Interest Rates Monthly

08 January 2014

2014 word of the year: normalisation

US Directional View ..................................................................................... Global growth is accelerating and 2014 should see the days of financial repression pass. Once again we see UST yields rising, but only at approximately half the pace of 2014. The worst-performing part of the curve should be the 5Y. US Directional View Rates Derivatives ....................................................... With 3M10Y implied volatility lagging during the recent rise in volatility, we examine the underperformance and the potential paradigm shift that is occurring in rates volatility markets. Eurozone Directional View........................................................................... Given that economic leading indicators and export performance suggest an ongoing recovery in the Eurozone economy, the recent lag between UST and core EGB yields is likely to be reduced going forward, leading to higher rates and a steeper curve. ECB support will focus more on addressing banking system fragmentation. Eurozone Relative Value ............................................................................. The beginning of the year seems to confirm our expectation of renewed interest in periphery convergence trades, partly due to calendar considerations and partly due to further evidence of fundamental improvement in the periphery. Periphery curve flattening will feature as part of the RV normalisation. Asian Rates View......................................................................................... Asian rates will be driven primarily by changing capital flows in a posttapering environment. Yield pick-up from asset swap trades in sovereign bonds is negative for most Asian markets. We would expect most Asian sovereign yields to move higher to become appealing again to foreign investors so Asian rates are to rise alongside USD rates. However, there could be divergences in the near term due to local factors, creating a delay in Asian market reactions. Curve moves could also differ because some have steepened a lot already while others are lagging. Inflation-Linked Strategy .............................................................................. Stuck between subdued inflation for at least six more months and rising nominal rates, European linkers are currently not well positioned, especially core ones. Italian linkers should perform better in 2014 from a relative value standpoint. In the US, we expect a bear flattening of the real curve. 15 13 8 6 4 2

David Keeble
Global Head of Interest Rates Strategy
david.keeble@ca-cib.com +1 212 261 3274

Luca Jellinek
Head of European Interest Rates Strategy
luca.jellinek@ca-cib.com +44 20 7214 6244

Peter Chatwell
Senior Interest Rates Strategist
peter.chatwell@ca-cib.com +44 207 214 5289

Frances Cheung
Head of Asian Rates Strategy
frances.cheung@ca-cib.com +852 2826 1520

Orlando Green
Senior Interest Rates Strategist
orlando.green@ca-cib.com +44 20 7214 7467

Jean-Franois Perrin
Inflation Strategist
jean-francois.perrin@ca-cib.com +33 1 41 89 94 22

Jonathan Rick
IRD Strategist
jonathan.rick@ca-cib.com +1 212 261 4096

https://catalystresearch.ca-cib.com
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Interest Rates Monthly

US Directional View
What the US environment will be at the end of 2014
What will the world look like at the end of 2014? Our economists forecasts expect each of the main global economic blocs to grow at the same pace or faster this year than in 2013. In the US, we cannot see any good reason to expect a significant slowdown in the pace of jobs growth assuming that GDP growth (at around 2.7%) will be around 100bp faster in the coming year than it was in 2013 and US corporates are rudely profitable. By the end of the year, there should be evidence of supply constraints and there are already sporadic hints of issues in some industries. By end-2014, the whole nature of monetary policy will have changed in the US. If the Feds own forecasts are approximately correct, Taylor rules would be arguing for higher rates by the end of 2014, so if the Fed is sticking with its zero interest rate policy, the zero percent Fed Funds rate flips from being too restrictive to being stimulative by itself and without the assistance of QE or forward guidance. Then there is the financial repression itself. By the end of this year, the Feds asset purchases will likely have concluded and forward guidance will no longer appear so forward. Remember that the Fed sweetened the start of the taper by saying that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal. By the end of 2014, the unemployment rate will be around 6.5% and the projected PCE deflator from the Feds summary of economic projections for 2015 and 2016 will be close to 2%. If the economy develops approximately as the Fed expects, then forward guidance will be close to its sell-by date at end2014. Structural impediments to growth have eased: the household sector has improved its balance sheet, the fiscal drag lessens this year and Europe looks much, much better. There may be other less familiar drags upon growth in the coming year: problems in emerging markets, higher US mortgage rates and the debt-ceiling problem doesnt seem to want to die. However, growth should be pretty decent. Overall, stronger global growth, disappearing financial repression and growing evidence that the copious spare capacity is disappearing create a good environment for somewhat higher Treasury yields and we see the 10Y UST at around 3% by year-end. Fig 1. UST yield increases since October 2013
bp 60 50 40 30 20 10
0 -10 Oct-13

Fig 2. Global growth expectations rising

% 7 6 5 4 3 2 1 0 -1

1y yield 3y yield 7y yield

2y yield 5y yield 10y yield

2013

2014

Australia

Latam

US

UK

Japan

Asia

EZ

Nov-13

Nov-13

Dec-13

Dec-13
Source: Bloomberg

Source: Bloomberg

08 January 2014

EM Europe

Africa/ME

Interest Rates Monthly

The belly really is aching

A 3% UST 10Y can be achieved by the end of the year because by then the first Fed hike will be viewed as a matter of months rather than years away. A 75bp movement from todays yield of around 3% is roughly half the sell -off pace of 2013 and will take the 10Y yield back to the upper end of the trading ranges seen in 2009-11. With this in mind, Treasury investors need to find a place to hide. Throughout the Great Recession and recovery, FX strategists have often used the phrase picking the least-ugly currency because no currency had strong fundamentals behind it. For the US rate market maturity selection this year, investors are in the same boat; we do not expect good returns from anywhere. For example, the 2Y yield has often been considered the safe-haven sector but, over the past few weeks, even this sector has started to move. Aside from a brief period in 2013, the existing 2Y yield is at the highest levels witnessed since mid2011 and the front end of the curve is just beginning its sell-off. As the economy moves inexorably toward the first Fed hike, we have every expectation that the 2Y yield will leap. However, in the first half of this year, the 2Y will still possess something akin to a safe-haven property. In Figure 3 we have plotted the 2-5Y UST spread showing that it is getting close to the highest levels at which it has ever traded (the spread generally hits around 150bp before the start of any rate-hiking cycle). The 2-5Y spread is currently around 130bp, so perhaps the risk/return does not look that great. But, if there was ever an environment in which we might argue that the spread should go steeper than usual, it is this one. The level of Fed Funds is zero and the Fed has promised to keep rates this low for longer than it really should, to ensure that spare capacity is quickly soaked up the Fed wants to overheat the economy. Figure 3 is one reason why investors are quite content to sit in the 2Y part of the curve at present; in a sell-off, the front end of the curve is a long way from reaching the moment when the 2Y really leads a sell-off from the sub-5Y sector. Equally, when we look at forward rates such as 5Y5Y, it is usual that such a forward would move up at a slower pace than the spot rate might once it reaches reasonable levels. For the yield curve to do this, there is a flattening bias between 5Y and 10Y spot in the later stages of a bond bear market. It can be seen from Figure 4 that the 5Y5Y swap has reached the 4-6% range that prevailed in the years before the Great Recession (currently 4.54%). We expect the 5Y5Y can go higher but will likely do so at a slower pace than the spot 5Y. It is difficult to convince people to underweight the belly of the curve because it is the best part of the curve for roll and carry. However, the assumed returns from rolling down the curve will work only if the yield curve is stable, but this is not something that should be expected this year. In short, the recent weakness of the 5Y sector compared to other sections of the curve looks set to continue at least through the early part of the year. The underperformance of the belly will swamp its roll and carry advantage. Fig 3. 2-5Y Treasury spread
bp 200

Fig 4. 5Y swap versus 5Y5Y swap rate

% 9 8 7 6 5 4 3 2 1 0 Jan-96

150 100
50

0
-50 Dec-90

5Y Jan-99

5Y5Y Jan-02 Jan-05 Jan-08 Jan-11 Jan-14

Dec-94

Dec-98

Dec-02

Dec-06

Dec-10

Source: Bloomberg

Source: Bloomberg

david.keeble@ca-cib.com

08 January 2014

Interest Rates Monthly

US Interest Rates Derivatives

Market normalisation finally begins
After five years of extraordinary measures, positive momentum in the economy has led to growing expectations of an end to quantitative easing and an eventual end to zero interest rate policy (ZIRP); following last months tapering announcement, things have changed. Across markets we have begun to see a paradigm shift, as markets are beginning to normalise. We have seen this begin to play out in rates markets as, for example, the 5-30Y curve has flattened in a bear market as growth has accelerated. Moreover, in non-rates volatility markets, what were fairly benign short expiry markets began to exhibit rising implied volatility. In particular, in the past month both EUR-USD 3M volatility and the VIX have risen noticeably and broken through their 100-day moving averages. The former touched levels it last saw in September, while the latter breached 16, a level it had not been near since the US government shutdown. Meanwhile, 3M10Y implied swaption volatility, after a mild rise to start the month, declined and flat-lined for the remainder of the month and has been effectively unchanged since the December FOMC announcement. We acknowledge that long-term correlations between crossasset volatility markets are weak. However, typically short-term trended rallies or declines tend to be coincidental across volatility markets. There are several factors that could explain this lack of excitement, as of late in rates vol markets, but we would focus on three main ones: 1. 2. 3. A change in the dynamic of the curve; Proximity of long-term rates to natural levels; and A normalisation of the volatility surface.

The first factor is the most basic: as we move towards a more normal rate cycle, the front end of the curve should be more susceptible to variance between Fed policy and market expectations. Each additional step in tapering as well as a virtuous cycle in the economy brings markets one step closer to an exit from ZIRP. Furthermore, as Fed officials have noted in recent comments, the Fed is capable of raising interest rates without first removing excess liquidity. As the potential for bear flattening increases in the market, conditional bear flatteners provide less and less attractive terms. Specifically in the current market, to strike a 3M->2s10s conditional bear flattener at zero-cost, and if you strike the 3M2Y payer at at-the-money forward (ATMF), the 3M10Y payer would be struck at ATMF+22bp. Leaving everything else constant and shifting vols to levels just prior to the FOMC, the 3M10Y payer could be struck at ATMF+35bp for a zero-cost trade previously attractive terms are disappearing. Fig 5. Both FX and equity vols rose towards the end of the year
10
EURUSD 3m Vol VIX (RHS)

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

22 20
60 ABPV 50 40 ABPV 130 120

9.5
9 8.5 8 7.5 7 6.5 % %

110
100 90

18 16 14 12
30 20
3M2Y 3M10Y (RHS)

80 70

60

6 1-Sep

10
1-Oct 1-Nov 1-Dec 1-Jan

10 1-Jan

1-Mar

1-May

1-Jul

1-Sep

1-Nov

50 1-Jan

Source: Bloomberg, Credit Agricole CIB

Source: Bloomberg, Credit Agricole CIB

08 January 2014

Interest Rates Monthly

The first factor is obviously only part of the story in rates, and the second factor also helps explain the recent underperformance of gamma (ie, short expiry options) of longer tails (ie, maturities). The second driver is that, with the 10Y Treasury bouncing around 3.00% and the long bond very near 4.00%, long-dated interest rates no longer look that expensive, as the ten-year average for the two is 3.49% and 4.22%, respectively. For comparison purposes, the 2Y note has a mean of 2.00% over the same period. Volatility markets seem to have taken this into consideration, as noted by the recent and significant decline in volatility skew shown in Figure 7. With longer-term rates moving to a more neutral rate, the expected probability of rates moving higher vs rates moving lower becomes more symmetric, which helps explain why the difference in level of implied volatility of a 3M10Y ATMF+25 option and ATMF-25 the skew has decreased. Furthermore, we have decomposed the volatility surface via principal component analysis (PCA), to highlight the three main analytical drivers of the shape of the surface. This is similar to performing PCA on the yield curve to decompose the yield curve into shift (level), twist (curve), and bow (convexity), with similar interpretations. Obviously, with PCA there are as many principal components as there are time series used, but traditionally the first three provide a significant amount of the explanatory power.1 When comparing the first principal component (PC) to the level of 3M10Y implied volatility we notice that, in the past month or so, the two have diverged as the gamma of tails 5Y and longer have generally underperformed the rest of the surface.2 In other words, 3M10Y vol is not moving so precisely with the global move in vol there is more independence. Fig 7. Vol spread for 3M10Y +/-25 risk reversal
13.5 13 ABPV Spread

Fig 8. 3M10Y vol no longer correlates with first PC

129
119

249 199 ABPV 149

99 49

12.5 12 11.5 11 10.5 10 9.5

9 7-Jan 7-Apr 7-Jul 7-Oct skew collapsed following FOMC 109 99

89
79 69 59 8-Jan
3m10y PC1 (RHS)

-1 -51 -101 -151

8-Apr

8-Jul

8-Oct

Source: Bloomberg, Credit Agricole CIB

Source: Bloomberg, Credit Agricole CIB

The final factor that is likely to drive volatility as we look to escape from a world of quantitative easing is a fundamental change in the volatility surface towards normalisation. The current shape of the volatility surface is far from a normal one. At the moment, the peak of the volatility surface is at the 5Y1Y point as the belly of the curve has been the most volatile. However, with the Fed in play in the coming year or two, one would not expect a one-year strip of rates five years out to be the one most conditioned upon Fed policy. Instead, we typically would see implied vols around the 2Y2Y point of the surface to be at the peak of the hump. There is a two-fold reason for this: although markets have a decent idea of what the Fed will do over the next two years, thanks in part to the Feds Summary of Economic Projections, the pace at which it proceeds beyond that point as well as the economic conditions that may arise between now and then are far less certain. jonathan.rick@ca-cib.com

When performing PCA on the level of volatility the first three principal components explain 98% of cumulative variance on the past one year of data with the first PC explaining 90% on its own. 2 Using the first three PCs shows a similar divergence, and can be seen in our daily USD Interest Rates Derivatives Report.

08 January 2014

Interest Rates Monthly

Eurozone Directional View

Bearish bond outlook remains in place for 2014
In 2013, the almost uninterrupted drop in core EUR rates that began in early 2011 finally came to an end. However, with the 10Y EUR swap rate closing just 45bp higher on the year, the sell-off was a fraction of the bear market moves that began in 1999 and 2005 or even the abortive sell-off of late-2010 (Fig. 9). The very moderate rise in rates reflects a number of factors from still moderate Eurozone output growth to advances in ECB policy communication (forward guidance, etc). The limited upside momentum for rate levels has left core EUR rates trailing well behind UST yields, to which they have traditionally been very highly correlated (Fig. 10). As a result, despite both the ECB and Fed promising to keep policy rates near 0% for protracted periods, the EUR curve is much flatter than the USD curve. For instance, the 2s10s spread is around 170bp in Germany as compared to nearly 260bp in USTs. Such large pick-ups by US rates relative to EUR ones are not unusual in the initial stages of past bond sell-offs but have tended to be reduced significantly over time. Fig 9. EUR 10Y rate in past sell-offs
6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 % +195 bp +195 bp

Fig 10. EGB yields lagging rise in UST yields

7

+200 bp

6 5
4 3 2 %

UST 10Y DBR 10Y US-DE spread

+45 bp

0
-1 Jan-97 Jan-02 Jan-07 Jan-12

1.0 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13

Source: Bloomberg, Crdit Agricole CIB

Source: Bloomberg, Crdit Agricole CIB

The standard explanation for the historically high difference between US and Eurozone medium-term rates is that the US has been growing and should continue to grow more rapidly the latest YoY real GDP figures being, respectively, +2.0% and -0.4%. However, the key consideration going forward is that Eurozone growth has been gradually accelerating and should continue to do so. The Eurozone PMI points upward and has been catching up to the US ISM. The Eurozone as a whole continues to post current account surpluses, despite a firm exchange rate, suggesting that accelerating growth elsewhere in the Atlantic rim will generate further growth in the Eurozone. Signs of renewed growth potential are also evident in the pick-up in gross fixed capital formation, which in Q3 marked the first set of two consecutive positive figures since 2008. Lastly, the overall level of intra-EMU dispersion in economic sentiment has decreased significantly, despite ongoing differences between countries.

08 January 2014

Interest Rates Monthly

Fig 11. EMU-US ISM-PMI spread and EMU C/A balance

2.5%
2.0% 1.5% 1.0% 0.5% C/A bal. (lhs) ISM-PMI (rhs)

Fig 12. EMU GDP out of recession (%)

1.5 1.0

10
8

% GDP

forecast 0.5
0.0 -0.5

4
2 0

0.0%
-0.5% -1.0% -1.5%

QoQ
-1.0

points
Mar-02 Mar-05 Mar-08 Mar-11 Mar-14

-2

-2.0% Mar-99

-4

-1.5 Mar-03

Mar-06

Mar-09

Mar-12

Source: Markit, ISM, Eurostat, Crdit Agricole CIB

Source: Eurostat, Crdit Agricole CIB

Another factor that suggests that EUR rates will rise more steadily in 2014 is that the safe-haven premium associated with core EGBs should shrink more markedly (we discuss the reasons for this view in our Eurozone Relative Value section). In the second half of last year, the core-peripheral yield spread compression decelerated clearly as domestic periphery investors booked profits and core institutions postponed some periphery buying until after the 2013 yearend. This was mirrored just as clearly in the lack of reduction in Target 2 balances at national central banks, an indicator of banking system fragmentation. Spreads have recently resumed their convergence process, and we think that a combination of improving fundamentals and ECB policy measures will also foster a degree of normalisation in EMU banks and, as a consequence, core EUR rates. Another way to conceptualise the steeper/higher core EUR curve (in absolute terms and relative to the US) is to consider that, in the moderate but positive growth scenario we have for the Eurozone economy, ECB policy support this year is likely to be targeted firmly at maintaining and improving interbank liquidity, reversing the negative corporate credit growth rate and reducing banking system fragmentation along national lines. We do not expect any of the measures linked to this effort to be announced in January, but there should definitely be significant progress in H1. Between now and year-end, we expect further, significant rises in core EUR rates, especially beyond the 2-3Y maturity. luca.jellinek@ca-cib.com

08 January 2014

Interest Rates Monthly

Eurozone Relative Value

New Years resolution for periphery spreads
Through the second half of last year, flows and pricing momentum for the periphery convergence trade decelerated significantly. On the one hand, domestic investors (especially banks) booked some profits on their large periphery bond positions, and on the other that outflow was not met with sufficient interest from abroad (although it did increase) to prevent a deceleration in the rate of yield spread convergence. Similarly, in the run-up to year-end, indicators of Eurozone banking system fragmentation such as gross Target 2 balances with national central banks and recourse to money-losing deposits with the ECB suggested that risk aversion has been retreating at a less robust rate than before. This apparent loss of convergence momentum brought forth an understandable but, in our opinion, misled flood of questions about whether periphery spreads (at least in the liquid issuers) had reached some sort of fair or equilibrium level. We think that is unlikely for a number of reasons: First of all, the overall trend remains firmly in place. If we divide the data set from tops to troughs, that naturally tends to exaggerate the dynamics as observed ex-post; but, if we look at more neutrally-defined time periods, we see that progress has been comparatively even. Using the Spain-Germany 10Y spread as a benchmark, the rate of convergence went from 76bp in H212 to 105bp in H113 and then 81bp in H213. The corresponding figures for the Italy-Germany spread were 106bp, 36bp and 72bp. Furthermore, we would point out that on a month-to-month basis, weighted average periphery spreads have not suffered a major reverse since April 2013 and no actual losses (on that basis) since September. In any case, there is a plethora of evidence, including in our research 3, to suggest that the relationship between sovereign spreads and macroeconomic or fiscal differences is too econometrically unstable to be able to define usefully a stable fair value. The fundamentals certainly matter but within a context of often turbulent flows. Fig 14. Periphery deficit/GDP* tightening
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
bp 500

Fig 13. Re-acceleration in EMU spreads convergence

600

0.0% -1.0% -2.0%

2012
2013

400 300
200 100 Jul-11 10Y Spain 10Y Italy Jan-12 Jul-12 Jan-13 Jul-13 Jan-14

-3.0%
-4.0% -5.0% -6.0%

-7.0%
-8.0%

% GDP

Source: Bloomberg, Crdit Agricole CIB.

Source: Nation finance ministries, Crdit Agricole CIB. * = Italian data adjusted for funding flows referring to previous FY.

The strong convergence price action more recently needs to be confirmed in a more normal environment of flow volumes, but it does suggest we were correct in thinking that, come the New Year, both domestic and international institutions would be minded to allocate more risk budget to the periphery trade4. That is not to deny that there are always significant domestic and EU political risks to the convergence process, ranging from the variable willingness of German authorities to support more mutualistic solutions to the stability of various periphery governments and their commitment to austerity. At the same time,
3 4

See for instance: Fundamentals and EGB valuations still converging, Nov. 2013. With specific reference to banks, see: Will periphery banks still support their govvies in 2014?, Dec. 2013.

08 January 2014

Interest Rates Monthly

however, investor sentiment regarding sovereign risk in the Eurozone has been understandably buoyed by the broad improvement in economic sentiment and external sector balances, confirmed most recently by strong manufacturing and service sector PMI data. The early part of the fiscal year sees the publication of final deficit figures for the preceding year and adjusted forecasts for the current one. Since 2010, that newsflow has had a significant impact on spread trends. The indications we can glean from the 2013 data available at this point is that the broad thrust from the periphery will, again, be positive. This, too, should provide a seasonal fillip to the convergence process. Turning to individual sovereign issuers within the periphery: Italys expected central government (CG) supply looks rather different depending on whether one looks at net or gross measures. Gross supply will remain quite high at over 15% of GDP but, in net terms, the figure is a relatively slim 3.5% of GDP and a major drop from last years 6.5%5. At any rate, supply is due to fall slightly even in gross terms and we expect this most liquid periphery issuer to attract demand despite still so-so growth. Spain has recently put in some strong macro figures, especially in terms of forward-looking indicators. Having exited the bank recap support programme, it seems reasonable to believe that there will be no shocking surprises from the AQR, a view confirmed by the Spanish debt agency itself. If that is so, we expect the still-substantial net supply requirement (above 5% of GDP, in 2014) to be cut too. Ireland and Portugal are perceived by rating agencies and the market quite differently, but they are both scheduled to return more decisively to the market this year. In both cases, the amount they need to raise on bond markets is unlikely to be above EUR10bn and therefore should be straightforward to achieve. The Irish are already funded through this year and therefore their new 10Y issue amounts to further pre-funding.

In positioning terms, we continue to like: The absolute valuation of Portugal, with 10Y yields still above 5.5% and 3Y yields above 3%, Periphery-Core relative flatteners (periphery term structures are much steeper than in the core) The strategic recommendation to switch duration risk into sovereign credit risk for a similar running yield (the Aug-2023 Bund yield not more than the Jul-2017 Obligacin, for instance). Fig 16. Return of switching duration into credit
6% 5% bp 4%

Fig 15. The Italy-Germany relative flattener

80 70 60 50 40 30 trade started

Spain 1-3 - Germ. 7-10

3%
2% trade started

IT DE 2016- 2023 box spd

1% 0%

20 10 0 Sep-13
Oct-13 Nov-13 Dec-13 Jan-14

-1%
-2% Jun-13

Aug-13

Oct-13

Dec-13

Source: Bloomberg, Crdit Agricole CIB.

Source: EFFAS, Crdit Agricole CIB. Total return difference between EFFA index maturity buckets.

luca.jellinek@ca-cib.com

The large difference between Italys financing need and Eurostat deficit in 2013 was due principally to the payment of pre-existing debt, which had, correctly, already been accounted for in previous years.

08 January 2014

Interest Rates Monthly

Normalisation remains the dominant RV regime for 2014

If we are right about the path for interest rate markets in 2014, with a likely protracted sell-off of long-term core rates driven by further US economic recovery, then we would expect to see more investors utilising RV strategies to boost returns in the coming quarters. No longer will it suffice to find extra yield simply by taking on more duration or credit risk. If more investors turn to RV, then market efficiency should continue to improve, and we expect the strategies we employ (a combination of curve fitting and mean reversion) in our EUR Govt RV publication to improve in the consistency of their returns. Normalisation was a great theme of 2013, not only in terms of periphery yield levels returning to historical averages and spreads tightening from crisis levels, but also in the RV space, as much of the periphery curve was unevenly priced last year as it continued its transition away from distressed pricing. The yield curve models we use in our EUR Govt RV publication have proven very effective in highlighting normalisation RV opportunities. Currently, there are still very large standard errors in our models for investors to exploit, particularly in Italian (4.8bp) Spanish (6.5bp) and French (3.6bp), which are comfortably larger than the typical bid-offer spreads in these markets, which augurs well for micro-RV strategies to continue to perform well. Moreover, as the ECB is likely to keep the Refi rate very low for a long time (our macroeconomists forecast a first rate hike in 2016), the favourable funding environment should further aid RV strategies. One of the biggest normalisation opportunities in 2013 was the excessive curvature of peripheral markets particularly in Italy and, although this was something that took considerable time to correct, strategies based on this (such as the BTP 2015-2017-2019 fly that we closed recently) paid handsomely. The equivalent periphery curve trade for 2014 is, we believe, the 5s10s flattener in Spain and Italy. We wrote about the attractiveness of receiving Italys 5Y5Y early in December 2013 (the same applies for Spain), and in Figures 17 and 18 below we simply note the directional relationship of Italys 5s10s slope again st the 10Y Italy-Germany spread. The steepening which took place in Q413 has taken the slope back up to extremes, not only in outright terms but also in these directionally-adjusted terms. Fig 17. Italy 5s10s slope vs 10Y BTP-Bund spread
150 140

Fig 18. BTP 5s10s residual to 10Y BTP-Bund derived fit

25 20 bp IT 5s10s steep

y = -0.1381x + 153.2 R = 0.1769

130
120 110 100 90 80 150 200 250 300 350 400
IT 5s10s (bp)

15
10 5 0

-5
-10 ITDE10 (bp) -15 -20 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13

Source: Crdit Agricole CIB

Source: Crdit Agricole CIB

One could look at Figure 17 above and think that the 5s10s flattener is a bearish trade. We think not it is a trade which has optionality within it due to the inflection we expect to see in periphery 5s10s slope directionality. Figure 19 puts the 5s10s slopes in context with other core and semi-core EGB paper (the dataset is the past year) and we have fitted a quadratic function through the data. Our point is simple as periphery spreads continue to tighten, the 5s10s slopes should enter a bull-flattening regime, but on the other hand the 5s10s flatteners should perform well if any serious stress materialises in periphery markets. The Italian or Spanish 5s10s flattener is thus not only cheap compared to the spread to Germany but we also expect it to be far less directional.

08 January 2014

10

Interest Rates Monthly

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

180 160

140
120 100 80 60
5s10s (bp)

10Y Bund spd (bp) 0 100

Austria Belgium Italy

France Spain Netherlands

40
200 300 400

Source: Crdit Agricole CIB

peter.chatwell@ca-cib.com

Firm agency/supra market, but some intra-market value

High-quality liquid Euro agency/supra bonds6 performed solidly last year, in both outright and relative terms, following what was a big revival of the market in 2012. At least part of this markets attraction has been the valuable yield in relative terms during a two-year period of low core sovereign bond yields that frequently set new record lows. Another test of the lows in the 10Y Bund yield is very unlikely this year. On the contrary, both internal (improving macro core and periphery data) as well as external factors (Fed tapering and signs of a sustained US economic recovery) are key driving forces that should push Euro core bond yields higher, to levels not seen for two to three years. A persistent rising yield move this year (our scenario) would present a different environment for the Euro agency/supra market. In theory, higher sovereign yields make maintaining tight spread levels harder as some investors feel the return on sovereigns has become more desirable. However, over the past year higher yields have coincided with the core-agency/supra yield ratio falling and vice versa (Fig. 20). The spread remained broadly stable even as yields rose. That said, the high point for the 5Y German yield over the past two years has been only 1%. A yield in close proximity to 1.75% (our year-end scenario) could be more of a challenge to keeping the spread tight. Even in a rising-yield environment, we maintain our long-standing positive stance on the Euro agency/supra market relative to sovereigns and swaps, given the minimal risk concerns that have featured prominently in the past, such as EFSFs sovereign and banking exposures pre-LTRO/OMT. However, at spread levels to sovereigns there is limited room to richen further. Fig 20. 5Y agency-sovereign yield ratio* vs direction
1.7

Fig 21. Euro-liquid core issuance and 2014 target

1.2 90

%
1.6 1.5

Yield ratio * - lhs 5Y German yield - rhs

% 1.0 0.8

80
70 60 50 40 0.6

EUR bn

2012

2013

2014

1.4

30
20 10 0

79 68 65

72 71 70 58 45 35 30 15 14

1.3 1.2 1.1 Jan-13

0.4

20 6 5

15 15 15
BNG*

9 17 ESM

Apr-13

Jul-13

Oct-13

0.2 Jan-14

KfW

EIB

EFSF CADES* EFSM (EU)

Source: Crdit Agricole CIB, Bloomberg. * KfW, CADES and BNG versus their core sovereign issuers
6

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

We classify high-quality liquid issuers here as KfW, CADES and BNG alongside panEuropean issuers like EIB, EFSF, ESM and EU/EFSM.

08 January 2014

11

Interest Rates Monthly

The few risks going into this year are likely to be specific to a minimal number of issuers. For instance, the ESM is lender/investor of last resort for the banks, which could be triggered if banks find raising capital difficult following the AQR and stress tests later this year. This could see the ESMs modest EUR17bn issuance target increase. Broadly speaking, the markets supply volume should be roughly similar to last year (Fig. 21), though this has hardly been a point of concern for some time. Another potentially vulnerable issuer is CADES due to pressure from French economic concerns. However, we do not see a decoupling of French sovereign bonds relative to their core counterparts in the months ahead even if there could be some pressure in the near term. When looking intra-market (Fig. 22 and 23) we still see potential for CADES bonds to underperform neighbouring EFSF bonds, especially the 3-7Y area of the curve. Despite the bank recapitalisation risk, we think ESM looks decent value against EFSF given its guarantee structure and creditor status. Among the more expensive issuers, KfW bonds that trade cheaper than EU bonds are attractive, such as KfW 4.375% Jul-18 at a 7bp pick-up against EU 3.25% Apr18. Meanwhile, there could be an argument for stronger-performing EIB bonds beyond the 5Y relative to their richer peers helped by its guarantee structure and diverse and historically sound loan portfolio. Fig 22. Agency/supra ASW term structures
40 30 20 10 0 -10 -20 -30 -40 -50 1 bp

Fig 23. Duration-weighted ASW quarterly change

8
6 4 2 0 bp Q3

Cheapening vs swap

Q4

KFW EIB ESM 2 3 4 5 6

CADES EU

BNG EFSF Duration 8 9

-2 -4 -6 Richening vs swap

KfW

CADES

BNG

EIB

EU

EFSF

Source: Crdit Agricole CIB, Bloomberg

Source: Crdit Agricole CIB, Bloomberg

orlando.green@ca-cib.com

08 January 2014

12

Interest Rates Monthly

Asian Rates View

Adjusting higher in a post-tapering environment
There have been a few exceptions to the generally upward movement in Asian rates in the past month, despite the beginning of the Fed taper. Notably, KRW IRS and THB IRS moved down across the curve in December, with a resilient bond market for the former and likely increasing demand for overseas investment for the latter of which the floating leg is an FX swap implied rate. For other rates, the development is clearly to the upside, most obviously for CNY IRS where domestic factors are adding to the momentum, followed by HKD IRS and SGD IRS, which have high correlations with USD IRS. For the year ahead, there is no one rule fits all when it comes to monetary policy in Asia. But the bottom line is that real interest rates are either negative or very low, pointing to very limited room for individual economies to cut their policy rates. This backdrop sets a floor to rates. Asian rate movements will be driven primarily by changing capital flows in a posttapering environment. Yield pick-up from asset swap trades in sovereign bonds from a USD-funded investors perspective is negative in most Asian markets. We would expect most Asian sovereign yields to move higher to become appealing again to foreign investors. Given high correlations between USD IRS and most Asian IRS on a 12M horizon, we expect Asian IRS to go higher alongside USD IRS in the coming quarters. However, there could be divergences in the near term, as already suggested by some breakdowns in 3M correlations, when local factors are the driver, such that there could be a delay before Asian markets react. Curve moves could also differ, because some Asian curves have steepened a lot already while others are lagging. Towards the latter part of 2014, whether Asian rate curves will flatten back depends on market expectations on front-end rates, which in turn depends in part on how effectively the Feds forward guidance works. The HKD IRS, TWD IRS and SGD IRS curves have steepened relatively more than other Asian curves. These curves could remain steep during Q114 as investors are still gauging the pace and impact of Fed tapering. However, as the year progresses, these curves, especially the HKD and SGD IRS curves, could flatten back if front-end rates start to react to the prospect of a Fed funds target rate hike although this expected hike may still be some time away. On the other hand, the CNY IRS curve looks relatively flat, compared with its own history and with its regional peers. We expect the CNY repo-IRS curve to steepen across the 1-5Y and 2-5Y segments in particular, with the risk to this view being a yetunexpected tightening in CNY liquidity. Fig 24. Asian rates to rise with USD rates
12-month correlation betw een LCY IRS and USD IRS 1.00 0.75 0.50 0.25 0.00 SGD HKD TWD PHP KRW MYR
Source: Bloomberg, Crdit Agricole CIB

Fig 25. There will be short-term divergences

1.00 0.50 0.00 -0.50 -1.00 Correlation betw een 2Y LCY IRS and USD IRS 3M 12M

2Y

5Y

10Y

INR

CNY

THB

HKD SGD

PHP TWD THB

INR

MYR KRW CNY

Source: Bloomberg, Crdit Agricole CIB

08 January 2014

13

Interest Rates Monthly

Individual markets
Front-end HKD IRS can continue to rise relative to USD IRS, with HKD liquidity potentially tightening. It is worth monitoring the HKD bank loan situation the percentage of HKD loans for use outside Hong Kong keeps increasing. We also notice there have been carry trades receiving 2Y and 3Y HKD IRS we would be looking to pay these rates beyond Q114. EFBNs have become bearish alongside USTs, but we see EFBNs outperform USTs, as EFBNs have a more favourable demand/supply dynamics. When asset swap trades are not viable in most Asian markets, bond investors will go for local currency bonds with a relatively stable FX outlook KRW is one of the obvious choices. Structural flows from the foreign public sector are key for KTB outperformance compared with regional peers. That said, KTB yields have to adjust higher to become attractive to more foreign investors. In this process of upward adjustments in yields, we expect the KTB curve to steepen, as foreign investors will likely choose not to leave the KRW bond market entirely but rather to shorten their portfolio duration. The KRW IRS curve should follow. In Thailand, while net LB supply in FY13/14 is scheduled to be less than in FY12/13, there is a risk that fiscal policy will become even more expansionary over the course of the year after disbursement gets back on track, with needs for stimulus and for extra money allocated to the rice pledging scheme. Asset swap trades in LBs from a USD-funded investors perspective are not appealing either. LB yields would be under upward pressure. The LB curve, however, is already very steep so we see scope for a flattening move in 2014. The THB IRS is steep as well, but it may maintain its steepness relative to the LB curve, as increased demand for overseas investment will push down 6M THBFIX an FX swap implied rate, and front-end THB IRS. In the offshore RMB market, we see further upside to CNH cross-currency swap (CCS) and offshore CGB yields across the curves. First, offshore rates have to catch up with the recent, marked upward moves in onshore CNY rates. Secondly, there would be a lack of receiving flows in CNH CCS, with the current levels still not attractive for opportunistic dim sum bond issuers to issue CNH bonds and swap the CNH proceeds back into USD. Thirdly, we suspect that a large bulk of the HKD loans for use outside of Hong Kong have been extended to mainland entities, which could result in paying flows at CNH CCS if they decide to swap the HKD loans into RMB. We expect more offshore RMB bonds to be issued in Taiwan in 2014. With the withholding tax in place, RMB bonds in Taiwan may not be particularly attractive to foreign investors. Still, there would be interest from local investors, especially if RMB bonds issued in Taiwan are to be exempt from the overseas investment limit (nothing is confirmed yet). Fig 26. Curve slope dynamics have varied
180 160 140 120 100 80 60 40 20 0 -20 bp 2/5 IRS slope USD Average of HKD, SGD, MYR, THB Average of CNY, KRW, TWD

Fig 27. Asset swap trades not attractive

0 -40 -80 -120 -160 -200 yield pick-up from 5Y LCY govies, USD funded bp

11

12

13

14

HKD

MYR

INR

KRW

THB

CNH

SGD

Source: Bloomberg, Crdit Agricole CIB

Source: Bloomberg, Crdit Agricole CIB

frances.cheung@ca-cib.com

08 January 2014

14

Interest Rates Monthly

Inflation-Linked Strategy
Dealing with very weak EUR inflation until Q3
Overall, 2013 was a painful year for European linkers, with falling realised inflation and increasing real yields, which resulted in large negative total returns and declining interest from investors. As an illustration, in the 10Y area, German, French and Italian breakevens all declined by about 30bp (Fig. 28). Even Italian breakevens, which had recovered in 2012 thanks to improving sentiment regarding the periphery, disappointed in 2013. Among the different factors driving breakevens, realised inflation will not help before late 2014 (Fig. 29). Indeed, we expect that Eurozone HICP inflation will remain stuck in a 0.6-1.0% corridor until end-Q314, meaning nine more months of very subdued yearly inflation. To be more precise, our hypotheses are relatively consensus-like regarding both oil prices and EUR/USD (which we see declining towards USD102/bl and 1.28 by end-2014, respectively). Only later in 2014, a declining EUR and slightly better macro conditions forecast by our economists suggest gradually rising headline inflation, to around 1.3% by end2014 and into a 1.3-1.5% range in 2015. Fig 28. Falling B/E in 2013
2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 Jan-12 DBRei 23 B/E All dow n about 30bp in 2013 Jan-13 BTPei 23 B/E Jan-14 OATei 22 B/E

Fig 29. More subdued inflation ahead in 2014 (%)

4 3 2 1 0 -1 -2 08 09 10 11 Energy Indus. Goods Headline inflation 12 13 14 Food Services 15

Source: Crdit Agricole CIB, Bloomberg. B/E are seasonally adjusted.

Source: Crdit Agricole CIB, Bloomberg, Markit.

Supply-wise, the issuance programmes look relatively benign in 2014. In Germany, the Finanzagentur announced an I/L issuance programme of EUR1014bn in 2014, similar to the EUR12.4bn seen in 2013. The 2014 programme will likely include new 5Y and 10Y Bundis. In France, 2014 OATi and OATei should make up about 10% of total AFT issuance, ie, about EUR17bn, which is a touch higher than 2013 total issuance (EUR15bn). The Italian issuance programme is more uncertain, given that the Italian Tesoro takes a more pragmatic approach, particularly with newer instruments such as the BTP Italia. The success of the BTP Italia 2017 issue last year (a record EUR22bn was issued in a day and a half) implies the Italian Treasury may supply more modest amounts of BTPei than in the past and tap some BTP Italia securities or attempt new maturities. With relatively stable I/L supply (France, Germany) and realised Euro inflation gyrating around 0.8% YoY in H113, the upside for core breakevens therefore looks limited for at least six months, but a further fall looks equally unlikely in our view. All in all, given our nominal yield scenario of higher core, the stabilisation in breakevens means that core real yields will rise again. A rise in 10Y German real yield of roughly 40bp by mid-June is plausible.

08 January 2014

15

Interest Rates Monthly

Italian linkers look more attractive in relative terms. First, Italian HICPx-linked supply may be more limited than before, given a possible orientation towards BTP Italia. Secondly, Italian nominal yields should rise much more slowly than core yields (see Eurozone Relative Value section) in 2014, implying a limited rise in real yields assuming Italian breakevens stabilise. Already in 2013, Italian real yields stabilised, being the exception in the EUR I/L universe (Fig. 30). Lastly, there remains value in Italian HICPx-linked products, with real yields close to 2.6% in the 10Y area and a steep real yield curve slope. The main flipside of going long Italian I/L products is that in the past three weeks the BTPei 10Y real yield has fallen 30bp. Fig 30. Core and Italian real yield paths have diverged
1.4 1.0 0.6 0.2 -0.2 -0.6 -1.0 Jan-12 Jan-13 DBRei 23 adj. YTM BTPei 23 adj. YTM (rs) Italy 3 2 Jan-14 OATei 22 adj. YTM Core 7 6 5 4

Fig 31. Italian B/E still lower than core

2.50 2.00 1.50 1.00 0.50 0.00 2014 season & carry adj. B/E

2019 OAT i

2024

2029 Germ i

2034

2039 BTP i

Source: Crdit Agricole CIB, Bloomberg. Real yields and breakevens are seasonally adjusted

US TIPS strategy: real curve bear flattening ahead

Our US economists forecast that inflation will rise only gradually this year, from 1.24% to 1.80% by year-end (Fig. 32), driven by relatively cautious unemployment forecasts (6.8% by Q414), a strong USD against most OECD currencies and soft energy prices. Our core inflation forecast remains in a 1.61.9% corridor until year-end. Given stability in other breakeven determinants like TIPS supply/demand, energy prices, etc, realised inflation will be important. Thus, low inflation means that the nominal yield rises that we are forecasting will manifest themselves mostly in the real yield rising. It is hard to imagine the 5Y breakeven (Fig. 33) much above 2% before mid-year, which is the post tapering-talk-era high. We see the nominal 5Y UST at 2.55% by midyear (+90bp or so) and somewhere in the region of +70bp in the 5Y real rate. Fig 32. US realised inflation to rise very slowly in 2014
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 10 11 12 13 CPI-U, NSA, y/y, % 14 15 fcast Nov. 13 1.24 Dec. 14 1.82 Dec. 15 1.94

Fig 33. providing limited upside in breakevens

2.8 2.6 2.4 2.38 2.2 2.10 2.0 1.91 1.8 1.6 1.44 1.4 1.2 1.0 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 TII 2 01/15/16, B/E TII 2.125 01/15/19, B/E TII 2.375 01/15/25, B/E TII 0.75 02/15/42, B/E

Source: Crdit Agricole CIB, Bloomberg

Source: Crdit Agricole CIB, Bloomberg. Breakevens seasonally adjusted

jean-francois.perrin@ca-cib.com

08 January 2014

16

Interest Rates Monthly

Trade recommendations
Trade Type 1 2 3 Switch old for current 7Y USD 2-5Y German ASW box Buy 10Y OATs vs DSLs & RAGBs Switch duration into sovereign credit risk 5Y KfW vs EU bonds 10Y UST vs 10Y Germany Spain-Italy 4-5-5Y fly Buy/ Receive Current 7Y (T 1.375% Jan 20) Schatz ASW spread Current 10Y OAT 1-3Y EFFAS Spanish index KFW 4.375 Jul-18 10Y UST (T 1.75% May-23) BTP Jun17 Sell/Pay Old 7Y (T 1.125% Dec 19) 5Y OBL ASW spread Current 10Y DSL & 10Y RAGB 7-10Y EFFAS German index EU 3.25 Apr18 10Y Bund (DBR 1.5% May-23) Bono Oct16 and Bono Jan18 US 7Y Swap Spread 3Y UST 0.875 Sep -16 UST 2 Feb-23 UST 1.375 09/18 -7.9 bp 94.9 bp Entry Level 2.2 bp -9.5 bp 18 bp Entry Date 04/02/13 03/04/13 20/05/13 Exit Date 08/01/14 08/01/14 open Target 2 bp -2 bp 10 bp Stop 3 bp -12 bp Latest 2.4 bp -2.2 bp 11.9 bp 1M Carry 0 bp 0 bp 0 bp P&L 0.2 bp 7.3 bp 6.1 bp

19/06/13

open

0 bp

5.25%

5 6

02/07/13 17/07/13

08/01/14 open 85bp

-12 bp 105bp

-12.8 bp 105.7 bp

0 bp 0 bp

-4.9 bp -10.8 bp

7 8

52.7 bp -15.4 bp -31 bp

11/09/13 30/09/13 01/10/13

08/01/14 08/01/14 open

5bp

13.7 bp -4.4 bp

1 bp 0bp -3bp

38 bp -11 bp 6.8 bp

Buy 7Y Swap Spread Sell current 3Y UST 9 and buy current 2Y UST Buy Current UST 10 10Y vs 2nd UST 10Y 11 Sell 5Y UST vs 3Y UST & 7Y UST

2Y UST 0.25 Sep-15 UST 2.5 Aug23 UST 0.625 10/16 & UST 2 09/20 US 2Y swap spread UST 3.625 08/43 UST 0.25 10/15 & UST 1.25 10/18 BTPS 3.5 11/17 US 5Y Swap Spread ESM Oct 18

-50bp

-20bp

-34.8 bp

5.9 bp

16/10/13

open

4bp

6.8 bp

0bp

-0.9 bp

-8.8 bp 12 bp

17/10/13 05/11/13

08/01/14 open open open open open open

0bp 15bp 100bp 45bp 25bp

-8bp 8bp 112bp 62bp 50bp

-23 bp 10.9 bp 96.5 bp 60.2bp 50.1 bp 5.5 bp

0bp 0 bp 0 bp 0 bp 0 bp 0 bp 0 bp

-14.2 bp -1.1 bp 13.6 bp -8.6 bp -1.3 bp 5.8 bp 0.8 bp

12 2Y Swap Spread 13 10Y - 30Y Flattener 14 2-3-5Y Fly sell belly 15 BTP 3-4Y flattener 16 5Y Swap Spread 17 Buy ESM Oct-18 against EFSF Jul-18

UST 2.5 08/23 UST 0.625 10/16 BTPS 2.75 11/16

110.1 bp 05/11/13 51.6 bp 48.8 bp 11.3 bp 07/11/13 11/11/13 14/11/13 08/11/13

EFSF Jul 18

-0.9 bp

-10bp

2.1 bp

-1.7 bp

Receive 3M Eonia 18 and pay 9 x 12M Eonia Sell 5Y UST vs 7Y 19 UST 20 21 BTP-Bund 20232016 Box buy 2Y Schatz in ASW

3M Eonia UST 2 Nov-20 BTP 4.5 03/24 & OBL 1.25 10/16

9x12M Eonia UST 1.25 Nov18 DBR 1.5 05/23 & BTP 2.75 11/16 Schatz ASW spread UST 0.625 Nov-16 UST 1.25 Nov18 UST 2.75 Nov -23 UST 0.25 Nov15 UST 0.625 Dec-16 UST 2.5 Aug23

-0.5 bp 73 bp 63 bp -29.1 bp -29.4 bp

28/11/13 03/12/13 04/12/13 04/12/13 05/12/13

open open open open 08/01/14 open open open open open

-10 bp 66 bp 25 bp -40bp -39 bp 120 bp 90 bp -18 bp 190 bp 2.2 bp

5.5 bp 74 bp 85 bp -25 bp -27 bp 140 bp 115 bp -4 bp 235 bp 3.4 bp

. bp 69.4 bp 65 bp -32.3 bp -37.3 bp 128.5 bp 93.3 bp -17.1 bp

0 bp 0 bp -2.5 bp 0 bp 0 bp 0 bp 0 bp 0 bp

-0.5 bp 3.9 bp -4.4 bp 3.2 bp 7.9 bp 8.3 bp 9.9 bp 9.5 bp -0.2 bp 0.1 bp

22 US 2-3Y steepener 23 US 5-10Y flattener Buy 30Y UST vs 10Y Sell 2Y UST into 25 German 2Y Sell 3Y UST vs 10Y 26 UST Switch out of 10Y 27 1st old into 10Y Current 24

UST 0.25 Nov15 UST 2.75 Nov23 UST 3.75 Nov43 2Y Schatz Dec-15 UST 2.75 Nov23 UST 2.75 Nov23

136.8 bp 06/12/13 103.2 bp 09/12/13 -7.6 bp 12/12/13

219.2 bp 13/12/13 3 bp 16/12/13

221.2 bp -1.75 bp 2.9 bp 0 bp

08 January 2014

17

Interest Rates Monthly

Trade 1: The 7Y current (Jan 2020) appears cheap compared to older 7Y securities. Analysis of the past two years shows that a new 7Y starts off poorly but then picks up steam. The pattern of performance suggests that the 7Y current will become more expensive to the spline curve in the coming weeks. Take Profit. Trade 2: The heightened perception of banking credit risk in recent weeks has benefited bonds in the 5Y area most against swaps. Our medium-term view for a simmering of fears should therefore see the OBL cheapen against swaps gradually. We recommend selling the OBL against swaps in a 2-5Y German swap spread box. Take Profit Trade 3: We plotted the z-spread of benchmark core-Eurozone 10Y bonds to the Euribor swap curve against both credit ratings and adjusted required-primary-balances. From a statistical standpoint, French OATs offer better value than Dutch and Austrian paper in the 10Y area, and we would overweight it until the spread shrinks. Hold. Trade 4: This trade involves swapping interest rate risk for credit risk while maintaining running yield in EGBs. Essentially, we sell longer-dated core paper and buy short-duration periphery paper with comparable yields. If economic recovery in the G10 bond markets does take place, then fiscal benefits to the periphery will be considerable. Hold. Trade 5: In the intra-market, relative moves have made the pricing order among issuers fuzzier than before (eg, KfW was the most expensively priced issuer, pre-LTRO). In some cases, EU bonds are trading more expensively than neighbouring KfW bonds. We think the KfW 4.375% Jul-18 looks decent value against the EU 3.25% Apr-18 at -8bp. Take Loss Trade 6: The spread between the two blocs is at its 89th percentile. If the US economy really begins to grow, a lot of the safe-haven premium for Bunds will go. Hold. Trade 7: Spain has outperformed Italy since mid-2012 with the trend accelerating post the Italian elections. Though we look upon the current economic position of Spain more favourably than that of Italy we see relative headline risks as more balanced than the current market suggests and note that sharp Italy-Spain spread swings have provided good trading opportunities in the past. Given current momentum in favour of Spain we would be very cautious about building a long Italy position. We enter the Spain Italy 3-4-5Y. Take Profit Trade 8: Swap spreads tend to widen on a seasonal basis leading into Q4. This widening bias should be reinforced by the current government shutdown/debt-ceiling concerns. Based on our models, existing swap spreads are due an adjustment. This trade looks particularly good at the 7Y tenor since the 7Y swap spread has cheapened of late. Buy 7Y swap spread. Take Loss. Trade 9: Following the unexpected Fed tapering delay, the 3Y yield has dropped to an important support level of 0.61 and, without further impetus, we dont see it dropping below this level so we consider this a good level to sell. However, selling the 3Y directly would generate roll and carry losses of about 14.5bp per 3 months. To offset this we recommend buying the 2Y, which in turn will reduce the losses to about 3bp. Hold. Trade 10: As the debt ceiling approached, off-the-run issues declined in liquidity; in the event of a default this effect would y be exacerbated, in which case we would expect some liquidity premium from holding the current 10Y, which would reduce some of the recent cheapening of the 10Y. However, if the debt-ceiling issue was resolved so the 5-10Y part of the curve should probably flatten as the belly unwinds its recent outperformance leading to some flattening of the current 10Y relative to the 2nd old. Buy current 10Y UST and sell 1st old 10Y UST. Hold. Trade 11: Carry and roll have recently moved inversely to yield movements strengthening the 5Y sector (due to improved carry). We believe that delayed Fed tapering and the appointment of Yellen are already priced into markets and that the following month will be data-heavy with added uncertainty on the impact of the shutdown. For this reason we sacrifice potential carry by selling the 5Y UST vs the 3Y and 7Y USTs. Take Loss. Trade 12: Since the 2Y swap spread is highly influenced by the date of the taper and also highly correlated to the MOVE volatility index, which has increased of late, we expect the spread to increase. Buy the 2Y swap spread. Hold. Trade 13: The 10-30Y spread is also a taper proxy since the lack of a taper reduces the attractiveness (in roll and carry terms) of the 10-30Y flattener, leading to the unwinding of such trades in the event of a taper. Whats more, this spread sits just below an important resistance of 110bp. Therefore, positive surprises from Fridays announcement have scope to impact the spread to the upside, with more limited potential to influence to the downside. We enter the 10-30Y flattener at about 110bp with a target of 100bp and a stop at 112bp. Hold. Trade 14: Whilst Yellen advocated the optimal control method for calculating interest rates recently suggested in two papers (which suggests very low rates for some time to come), she also noted that it suffers strong assumptions and advocated a Taylor rule, which produces much higher appropriate rate levels for end-2015 than implied by OIS forwards. We believe that the recent disjointedness in the curve is overdone and that the market is fully priced only at the front end of the curve. We sell the US 3Y in a 2-3-5Y Butterfly trade. Hold. Trade 15: Given ongoing spread convergence and ECB liquidity support we would expect the 2s4s spread to flatten in Spain and Italy to about 80bp (from about 110bp at present). However, that trade has a carry cost of about 6bp over the next six months. A less carry-expensive alternative is the BTP 3s4s flattener (currently about 50bp) with a 6-month carry cost of about 1bp. Hold. Trade 16: UST Swap spreads have not widened as much as anticipated recently. This can be attributed to a number of possible factors including curve steepening and an improved swap curve credit rating. However, the current situation of an

08 January 2014

18

Interest Rates Monthly

improving US budget deficit and an imminent tapering of the Federal Reserves asset purchasing programme should be sufficient to drive up spreads going forwards. We enter the 5Y US Swap Spread widener. Hold. Trade 17: In October the ESMs 5Y bond issue was well received. The bonds subsequent performance does not reflect the initial strong primary market interest. Since launch this bond has cheapened relative to neighbouring EFSF and EIB bonds. We would recommend buying ESM 1.25% Oct-18 against EFSF 1.25% Jul-18. Hold. Trade 18: A number of factors have contributed to a reduction in excess liquidity of late, driving Eonia to its highest level in over a year. Eonia forwards have not risen to the same extent and thus we expect an upcoming ECB loosening to undo some of the current Eonia forward term structure inversion. We enter the trade receiving 3M Eonia and paying 9 x 12M Eonia at -0.5bp targeting a move to -10bp and setting a stop at +5.5bp. Hold. Trade 19: The 7Y suffered a poor auction last week and has been on the unfortunate end of the popular 7-30Y flattener trade. Conversely, forward guidance enthusiasm has bolstered the 5Y leading to a severely broken curve relationship between the 5Y and the 7Y. The current spread is 72.5bp; we target a move to 66bp with a stop at 74bp. Buy 7Y vs 5Y. Hold. Trade 20: One potential source of valuable trading opportunities is the extreme steepness of the periphery term structure relative to the already steep core yield curves. Though most box spreads between BTPs and Bunds look interesting, the 2015-2023 and 2016-2023 box spreads seem to offer the best outright mix between outright spread size and deviation from the norm. Hold. Trade 21: Though Euro core swap spreads have generally traded in a tight range this year, the Schatz ASW spread is trading at the tightest levels of the year. Since the Schatz ASW can be seen as a derivative of money market bases but has recently moved unilaterally, we believe it to be about 12bp too cheap. Furthermore, any sense that the ECB is behind the curve will likely benefit core bonds relative to swaps. We buy the Schatz in ASW terms. Hold. Trade 22:. The market has been very excited about the prospect of new forward guidance but we think that it will be very difficult for the Fed to live up to expectations in this regard and that the combination of decent payrolls and largely unchanged Fed forecasts could really shift the short end around. We enter the 2-3Y steepener trade. Take Profit. Trade 23: The yield curve is looking increasingly steep; more so in some areas than others. Using data going back to 1978 the 5-10Y spread is in its 99th percentile. As the US economy shows increasing signs of improvement the impact of Fed forward guidance will begin to stretch less far in the future. We believe that even enhanced forward guidance would lack the credibility to hold down the 5Y yield and prevent 5-10Y flattening. We enter the US 5-10Y flattener trade. Hold Trade 24: The usually close relationship between client positioning (ie, duration-weighted dealer positions across all euro$ futures contracts) and the UST 10Y yield has broken down of late. Unusually large institutional longs sit in the 5Y and Ultra contracts; around year-end strange position-driven moves may occur with the 5Y looking particularly susceptible. We see scope for flattening of the 10-30Y into year-end. Buy 30Y UST vs 10Y UST. Hold Trade 25: The current spread of the 2Y T-Note over the German Schatz is 8bp (around its lowest level since 2011). We are somewhat bearish on the front end of the US curve. The has begun tapering its asset purchases and may even hike rates within the next couple of years. This contrasts against the ECB with its unlimited supply of MROs and LTROs until the end of 2015 and the possibility of a new round of vLTROs. These contrasting stances will likely support the Schatz-T-Note spread. We buy the 2Y Schatz vs the 2Y T-Note looking for a move to 18bp with a stop at 4bp. Hold Trade 26: Historically the 3-10Y spread has flattened in a bull market and steepened in a bear market. Thanks to the Feds commitment to low rates the 3Y has struggled to show any significant movement of late. We expect the status quo to return in the not-too-distant future. However, before it does we see an opportunity. If we transition into a bear market the 3Y and 10Y will initially rise in parallel before giving way to a bear flattening. In contrast if the current bond rout becomes a rally we will likely see the 10Y lead the bull flattening. Sell 3Y UST vs 10Y UST. Hold Trade 27: The 10Y current has cheapened significantly. Unusually, the newer benchmark is trading with a spline spread which is cheaper than the 1st old. We think that the current unusual cheapening of the 10Y is linked to investor reluctance to own 10Y paper ahead of the possible taper and that this could lead investors to switch out of the front end and into the 10Y following the taper announcement. Hold

08 January 2014

19

Interest Rates Monthly

Interest rate forecasts

Now FF target FF effective 3M $ Libor USTs 2Y 5Y 10Y 30Y USD sw aps 2Y 5Y 10Y 30Y EUR Refi rate Eonia 3M Euribor 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y Call rate 3M Libor 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y Bank Rate Sonia 3M Libor 2Y 5Y 10Y 30Y 2Y 5Y 10Y 30Y USD 0.25 0.08 0.24 0.39 1.68 2.94 3.88 0.50 1.74 3.01 3.86 0.25 0.10 0.28 0.21 0.88 1.89 2.72 0.29 1.17 2.49 3.43 0.99 2.44 3.87 4.77 1.04 2.34 3.80 4.71 0.53 1.23 2.13 2.72 0-0.10 0.15 0.09 0.21 0.69 1.70 0.21 0.38 0.89 1.87 0.50 0.43 0.52 0.52 1.77 2.95 3.62 0.96 2.04 2.92 3.37 Mar-14 0.25 0.10 0.25 0.75 2.20 3.15 3.95 0.95 2.35 3.30 3.95 0.25 0.10 0.25 0.30 1.00 2.10 3.00 0.40 1.25 2.60 3.60 1.10 2.50 4.00 5.00 1.10 2.45 3.95 4.95 0.60 1.35 2.40 3.05 0-0.10 0.14 0.10 0.25 0.75 1.85 0.25 0.40 0.90 1.95 0.50 0.45 0.55 0.70 1.95 3.20 3.80 1.10 2.20 3.20 3.65 Jun-14 0.25 0.10 0.40 1.25 2.55 3.40 4.05 1.45 2.85 3.70 4.05 0.25 0.15 0.25 0.50 1.25 2.35 3.20 0.55 1.45 2.75 3.70 1.25 2.65 4.05 5.05 1.25 2.65 4.05 5.05 0.80 1.55 2.65 3.30 0-0.10 0.14 0.10 0.20 0.65 1.75 0.25 0.35 0.80 1.85 0.50 0.45 0.55 0.90 2.25 3.35 3.85 1.20 2.50 3.40 3.75 Sep-14 0.25 0.10 0.50 1.55 2.85 3.55 4.10 1.75 3.15 3.85 4.10 0.25 0.15 0.30 0.70 1.50 2.55 3.30 0.75 1.70 2.90 3.75 1.40 2.80 4.05 5.05 1.40 2.80 4.05 5.05 1.00 1.80 2.85 3.40 0-0.10 0.14 0.10 0.25 0.70 1.80 0.25 0.40 0.85 1.90 0.50 0.50 0.60 1.25 2.40 3.40 3.90 1.50 2.65 3.45 3.80 Dec-14 0.25 0.10 0.60 1.85 2.95 3.75 4.20 2.05 3.25 4.05 4.20 0.25 0.20 0.35 0.90 1.75 2.70 3.40 0.95 1.90 3.00 3.80 1.55 2.95 4.10 5.05 1.55 2.95 4.10 5.05 1.20 2.05 3.00 3.50 0-0.10 0.14 0.10 0.25 0.75 1.85 0.25 0.40 0.90 1.95 0.50 0.50 0.60 1.35 2.50 3.45 3.95 1.60 2.75 3.50 3.85 Mar-15 0.25 0.12 0.60 1.95 3.05 3.85 4.30 2.15 3.35 4.15 4.30 0.25 0.25 0.40 1.10 1.95 2.80 3.45 1.15 2.10 3.10 3.85 1.70 3.05 4.10 5.00 1.70 3.05 4.10 5.00 1.40 2.25 3.10 3.55 0-0.10 0.14 0.10 0.30 0.80 1.90 0.25 0.40 0.90 1.95 0.50 0.50 0.60 1.40 2.55 3.50 4.00 1.65 2.80 3.60 3.95

Germ any

France

Italy

Spain

EUR sw aps

JPY JGBs

JPY sw aps

GBP

UK Gilts

GBP sw aps

Source: Crdit Agricole CIB

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Interest Rates Monthly

Global Markets Research contact details
v.19/04/13 Asia (Hong Kong & Tokyo) Mitul Kotecha Head of Global Markets Research for Asia and Global Head of FX Strategy +852 2826 9821 Macro Strategy (Facilitator: Herv Goulletquer)

Herv Goulletquer Head of Global Markets Research +33 1 41 89 88 34

Europe (London & Paris) Sbastien Barb Head of Global Markets Research for Europe and Head of EM Research and Strategy +33 1 41 89 15 97 Frederik Ducrozet Senior Economist Eurozone +33 1 41 89 98 95 Americas (New York) David Keeble ** Head of Global Markets Research for the Americas and Global Head of Interest Rates Strategy +1 212 261 3274 Michael P. Carey ** Chief Economist North America +1 212 261 7134

Kazuhiko Ogata

Chief Economist Japan +81 3 4580 5360 Yoshiro Sato Economist Japan +81 3 4580 5337 Frances Cheung Head of Asian Rates Strategy +852 2826 1520

Interest Rates (Head: David Keeble)

Luca Jellinek Head of European Interest Rates Strategy +44 20 7214 6244 Peter Chatwell Senior Interest Rates Strategist +44 20 7214 5289 Orlando Green Senior Interest Rates Strategist +44 20 7214 7467 Jean-Franois Perrin Inflation Strategist +33 1 41 89 94 22 Sbastien Barb Head of EM Research and Strategy +33 1 41 89 15 97 Jakub Borowski Chief Economist - Crdit Agricole Bank Polska SA + 48 22 573 18 40 Alexander Pecherytsyn Chief Economist Crdit Agricole Bank Ukraine + 38 44 493-9014 Guillaume Tresca Senior Emerging Market Strategist +33 1 41 89 18 47 Adam Myers European Head of FX Strategy +44 20 7214 7468 Manuel Oliveri FX Strategist +44 20 7214 7469

David Keeble ** Global Head of Interest Rates Strategy +1 212 261 3274 Jonathan Rick ** IRD Strategist +1 212 261 4096

Emerging Markets (Head: Sbastien Barb)

Frances Cheung Head of Asian Rates Strategy +852 2826 1520 Dariusz Kowalczyk Senior Economist/Strategist Asia ex-Japan +852 2826 1519

Mark McCormick ** FX Strategist +1 212 261 4108

Foreign Exchange (Head: Mitul Kotecha)

Mitul Kotecha Global Head of FX Strategy +852 2826 9821

Mark McCormick ** FX Strategist +1 212 261 4108

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

Certification
The views expressed in this report accurately reflect the personal views of the undersigned analyst(s). In addition, the undersigned analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. David Keeble Luca Jellinek Peter Chatwell Orlando Green Jonathan Rick Frances Cheung Jean-Franois Perrin Important: Please note that in the United States, this fixed income research report is considered to be fixed income commentary and not fixed income research. Notwithstanding this, the Crdit Agricole CIB Research Disclaimer that can be found at the end of this report applies to this report in the United States as if references to research report were to fixed income commentary. Products and services are provided in the United States through Crdit Agricole Securities (USA), Inc.
This commentary has been produced by Credit Agricole Securities (USA) Inc.s (CAS -USA) Fixed Income FX Department and is not a fixed income research report prepared by a research analyst. These views may differ from those of the Research Department. The material contained in this commentary is intended solely for accredited, expert institutional investors and is provided for informational purpose only. This commentary is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Any comments regarding the future direction of financial markets is illustrative and is not intended to predict actual results. It should not be construed as advice designed to meet the particular investment needs of any investor, nor as an offer or solicitation to buy or sell the securities or other products mentioned herein. Changes to assumptions may have a material impact on any returns detailed. Price and availability are subject to change without notice. No representation is made that any transaction can be effected at the values provided. The values provided are not necessarily the values carried on CAS-USAs books.

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Disclaimer
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