Macro Strategy: Charts of the Week

GLOBAL FIXED INCOME STRATEGY

NOMURA INTERNATIONAL PLC
The Macro Strategy Team Lefteris.Farmakis@nomura.com FIDMacroStrategy@nomura.com

Week Summary

11 July 15 July 2011

Monday Gold, gold get the real story, without taking the shine off
Our recent research on gold generally supports market intuition that gold prices are negatively correlated with the US dollar and real rates. In recent years Asian demand for gold has emerged as a key driver of golds price. With our economists not expecting the Fed to hike interest rates until 2013, it seems reasonable to expect gold to continue to rise in the near future. However, the low likelihood of further Fed easing suggests that a move higher is likely to be measured.

Tuesday Where is the hedge?

We consider the best way to hedge against the euro area debt crisis becoming globally systemic is by considering options positions across a broad range of global assets. It appears that the best hedges are interest rates across G4, EM assets, some clear risk sentiment hedges such as USD/JPY and direct plays on European economic growth.

Wednesday Italys long-term fiscal challenges

Despite Italys stronger fiscal starting point relative to other periphery countries, its longer-term fiscal sustainability is primarily challenged by weak growth. In the short term, we think only a bold policy response from EU and Italian policymakers will restore confidence in sovereign debt markets before increased funding costs spill over to banks provision of credit and, ultimately, growth.

Thursday C10: how to short USD when EUR is also in trouble

Just because Europe is in trouble does not mean investors should be long USD. It may make sense to be long the China bloc, short USD, and flat EUR. Nomuras C10 index provides this and recent performance has been encouraging.

Friday A hedge for disaster: OTM Schatz calls

We consider a possible European market-based trade to hedge against the unthinkable euro area break-up. In such a scenario the bid for Schatz, as a proxy DEM-based asset, could be substantial. The increased bid for safe assets, a collateral squeeze and expectations of DEM appreciation post a break-up could all provide a strong bid for Schatz, leading to it trading as a price-based asset rather than a yield-based one. In such a scenario owning OTM calls on the Schatz appears to be a good hedge.

Chart of the week

Tuesday: Where is the hedge?

Implied sigma Greek Crisis: April - end of May 2010 Lehman: Sept - Dec 2008

Annualised average return during previous risk events standardised by current implied volatility

14 12 10
8

6 4
2

0
ED6 future L 6 future ER6 future Gold EURCHF 10y GBP rate 5y USD rate BOVESPA ZAR 5y rate USDJPY 5y EUR rate AUDNZD 10y JPY rate USDTRY PLN 5y rate 10y AUD rate ILS 5y rate EuroStoxx 50 LMEX USDKRW AUDUSD DJUBS Copper USDCAD EURPLN AUDJPY Oil USDINR FTSE HSCEI USDBRL EURGBP S&P 500 EQTY VOL EURUSD HANG SENG DAX YE2 future EURSEK EURNOK EuroStoxx Financials NIKKEI
Sources: Nomura, Bloomberg

Please see important analyst certifications and important disclosures on page 7 of this report.

Macro Strategy Charts of the Week

Monday 11 July 2011 Gold, gold get the real story, without taking the shine off
Saeed Amen +44 (0) 20 710 37119 Geoffrey Kendrick +44 (0) 20 710 36589 Figure 1. Figure 2. saeed.amen@nomura.com geoffrey.kendrick@nomura.com

$ 1800 1600 1400 1200

rate Real rates are important for understanding the direction of gold 0

Index 160 150 140

Gold has appreciated most during Asian hours over the past few years

0.5 1

Asia LDN AM LDN PM NY PM

130 1.5 120 110 100 90

1000 2 800 2.5 600 400 Gold price 200 0 2006

Source: Nomura, Bloomberg

3 80 3.5 4 2008 2010 70 60 2007 2008 2009 2010

US 10y real rate (rhs inverted)

Our recently published Gold, Gold - What drives gold? (7 July 2011) generally supports market intuition on the behavior of gold. We find that on a day-to-day basis gold is most highly correlated with EUR/USD and AUD/USD. On a quarterly basis, it has a strong relationship with most G10 USD crosses, as gold strength is generally accompanied by USD weakness. Gold is also negatively correlated with real rates. Indeed, real rates are one of the most important drivers for gold, as the opportunity cost of investing in gold diminishes in a low-rates environment (Figure 1). Perhaps unexpectedly, we find that in the immediate aftermath of many recent market crises gold has behaved more like a risky asset than a safe-haven asset (with the exception of the period immediately following the Lehman Brothers bankruptcy). Indeed, gold has a statistically significant positive relationship with GRAM+, Nomuras proprietary risk indicator. We also find that in recent years, gold has appreciated most during Asian trading hours (Figure 2). This is consistent with gold demand data showing that the majority of demand comes from Asia. This suggests that Asian sentiment towards gold is likely to be increasingly important going forward. As a result, Asian inflation should impact gold more. This is because higher levels of Asian inflation, for example through higher food prices (see The coming surge in food prices), should spur Asian investors to buy gold as an inflation hedge. We have used the above observations to construct several active trading rules for gold. We have also created a portfolio of active gold trading strategies. We look at real rates, momentum, risk sentiment and the FX market to generate gold trading signals. Our portfolio has an information ratio of 0.57 and annualised returns of 6.5% since 1997, while the drawdowns from our active strategy are nearly half those of a static long-only gold position. With our economists not expecting the Fed to hike interest rates until 2013, it seems reasonable to expect gold to continue to rise in the near future. The low likelihood of further easing by the Fed (QE Thoughts: 2s Company, 3s a Crowd, 13 June 2011), however, suggests that a move higher is likely to be measured.

Nomura

Macro Strategy Charts of the Week

Tuesday Where is the hedge?

Owen Job +44 (0) 207 103 4849 Olgay Buyukkayali +44 (0) 20 710 23242 Geoffrey Kendrick +44 (0) 20 710 36589 Figure 1.

12 July 2011
owen.job@nomura.com olgay.buyukkayali@nomura.com geoffrey.kendrick@nomura.com

Implied sigma Greek Crisis: April - end of May 2010 Lehman: Sept - Dec 2008

Annualised average return during previous risk events standardised by current implied volatility

14 12 10
8

6 4
2

0
ED6 future L 6 future ER6 future Gold EURCHF 10y GBP rate 5y USD rate BOVESPA ZAR 5y rate USDJPY 5y EUR rate AUDNZD 10y JPY rate USDTRY PLN 5y rate 10y AUD rate ILS 5y rate EuroStoxx 50 LMEX USDKRW AUDUSD DJUBS Copper USDCAD EURPLN AUDJPY Oil USDINR FTSE HSCEI USDBRL EURGBP S&P 500 EQTY VOL EURUSD HANG SENG DAX YE2 future EURSEK EURNOK EuroStoxx Financials NIKKEI
Source: Nomura, Bloomberg

The widening of Italian spreads (Macro Insight - Italy entering the fray) to Bunds is a real systematic risk not just to the euro area but to broader markets. The limitation of substantial spread widening to the weaker periphery so far in 2011 has made it appear that broader market returns were less affected by the eurozone debt crisis. The sharp widening of Italian spreads in the past week reminds us that the euro area debt crisis has the potential to have far-reaching repercussions. The widening of Portuguese, Greek and Irish spreads alone did not represent a systematic risk because their relative size in euro area GDP and debt markets was relatively small. This meant that a bailout is at least economically possible if the politics remain challenging. However, Italy and Spain are different. Their bailouts would be economically difficult or nearing impossible in the case of Italy. And the size of Spain and Italys debt markets are larger than those of the weaker periphery Greece, Ireland and Portugal. In addition to this there is a large, but difficult to precisely quantify, structured product market in Italy. A debt crisis and potential banking crisis in Italy poses a far larger risk to broader market risk sentiment than any previous leg of the European debt crisis. The involvement of structured products and the opaque interconnected counterpart risk that they present provides a concerning reminder of the Lehman failure in 2008. Any crisis affecting Italy is likely to have a large and possibly outsized impact relative to the government debt market on investors globally. With these risks in mind we consider where the best hedges may be to the euro area debt crisis becoming globally systemic. We do this by considering option positions across a broad range of global assets. For an approximation of potential market moves we consider two risk events: May 2010 when the eurozone debt crisis first threatened to become systemic and the collapse of Lehman. The exact response of assets is unlikely to be a mirror image of a previous crisis as the interconnections of different markets and the different starting points before each crisis will always have idiosyncratic impact, but such analysis provides a good starting point for considering hedges. To put these asset moves into the current context we normalise them by the current implied volatility of ATM options on the asset. This provides a metric of value for buying ATM options on these assets as a hedge of such risk events. The conclusions are informative. First, May 2010 and Lehmans collapse were clearly two very different events. May 2010 remained relatively contained and major movers were interest rates, European assets, a few key risk metrics such as Gold and USDJPY and a couple of EM assets Bovespa and ZAR 5y rates. However, the collapse of Lehman was more systemic, with the largest moves coming across a far broader range of global growth-related assets commodities including copper and oil, and a broader range of stock markets including the FTSE and S&P 500. The involvement of Italy and its large structured product market increases the systemic risks of the euro area debt crisis and hence increases the risk that the market reaction to the crisis morphs from a May 2010-style event into a Lehman-type risk. The market reaction is unlikely to be as severe because of the improved starting position of banks balance sheets globally and the reduced leverage across the investor spectrum; however, in our view, the universe of assets most involved could increasingly reflect the aftermath of Lehmans collapse if the situation is not dealt with quickly.

Nomura

Macro Strategy Charts of the Week

Because of the uncertainty, the best hedges are probably those that were significantly involved in both the May 2010 and post Lehman crises, as they cover a large range of outcomes: Interest rates across G4 in longer tenors - 10y GBP rates, 5y USD rates, 5y EUR rates and 10y JPY rates. Some clearer risk sentiment hedges USDJPY. EM assets, as leveraged plays on global growth and risk sentiment Bovespa, RUB, PLN 5y vs EUR.

(Our analysis of Lehman history suggests that ZAR 5y rates and TRY would be much better candidates. However we have doubts that in a sharp global slowdown and / or as global growth proxy they would work as well for the simple reason that the current dynamic and positioning is very different. South Africa is going through a softer recovery with the central bank not behind the curve and also TRY would trade better should oil prices plunge. Hence, given the current dynamics we would argue RUB and PLN 5y are better candidates.) Direct plays on European economic growth eurostoxx, USD/PLN, USD/CZK.

(PLN, even though Polands domestic economy is strong it suffers from having the most liquid currency and the PLN would probably be used as a proxy trade. Even though our analysis of history did not yield PLN or CZK, we are including them in a discretionary way.) But this analysis suggests that deep outside hedges of the market reaction becoming systemic and a threat to global growth are probably best placed in purer risk sentiment and global growth-related trades: USDKRW, Copper, USDCAD, AUDJPY, USDBRL.

This is a first blush assessment of potential hedges and does not delve into the detail of each position. It makes the assumption that any ensuing risk event will reflect previous ones and although we have added a degree of discretionary overlay there is still room for further idiosyncratic analysis of each hedge. Note, although eurodollar, short sterling and euribor all appear good hedges, there is a limit to the degree to which these rates can rally with the implied rate already below 1% in some cases.

Nomura

Macro Strategy Charts of the Week

Wednesday Italys long-term fiscal challenges

Lavinia Santovetti +44 (0) 20 710 26364 Peter Westaway +44 (0) 20 710 23991 Domenico Santoro +44 (0) 20 710 22375 Figure 1. Figure 2.

13 July 2011
lavinia.santovetti@nomura.com peter.westaway@nomura.com domenico.santoro@nomura.com

pp

3.5 3.0

primary surplus necessary to stabilize debt/GDP around 120%

1 0.9 0.8

Correlation of Italian Banks CDS to 10y gvt spread to Bunds 10y Italian gvt spread to Bunds (rhs)

bp 400 350 300

2.5 2.0 1.5 1.0 0.5

0.7 0.6 0.5 0.4 0.3 100 0.2 0.1 50 0 Jul-08 Jul-09 Jul-10 Jul-11 250 200 150

0.0 Interest rates at 6% Interest rates at 4.5%

0 Jul-07

Source: Nomura, Bloomberg Note: Figure 2 looks at 60-day rolling correlation of daily changes in 10yr Italian government bond spread to Bunds and the average CDS spread of Italian banks included in the ITRAXX Senior Financial index.

Italy has been hit hard by financial markets since last week, amid speculation that Finance Minister Giulio Tremonti may resign ongoing political instability and a recent run of poor macro economic growth indicators. Arguably, European ministers aims towards resolving the sovereign debt crisis and further austerity measures soon-to-be approved by the Italian parliament are expected to provide some relief in the short term. However, despite Italys stronger fiscal starting point the recent sharp rise in the cost of borrowing inevitably raises the issue of longer-term solvency. Fundamentally, our economists continue to believe that Italy faces a solvency issue that is of a different magnitude to the other periphery countries (see Italy: Guilty as charged or innocent bystander?). Having said that, if current elevated spreads were to persist, a stronger fiscal consolidation effort would be needed. Our debt-dynamics analysis suggests that with interest rates on the outstanding level of debt at 6% and nominal growth of around 3-3.5% (real growth of around 1% long-term average real GDP growth is at 1.2% - plus inflation at or slightly above the ECBs 2% target), a primary surplus of around 3-3.5% of GDP would be necessary to stabilise debt to around its current level of 120% of GDP (Figure 1). At more normal levels of funding rates of, say, 4.5%, Italy would need to run a surplus of 1.5-2% of GDP, some 1.5pp less. One striking feature of this analysis is the persistently low level of potential real growth that is assumed for Italy. Unlike other periphery countries, Italys main fiscal sustainability problem relates to poor growth. Consequently, political determination to implement long-term reforms aimed at tackling Italys structural weaknesses (such as poor competitiveness, heavy regulation of the services and energy sectors and poor infrastructure) is of paramount importance. Another worrying aspect of Italys growth prospects is the possibility of a downward spiral between the sovereign and the banks. Italian banks look adequately retail funded in the context of the European banking sector (when including all retail deposits they have a loans-to-deposits ratio of 117%). However, the low level of short-term rates, coupled with the still high level of net provisions, has over the last three years created a precarious mix for their profitability. Funding markets have always considered this as the weak link in the Italian banking system, resulting in increasing spreads on banks recent debt issues. The recent widening of sovereign spreads feeds through the banks own cost of borrowing, further exaggerating the problem. Figure 2 shows that as 10yr Italian spreads to Bunds rose nearly 100bp over the past week, their 60-day correlation with bank CDS spiked from 0.5 to 0.8 currently. Continued widening of sovereign spreads and a potential rating downgrade for Italy would increase the cost of funding for banks, depressing profitability further. If funding conditions remain unfavourable or deteriorate further, there is a risk of banks downsizing their lending books. The end result is a downward spiral that will ultimately weigh on growth through tighter credit conditions for households and corporates. In conclusion, despite Italys stronger fiscal starting point relative to other periphery countries, its longer-term fiscal sustainability is primarily challenged by weak growth. Political determination is required to resolve the continued lack of competitiveness and competition in many sectors of the economy. In the short term we think only a bold policy response from EU and Italian policymakers would restore confidence in sovereign debt markets before increased funding costs spill over to banks provision of credit and, ultimately, growth.
Nomura 5

Macro Strategy Charts of the Week

Thursday 14 July 2011 C10: how to short USD when EUR is also in trouble
Swati Aggarwal +44 (0) 20 710 20583 Anthony Morris +44 (0) 20 710 29215 Figure 1. Figure 2. swati.aggarwal@nomura.com anthony.morris@nomura.com

250 200 150

100

32% 24% 16%

8%

Cumulative exces returns (volatility-adjusted)

Cumulative excess returns (vol-adjusted)

300

40%

140 130 120 110 100 90 80 Oct-09

Gold
Short DXY futures

50 0 2001 2003 2005 2007 2009 2011 Short DXY down / C10 down Short DXY down / C10 up C10 outperformance (rhs) C10 Index (lhs) Short DXY futures (lhs)

0% -8%

Apr-10

Oct-10
C10 Index

Apr-11

EUR/USD returns

Source: Bloomberg, Nomura Research (June 2011). Short DXY futures refers to the return on a strategy of shorting the first DXY future contract and rolling the position at expiry. EUR/USD returns refers to the returns of holding a long-only position in EUR using the first futures contract and have been taken directly from the Nomura FX return indexes.

Nomuras C10 index recently celebrated its first birthday. It has performed relatively well thus far in its live period, returning over 10% above cash, with a volatility around 5% (see Quantitative Strategies - Efficient Frontiers for a discussion of our other indexes). It has provided a reasonable proxy for Chinese growth, currently running at approximately 9%. In contrast, Chinese equities have languished and CNY carry remains repressed. But beyond its role as a China proxy, C10 can add value in another wayas a tool to short USD without getting long EUR, as we have highlighted in our latest publication - Why C10 is better than short DXY. It is traditional to believe that short USD is essentially the same as long EUR or short DXY (about 60% of which is EUR exposure). But this belief, like the DXY itself, dates from the Bretton Woods era in which Europe and Japan were the only relevant countries outside the US in economic terms. While it is fashionable to discuss the rise of Asia and EM economies in general, few grasp the implications for FX positioningin our view, DXY is no longer enough and a tool like C10 is now essential. This is especially true as the Eurozone lurches from one crisis to another, no longer offering an obviously better alternative to USD. Figure 1 shows how this dynamic has evolved over the last 10 years. Both C10 and short DXY positions (here modelled as rolled futures) added value over time as USD deteriorated. First, C10 outperformed over the sample as a whole. Second, in every quarter in which short DXY was up, C10 was also up, even if sometimes by less. Third, in more than half the quarters in which short DXY was down, C10 was still up (see areas shaded grey). In other words, C10 participated in USD weakness in the same way as short DXY, but it also performed when USD was strong, EUR was weak, and short DXY fell. Figure 2 looks at this dynamic in more recent times. First, EURUSD returns appear to have driven DXY returns. Second, DXY and EUR have stayed within a broad range against USD since 2009, despite the evident problems in the US economy. Third, C10 (together with gold) has steadily pulled away from both USD and EUR. In a nutshell, C10 is the basket of currencies Chinas real economy is buying. Gold is what the Chinese private sector is buying in a scale on par with Indias. We believe the time has come to look beyond both USD and EUR.

Nomura

Macro Strategy Charts of the Week

Friday A hedge for disaster: OTM Schatz calls

Owen Job +44 (0) 207 103 4849 Sean Maloney +44 (0) 20 710 35954 Figure 1. Figure 2.

15 July 2011
owen.job@nomura.com sean.maloney@nomura.com

Px 110.5 110 109.5 109 DU1 Strike Expiry

Adjustment in manufacturing ULC relative to Germany 1.8 1.7 1.6 1.5 1.4 Aust Spai Fran Ital Neth Esto Finl Gree Luxe Avg

108.5

1.3

108 107.5 107

1.2 1.1 1 0.9

106.5 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11

0.8 Mar-99 Mar-02 Mar-05 Mar-08

Source: Nomura, Bloomberg

With the recent sharp widening of Italian bond spreads consideration of the unthinkable a euro area break-up have become increasingly common. In previous publications (Macro Daily - Where is the hedge?) we have considered the cheapest hedges for the euro area debt crisis becoming a global systemic event. Here we consider a possible European market-based trade to hedge against the market pricing in the possibility of the euro area debt crisis escalating and an eventual euro area break-up. Even if there are only low expectations of this occurring the likelihood that the market has to move much closer to this before policymakers finally provide a solution is much higher. In a European disaster situation we think three things (amongst many others) would happen: 1. 2. There would be a broad-based rise in risk aversion and bid for safe assets. There would be a search for an ever-shrinking pool of safe collateral, e.g. BTPs may no longer be acceptable collateral (this has already started to occur). This would provide a bid to all assets that remain safe and acceptable collateral, i.e. Bunds, as ineligible collateral is replaced with collateral from the remaining smaller pool of acceptable collateral. Intra-euro area Investors would likely flock to the strongest perceived European assets, i.e. proxy-Deutsch Mark (DEM) assets. If the probability of a euro break-up were to become non-negligible, DEM assets would probably appreciate in common currency terms because of expectations of a strong appreciation of a new free floating DEM post a break-up.

3.

In our view, all of these three effects would provide a strong bid to Schatz. And the potential for repo squeezes because of the increase in volumes for German benchmarks this implies would also be significant. To get a guide to the potential impact of the third factor we consider how much a free floating DEM could be expected to appreciate vs the rest of Europe. As a rough guide we consider the evolution of manufacturing (so exportable) unit labour costs (ULC) throughout the euro area since the formation of the monetary union. Manufacturing ULC in the GDP-weighted rest of Europe have risen 20% more than in Germany since monetary union (Figure 1). If there is a break-up, DEM-proxy assets such as the Schatz could begin to trade on a price basis not a yield basis, i.e. investors expecting a significant appreciation of a free-floating DEM vs its European counterparts would be prepared to own a DEM-proxy asset at a significant premium. This relative premium investors would be prepared to pay could in a most favourable scenario could be as high as the currency appreciation they were expecting. In simple terms if the Schatz began trading as a DEM pricebased asset instead of a yield-based one and the DEM were expected to richen 20% relative to its European counterparts (to neutralise the ULC dispersion of the past 12 years) Schatz could appreciate up to 20%, in relative price terms, to other European assets, in our view. This is an extreme example. Among other issues such as capital flight from the euro area altogether, it is a relative comparison and a sizeable share of this relative appreciation could be absorbed in non-DEM asset depreciation rather than DEM asset appreciating. There is also the question of convertibility; would the notional of a Schatz bond be converted

Nomura

Macro Strategy Charts of the Week

to DEM one-to-one with its EUR value? Possibly not, but in the instance of market pricing this scenario the bid would certainly favour the strongest perceived asset, i.e. DEM assets. All these caveats aside, the thought experiment puts into context the potential high convexity price appreciation (an appreciation measured in points not ticks) that may occur if any sizeable probability of a euro area disaster scenario were priced. It seems increasingly likely, even if the final outcome is not a euro break-up, the path to resolution will include a period of the markets pricing an increased probability of a euro break-up. When all three of these strong factors are considered owning OTM calls on the Schatz appears a good hedge against such a scenario. We recommend buying the Schatz September expiry 109.50 calls at 7.5 ticks. The strike, the furthest out with liquidity, is still within the range of the past year (Figure 2) and if this scenario materialises the Schatz is likely to trade several points through this level. The December calls are not liquidly traded for another month or so, but once they do we would consider rolling into December OTM calls to prolong the period of the hedge.

Nomura

Macro Strategy Charts of the Week

ANALYST CERTIFICATION
We Owen Job, Geoffrey Kendrick, Saeed Amen, Lavinia Santovetti, Peter Westaway, Domenico Santoro, Olgay Buyukkayali Swati Aggarwal, Anthony Morris and Sean Maloney hereby certify (1) that the views expressed in this report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

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July 15, 2011

Macro Strategy Charts of the Week

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July 15, 2011