEI
-20
Real Yld
Nom Yld
1w change on 16-Oct, carry adj, bp
UKTi68
UKTi62
UKTi58
UKTi52
UKTi50
UKTi47
UKTi44
UKTi42
UKTi40
UKTi37
UKTi34
UKTi32
UKTi29
UKTi27
UKTi24
UKTi22
UKTi19
UKTi17
-24
Source: Deutsche Bank
2. RPI & core CPI surprise trends
0.4
UK RPI forecast error, 5mma
0.3
UK core CPI forecast error, 5mma
0.2
0.1
0.0
-0.1
Sep-14
May-14
Jan-14
Sep-13
May-13
Jan-13
Sep-12
May-12
Jan-12
Sep-11
May-11
Jan-11
Sep-10
May-10
Jan-10
Sep-09
Jan-09
-0.2
Source: Deutsche Bank
4. 5y RPI at 1y z-score of -5
4.0
70
GBP AWE reg pay, priv, % y/y
3.0
REC report on jobs, wages (perm & tmp), 9m lead (rhs)
6.0
1. B/Es down again
May-09
UK B/Es fell further this week, with the front-end underperforming again; real
yields declined strongly (chart 1). September RPI was in line with forecasts
(chart 2), but CPI and especially core CPI surprised on the downside (after
some upside surprises earlier this year; chart 2), which weighed on policy rate
projections and, via MIPS, on RPI expectations. While the decline in CPI was
relatively broad-based across main components (food, energy, core goods and
services all lower), the surprise mainly came from core goods items. While
core inflation has been volatile, it has trended broadly sideways to slightly
higher through this year at levels not too far from the BoE target, and we
would expect that trend to remain in place, ie would expect some renewed
increase into Q4. Energy and food inflation could remain weak for now, but the
BoE has in the past tended to look through temporary non-core trends. Wage
inflation on the other hand showed some signs of acceleration in August. The
y/y rate (at 1.4% for private sector regular pay; chart 3) remains low given the
weakness seen this spring, but wages have now risen by 2.7% (annualized)
over the past 3m, which is broadly in line with what leading indicators are
suggesting. With unemployment still falling, this may keep the focus on the
timing of the start of policy normalization, and should support short-end B/Es.
With oil down strongly again, and CPI disappointing our suggestion last week
that the risk-reward for long 5y B/E positions had increased proved premature
however. 5y RPI now stands about five standard-deviations below 1y averages
(chart 4), and the 5y10y slope has steepened towards 3y highs (chart 5), which
has supported 5y5y. Looking at changes in forwards since the end of last
month shows that all the weakness has come from the front-end, while 4y1y
and 5y5y are close to unchanged and 9y1y is up (chart 6). Out to 3y the curve
has however almost declined in parallel, and 2y1y is now significantly below
baseline RPI forecasts. We see some upside for 5y and in particular 2y1y RPI.
5.0
65
2.0
1.0
60
0.0
4.0
55
-1.0
3.0
-2.0
50
2.0
-3.0
45
1.0
0.0
40
-1.0
2001
35
2003
2005
2007
2009
2011
2013
-4.0
5y RPI, 1y z-score
-5.0
-6.0
Jan-10
Aug-10
Mar-11
Oct-11
May-12
Dec-12
Jul-13
Feb-14
Sep-14
2015
Source: Deutsche Bank
Source: Deutsche Bank
5. 5y10y RPI steepest in three years
35
6. 2y1y cheapest point
UK10 UK5
20
average
30
RPI swap, change since 30-Sep, bp
10
25
0
20
-10
-20
15
-30
10
-40
5
-50
0
Sep-11
1y
Feb-12
Source: Deutsche Bank
Page 52
Jul-12
Dec-12
May-13
Oct-13
Mar-14
1y1y
2y1y
4y1y
9y1y
5y5y
Aug-14
Source: Deutsche Bank
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
United States
Rates
Gov. Bonds & Swaps
Inflation
Rates Volatility
Alex Li
Research Analyst
(+1) 212 250-5483
alex-g.li@db.com
Inflation-Linked

Treasury will issue additional $7 billion February 2044 TIPS through a
second reopening auction on Thursday, October 23. Customers took down
67.9% of the supply in June this year. Except the auction in October 2013,
which came through 2.3bp, recent 30-year bond TIPS auctions since 2011
have tailed.

We believe bond TIPS are cheap on a relative value basis, and the 10s/30s
breakeven curve has room to steepen.

We analyze the latest ten-year TIPS auction allotment data.
Auction preview: 30-year TIPS, re-opening
The Treasury will issue additional $7 billion February 2044 TIPS through a
second reopening auction on Thursday. Customers took down a solid 67.9% in
June this year. The indirect bidder takedown was good in the last four auctions
except for the one in last October, in which indirect bidders bought 45% of
supply versus their one-year average of 53.7%. The direct bidder participation
however was just the opposite as it was strong in October but weak in the
other three. The opening auction this year had a weak bid-to-cover ratio of
2.34 (average 2.62) while the last auction was strongly bid (2.76). Except the
one in October 2013, which came through by 2.3bps, every auction since 2011
has tailed. We believe bond TIPS are cheap on a relative value basis, and the
10s/30s breakeven curve has room to steepen.
30-year TIPS auction statistics
Size
($bn)
1yr Avg
$7.67
Primary
Dealers
35.5%
Jun-14
$7.00
32.1%
Feb-14
$9.00
Oct-13
$7.00
Jun-13
$7.00
Feb-13
$9.00
Oct-12
Direct
Bidders
10.8%
Indirect
Bidders
53.7%
Cover
Ratio
Stop-out 1PM WI
Yield
Bid
2.62
BP Tail
1.0
8.2%
59.7%
2.76
1.116
1.082
3.4
38.5%
4.9%
56.5%
2.34
1.495
1.475
2.0
35.9%
19.1%
45.0%
2.76
1.330
1.353
-2.3
38.9%
0.4%
60.8%
2.48
1.420
1.390
3.0
31.6%
14.0%
54.5%
2.47
0.639
0.620
2.1
$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
Aug-10
$7.00
33.1%
28.0%
38.9%
2.78
1.768
1.783
-1.5
Source: US Treasury and Deutsche Bank
Deutsche Bank AG/London
Page 53
17 October 2014
Global Fixed Income Weekly
30y TIPS breakevens around auctions
0.20
30 yr Breakeven
6/19/2014
10/24/2013
2/21/2013
Average
0.15
0.10
2/20/2014
6/20/2013
10/18/2012
0.05
0.00
-0.05
-0.10
-0.15
-10
-8
-6
-4
-2
0
2
4
6
Trading Days Relative to 30yr TIPS Auction Date
8
10
8
10
Source: Deutsche Bank, Bloomberg Finance LP
10s/30s breakevens around auctions
10s/30s BE
0.14
0.12
6/19/2014
2/20/2014
0.10
10/24/2013
6/20/2013
0.08
2/21/2013
10/18/2012
0.06
Average
0.04
0.02
0.00
-0.02
-0.04
-0.06
-10
-8
-6
-4
-2
0
2
4
6
Trading Days Relative to 30yr TIPS Auction Date
Source: Deutsche Bank, Bloomberg Finance LP
CPI preview: Soft patch likely to continue in September
We expect the headline CPI index to change little in September, as the Bureau
of Labor Statistics (BLS) reports the inflation data on Wednesday, October 22.
On year-on-year basis this would translate to 1.6% gain in the Index, down
from 1.7% increase in the previous month.
Falling gasoline prices and the subdued food inflation is likely to keep the
headline under pressure in coming months. Strong dollar should keep the
commodities inflation soft. However, the trend in rent and owner’s equivalent
rent prices remains strong and is expected to keep the services inflation
supported. Core CPI should remain in the 1.7% to 1.8% range until July 2015
and then could finally pick up towards 2% in the second half of 2015.
Page 54
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
US CPI-U NSA y/y, actual and forecast
MoM CPI-U, actual and forecast (non-seasonallyadjusted)
6.0
0.8
%Y/Y
Projections
5.0
%MoM NSA
Projected
0.6
4.0
0.4
3.0
0.2
2.0
0.0
1.0
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
Source: Bureau of Labor Statistic, Deutsche Bank and Bloomberg Finance LP
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
Allotments update: Ten-year TIPS
In the September ten-year TIPS re-opening auction, the foreign and
international investor allotment share fell to 12.4%, the lowest since March
2013, from 17.8% in July and compares with its one-year average of 20%. The
allotment share to investment funds however increased slightly to 44.7% and
remained above the average 41.4% for the third straight month. The combined
share allotted to the two investor classes was down to 57.1% from the about
average 61.4% in July.
Ten-year TIPS auction allotments
Settle Date
1 Yr Avg
9/30/2014
7/31/2014
5/30/2014
3/31/2014
1/31/2014
11/29/2013
9/30/2013
7/31/2013
5/31/2013
3/28/2013
1/31/2013
11/30/2012
Total
(less Fed)
$bn
14
13
15
13
13
15
13
13
15
13
13
15
13
Federal Reserve
$bn
%*
0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
Dealers and Brokers
$bn
%
5.2
5.5
5.7
3.6
5.9
6.2
4.4
6.1
5.3
4.3
5.8
5.5
5.7
38%
43%
38%
28%
46%
42%
34%
47%
36%
33%
44%
37%
44%
Investment
Funds
$bn
Foreign and
International
$bn
$bn
%*
$bn
5.7
5.8
6.5
7.1
4.3
6.0
4.2
4.6
5.8
5.9
6.0
8.0
6.3
2.7
1.6
2.7
2.3
2.7
2.7
4.4
2.2
3.7
2.7
1.2
1.5
1.0
0.1
0.0
0.1
0.0
0.1
0.1
0.0
0.1
0.1
0.1
0.0
0.1
0.1
0.4%
0.3%
0.5%
0.2%
0.4%
0.5%
0.2%
0.5%
0.8%
0.5%
0.1%
0.3%
0.4%
41.4%
44.7%
43.5%
54.4%
33.4%
39.9%
32.4%
35.8%
38.6%
45.2%
46.0%
53.4%
48.3%
20.0%
12.4%
17.8%
17.6%
20.5%
18.0%
33.7%
16.8%
24.9%
21.1%
9.5%
9.8%
7.8%
Other
* Percentage as of total less Fed SOMA
Source: US Treasury and Deutsche Bank
Deutsche Bank AG/London
Page 55
17 October 2014
Global Fixed Income Weekly
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CROSS-MARKETS
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Source: Deutsche Bank
Page 56
Deutsche Bank AG/London
17 October 2014
Global Fixed Income Weekly
Appendix 1
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Global Fixed Income Weekly
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Deutsche Bank AG/London
Page 59
David Folkerts-Landau
Group Chief Economist
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Research
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