Outlook: Something Has Got To Give

December 2010
Rates Strategy
Annual report
www.sgresearch.com
Outlook 2011
Something has got to give
© iStock Photo
Austerity, Inflation or Default - which will it be? The UK is going the austerity road -
painful, but best for long-term stability. The US is embarking on fresh stimulus,
raising the risk of inflation in the long run. Europe has yet to make up its mind. But a
clear reprivatisation of risk is under way. That is good for the safest bonds,
especially now that better economic news has been priced in.
Macro Commodities Forex Rates Equity Credit Derivatives
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Global Rates Strategy – Outlook 2011
Contents
Contents ............................................................................................................................................................... 2
2011 Views & Trades ............................................................................................................................................ 3
Editorial: Something has got to give .................................................................................................................... 5
Summary of SG’s Macro and Financial Forecasts ............................................................................................... 9
Global Inflation-Linked Markets ......................................................................................................................... 12
Disinflation threat shifts from US to Euro area ...................................................................................................12
Euro linker supply at record high will not rattle the markets .............................................................................14
Global Volatility ................................................................................................................................................... 16
EUR gamma : a déjà vu ? .....................................................................................................................................16
Impact of QE2 on USD volatility likely negligible ................................................................................................18
EUR vega – friendly flows ....................................................................................................................................19
Sovereign credit ................................................................................................................................................. 20
Time for governments to choose – Austerity, Inflation, Default?.......................................................................20
Can the eurozone hang together? .......................................................................................................................22
Is European default legislation to be feared? .....................................................................................................24
Sovereign risk: a quantitative ranking .................................................................................................................26
USD Markets ...................................................................................................................................................... 32
QE2 expectations remain front and centre in 2011 ............................................................................................32
Elasticity of demand for Treasuries is rapidly declining.....................................................................................33
Carry is King..........................................................................................................................................................35
GSEs: No reforms soon ........................................................................................................................................37
EUR Markets....................................................................................................................................................... 38
Bank stress means ECB can’t pull the plug ........................................................................................................38
EUR curve – trapped in one dimension ...............................................................................................................40
What outlook for eurozone issuance? .................................................................................................................42
Core covered bonds offer value ..........................................................................................................................45
GBP Markets ...................................................................................................................................................... 49
A time for giving? Be selfish – it’s better to receive ...........................................................................................49
CEEMA Markets ................................................................................................................................................. 51
Search for yield to continue to support EM bonds in H1 2011 ..........................................................................51
Asia-Pac Rates Markets ..................................................................................................................................... 53
Japan: odds of exiting deflation greater than that of sovereign crisis ..............................................................53
Antipodes: (AU)ver N(Z)ormalisation? .................................................................................................................56
EM Asia: further policy normalisation with capital control risks ........................................................................59
Technical Analysis .............................................................................................................................................. 62
2 December 2010
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2011 Views & Trades
1. Bullish into Spring

The reprivatisation of risk has started: good for the safest bonds. Good economic news is already priced in: we see room for
bond yields to pull back into spring, before QE2 expires and the economy picks up again later in the year. Supply-demand
dynamics will also help in H1.
2. Elasticity of demand for Treasuries is rapidly declining

Treasury securities are now concentrated in the hands of investors that are less price sensitive. As a result, large price
fluctuations are possible. Once 10-year Treasury yields have entered the 2%-2.3% trading range, start establishing 50-100bp
OTM high-strike protections.
3. Roll-down trade in USD, with protection

Roll-down on the LIBOR-OIS March 2011 IMM forward spread is about 10bp/month in USD. We view this as one of the best roll-
down opportunities in the USD market. A eurozone-led banking crisis would hurt, however. So it may be wise to invest some of
the carry into Eurodollar puts.
4. Global inflation: Disinflation pressures are shifting

Deflation risk is subsiding in the US but underappreciated in the euro area. We would be short 2y euro linkers on either a real
yield or breakeven basis, or on cross-market trades versus TIPS.
5. EUR inflation: Receive those high forward real yields

Extending from rich 2y euro linkers into cheap 10y issues receives a high forward real yield – one which is particularly high
relative to historical real ECB policy rates and offers generous roll down.
6. EUR sovereign: Defensive on non-core, flatter curve

Can the eurozone crisis be stopped? Austerity looks like the best medicine, but the patient does not want it.
So we remain defensive on non-core sovereigns. Non-core bond curves will flatten early 2011. We see the PGB curve as
abnormally flat.
7. SG sovereign scoring: DSL-Bund spreads will widen

We update our scoring model: the 10-year DSL-Bund spread is too tight relative to other spreads.
GGB-IRISH spreads look abnormally wide, in contrast.
8. Bank stress means ECB can’t pull the plug

Banks remain dependent on ECB liquidity, which will remain ample in H1. Q2 ECB meetings will be repriced lower still.
Receive February meeting at 0.85%. Or receive Feb vs Jan and Nov at flat.
9. Cheap widening basis trades still available in EUR

We need to see decisive action from policy makers, which does not penalise the banks, before we can enter basis tightening trades.
For now we remain biased towards wider EUR Bor/Bor bases.
Flattening basis trades offer good risk-reward. Buy EUR 1Y 1Mv6M basis vs 5Y 1Mv6M basis at +5bp.
December 2010 3
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10. EUR curve will flatten in a rally

We are biased towards larger EUR Bor/Bor bases for now.
Flattening basis trades offer good risk-reward. Buy EUR 1Y 1Mv6M basis vs 5Y 1Mv6M basis at +5bp.
11. EUR swaptions: profit from high volatility to position for lower rates in
early 2011
Sell the recent spike in implied short expiry vols via non-delta-hedged directional strategies. We recommend 1x2 receiver
spreads in short and intermediate rates and condors in 10y rates:
1/ buy EUR 3m10y 2.90/2.70/2.50/2.20% receiver condor, indicative price 3bp running (indicative fwd. 3.23%);
2/ buy EUR 3m5y 2.25%/1.88% 1x2 receiver spread, indicative price 6bp running (indicative fwd 2.50%);
3/ buy EUR 6m2y 1.78%/1.54% 1x2 receiver spread, close to zero cost (indicative), indicative fwd 1.79%.
12. Stay long core covered bonds with pick-up

We see UK and Dutch covered as attractive. We like UK covered bonds in particular, as they have only partially followed the
improvements in sovereign risk. Dutch covered bonds have an attractive pick-up vs Obligations Foncières, while the Dutch CDS
trades through the French.
Stay short peripheral covered bonds as they trade too closely vs sovereign bonds.
13. UK: A time for giving? We’d rather receive

We are bullish, but with several counter concerns there is a need for judicious selection of the optimal bull trade. Extending from
10-year into 20-year gilts “receives” a 10y10y gilt yield of 5.55% and remains our favourite.
Conversely, a 2y3y GBP rate that is only 17bp above the equivalent EUR rate looks too low. “Lower-for-longer” is a global
mantra, but we see rates needing to stay a lot lower for a lot longer in the euro area than in the UK. Consider 2y3y GBP-EUR
wideners.
14. CEEMEA: Flatter curves and prefer dollar-based to euro-based EM debt

We expect flattening to prevail into H1 2011 for most EM countries except for those where easing bias remains. Taking into
account mispricing in the short-end compared with our rates forecast, we still see value in flatteners in Poland and Turkey via
PLN 2y5y IRS flattener (target +25bp) and Turkey CCS 2y5y flattener (target +40bp).
Inter market, eurozone sovereign risks are likely to affect EM countries which are more closely connected to the eurozone - such
as CE3 and Romania - than those which are more correlated to the US markets - such as Russia, Turkey and South Africa.
Buy South African local bond R186 (SAGB10.5 12/26) with a target of 7.8%.
15. JPY: Briefly bullish and then out of deflation

Enter 2011 long duration on 20y JGBs circa 2.0% or 10y above 1.2% as low JGB supply and bullish USTs help in Q1 2011.
From Q2 2011 look for bear-flattening with a stronger economy and rising equities making IRS flatter (2y fwd 5y-25y at +120bp)
and the JGB curve less concave (10y-20y-30y above +65bp.)
16. Antipodes: RBA cycle close to over but RBNZ has much to do
RBA policy tightening cycle in Australia is close to over in 2011, implying flatter curves and some room for bonds to outperform.
We like long 10y ACGBs between 5.5-5.65% and 3y-10y IRS flatteners at +55bp. Falling supply means AUD EFPs will perform too.
In contrast, the RBNZ has much left to do, making us bearish NZD IRS and look for convergence to AUD on the 5y sector.
17. EM Asia: Fighting inflation

China’s PBOC is accelerating its inflation-fighting effort, making us think CNY 2y-5y repo-IRS curve flattening can continue.
Hong Kong remains tied to USD trends thus volatility in IRS box trades, such as 5y-10y, will provide range trading opportunities.
4 December 2010
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Editorial: Something has got to give
Austerity, Inflation or Default? The first is painful, but best for Graph 1. Planned and remaining adjustment needed until
long-term stability. 2020 in cyclically-adjusted primary balance terms (% of GDP)
Can the eurozone crisis be stopped? Although unpleasant,
austerity looks like the best medicine. Pain-relief treatments
are being shunned for now.
The reprivatisation of risk has started: good for the safest
bonds.
Good economic news is already priced in: we see room for
bonds yields to pull back into spring, before QE2 expires and
the economy picks up again later in the year.
Supply-demand dynamics will also help in H1.
 Austerity, Inflation or Default

Our long-term view has been that the multi-year outlook is
bleak for Europe and the US, given the unwinding of the
excesses of the period leading up to the subprime crisis. That
is against the backdrop of ever greater structural difficulties –
worsening demographics, heightened globalisation and
competition, combined with out-of-control public finances.
Gross Public Debt in the G7 has surged from 82% of GDP in
2007 to near 110% in 2010. We have, over the past 18
months, pressed for more fiscal prudence. The clock is now
ticking even faster.
‘The Fed needs a credible exit strategy – which it won’t need to use
for a long time. Deficits are exploding, and governments are most in
need of an exit strategy.’
SG 2009 H2 Outlook - ‘Exit Strategy’
‘Hopes are running high for a safe exit and a smooth recovery. That Source: IMF Fiscal Monitor, November 2010
gives good protection against higher yields, as the way out will be far
from easy.’
SG 2010 Outlook - ‘No easy way out’  Austerity painful, but best for long-term stability
‘Only responsible policies can spare us from further disasters.’ We discuss below potential circuit breakers for the eurozone
crisis. Austerity for us remains by far the preferred exit. It will
SG 2010 H2 Outlook - ‘The clock is ticking’
be painful, but best for long-term stability. The focus has been
Even the large countries can no longer ignore the message on eurozone developments, and will very much remain so in
from the markets. Austerity, Inflation or Default (AID) are the early 2011. But fiscal challenges go far beyond Europe. Graph
available options. The UK has an ambitious austerity plan (see 1 highlights the required adjustment over the next 10 years for
Graph 1). The US and Europe in contrast, remain hamstrung these countries to achieve similar debt targets by 2030 (60%
by vain and ever more desperate attempts to maintain living of GDP in the developed world) 1. Some tightening is already
standards. The public, egged on by politicians, have in the pipe, and, if delivered as promised, appears substantial
unrealistic expectations. They are told they are in “austerity”. in countries like the UK or Greece. But much remains to be
We disagree strongly. Next year, again, Ireland– excluding done in Ireland, the US and Japan.
bank support - will have a deficit to GDP of well above 10% Inflation may help a bit in the future in the US, but is hard to
GNP. And yet it is lauded for “austerity”, even by the ECB. instigate in the near term. In any event, it is naïve to believe
Without austerity, the US may be going down the reflation
road; while the eurozone is flirting with default. Both routes
involve a transfer of wealth from savers to the borrowers. 1
‘Fiscal Exit: From Strategy to Implementation’ – IMF, November
2010
December 2010 5
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that it can save us from our sins. As if central bankers had resolution regimes (bail-in) ‘may include statutory powers or
forgotten about inflation casualties. Default is not, moreover, a contractual arrangements to convert debt into equity or
desirable option for countries like Greece and Ireland that still impose haircuts on creditors as an institution approaches
need to fund large running deficits. “Our challenge is clear insolvency, so that losses are absorbed by the private sector’
and inescapable: America cannot be great if we go broke,” (IMF).
the National Commission on Fiscal Responsibility and
These changes will restore fiscal and investment
Reform 2 said in early December. US government spending
accountability. But they also alter the price of risk: as bail-outs
stands at 24% of GDP in 2010, its peak since WWII; taxes, at
become less likely, investors become more nervous. The
15%, are the lowest since 1950. That cannot continue. The
regulatory effects may well be compounded by cyclical
commission’s proposals would reduce the deficit from 9% of
forces. Deleveraging crises tend to lead to more economic
GDP in the current fiscal year to 2.3% by 2015.
volatility. Coincidentally, realised volatility of the Nikkei
The medium-term bond outlook very much depends on jumped higher during the two lost decades (particularly the
political responsibility. The hawkish fiscal proposals above first one). QE2 and the ongoing confidence in Chinese
are sure to be rejected in the US. But a degree of fiscal policymakers’ capacity to generate growth have generally
tightening is hopefully in the pipe. Our economists expect supported the appetite for risk over the past six months. But
that, for the first time since the start of the crisis, fiscal policy the developments above should make safe government
will be a drag to growth in G4. This would give central banks bonds (there are still some) relatively more attractive over the
even more time to exit – all good for bonds, at least until medium term.
economic growth reaches its potential. Ongoing fiscal
profligacy, instead, would raise the risk of future downgrades
 Which way out for EMU sovereigns?
(not in the pipe in 2011 for the big AAAs, but warnings likely
will intensify). The EMU crisis will remain a key focus in early 2011. We
discuss it in more detail in our European sovereign section.
We believe that the German-led efforts to shift from bail-outs
 The boomerang comes back: reprivatisation of risk
to bail-ins are a strong positive for long-term stability. But the
We are disappointed with the slow progress towards fiscal proposals are traumatic for investors. The default risk – after
responsibility. Yet critical reforms are underway. They will mid-2013 – is the primary fear factor. But investors are also
imply a reprivatisation of risk that finally should stop concerned that earlier disasters may be looming. As we
governments from piling up liabilities. The past three years explained in our EFSF special, the current support
have seen a massive transfer of risk from the private sector to mechanism (funding capacity of €475bn in total) may not be
the public sector and from small countries to large countries. large enough to meet the financing requirements of countries
Reforms in the making are expected to stop and even reverse larger than Ireland or Portugal. Table 1 below provides details
that move. about the inter-linkages within the eurozone. ‘The EU Stress
Test and Sovereign Debt Exposures’ also provides shocking
- We see the German plans to reprivatise risk, as pre- details about the exposure of banking books to sovereign
announced at the EU Summit in late October, as a positive debt (near €1.5trln).
development in the long run, as this will finally enforce fiscal
responsibility in the area. A country that seeks rescue, post Table 1. Consolidated foreign claims of EU banks vis-à-vis
mid-2013, will likely see private investors share the costs. selected EU countries ($bn)
There is also a clear affirmation that EU loans will enjoy
preferred creditor status 3 in the new permanent rescue
mechanism. This is in direct contrast with current EFSF
arrangements, where EU loans are said to be pari passu with
government debt.
- Basel III also implies that investors need to prepare for
assuming more risk on bank debt, including senior debt, in
the long run (if not the short one). The focus often is on the
new capital and liquidity standards, which are clearly Source: ECB’s EU Banking Sector Stability, Sep. 2010
described in ‘Shaping the new financial system.’ But the

reform also includes new resolution mechanisms, as G20
What can be done to restore confidence?
leaders agree that tax payers should no longer be asked to
rescue failing financial institutions. Instead, effective 1) ‘Shock and awe’ buying of non-core securities. We are not
big fans (see below). Where would the cash come from
anyway? The ECB will only venture into heavy quantitative
2
‘The Moment of Truth: Report of the National Commission on easing if it becomes an absolute prerequisite to save the
Fiscal Responsibility and Reform’ – December 2010 eurozone. By shifting, at the December meeting, the inflation
Also see Bloomberg { NSN LCT6CP07SXKW <GO>} risks from the upside to ‘balanced’, the ECB has made QE
3
“In all cases, in order to protect taxpayers' money, and to send a
less impossible (rather than more likely). But there are still
clear signal to private creditors that their claims are subordinated obstacles, namely moral hazard (does the ECB want to be
to those of the official sector, an ESM loan will enjoy preferred perceived as subsidising fiscal sinners?) and the massive risk
creditor status, junior only to the IMF loan.” that the ECB would be putting onto its balance sheet. Another
http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdat option is to get the EFSF to do some pre-funding and buy
a/en/ecofin/118050.pdf non-core debt. We hear that it is ruled out for now.
6 December 2010
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In any event, the problem with such a strategy is that official if it raises more moral hazard issues. Our particular concern is
purchases may just offer a window of opportunity for that not enough is being done on the fiscal consolidation side;
investors to get out. This will be even truer if the ECB we are shocked that Ireland is still allowed to run such
continues to run a stop-and-go strategy, rather than gigantic deficits over the next two years. That makes it
committing to substantial purchases over a relatively long infinitely harder to think of credible solutions that can stop the
period (Fed style). Investors may well never return, or at least crisis just now. We will stay defensive on non-core risks in
not before the countries have proved that their finances are early 2011.
returning to a sustainable path. What is needed instead is
spread tightening driven, or at least accompanied, by the
 The economy is not that strong
return of private investors. Otherwise we will see a repeat of
May 2010: purchases from the ESCB will simply lead to a Our fears regarding non-core sovereign spreads add to our
temporary richening of cash bonds, in absolute terms and confidence that Bunds and Treasuries will rally in the New
relative to CDS (Graph 2). Year. To be fair, that link broke spectacularly in November
2010 (Graph 3).
Graph 2. ESCB purchases lead to temporary distortion
Graph 3. Can SOVX and the Bund continue to part ways? We
doubt it.
Source: SG Cross Asset Research

2) Reassuring investors by beefing up the size of the rescue
package. To be fair, the umbrella will never be large enough to
protect investors from a systemic crisis. In its current format, The ex-post rationale is of little interest, unless it provides
it can technically cover Ireland, Portugal and Spain’s funding guidance for the future. Specifically, we believe that the
needs for the next three years, but no more. The umbrella corrective sell-off of late 2010 will again become a buying
does not cover the inevitably large needs for bank capital in opportunity into spring.
such a scenario. A new round of stress tests is being
- The concentration of QE2 purchases on the belly, rather
prepared for spring or summer 2011 (date unclear yet). The
than the long end, has been a key driver for the rise in long US
only way to make those beneficial for non-core sovereigns is
rates. That news, we reckon, has been digested, i.e.
to make sure that bad banks are being dealt with away from
aggressive longs have been cut.
the national sovereign balance sheets, e.g. through a TARP-
like European (common) fund. That would de facto increase - The heavy criticism of the Fed in Republican circles has also
the size of the collective rescue scheme. raised questions about the execution of QE2. Congressmen
would do better to address structural fiscal problems as soon
3) Finally, allowing investors to take haircuts on senior bank
as possible, rather than bash the Fed for trying to support the
debt in order to free governments from bad banks. That,
economy and protect it from the threat of deflation. It is urgent
however, was reportedly ferociously opposed by the ECB
for policy-mix stimulus to rely less on fiscal policy, and more
when the Irish rescue was negotiated. Of course a U-turn on
on monetary policy. The critics will fall silent as
this would have us buying protection on bank risk vs selling
unemployment stays sky high.
protection on sovereign risk.
- Data has been robust globally. US job creations have picked
We doubt stability can durably return unless some of these
up, though the unemployment rate has hardly pulled back.
actions are taken. Without them, an early sovereign
Data in Europe has been solid, particularly in Germany. If our
restructuring becomes a distinct possibility. This may raise
economists are right in predicting a progressive acceleration
legal issues; however, they appear manageable (see our
in H2, bonds will sell off then. For now, however, they still see
Sovereign section). These are extreme scenarios, but would
simply represent an acceleration of the German agenda: in a stuttering recovery 4, with risk still firmly skewed to the
essence, a reprivatisation of the risks. downside. We point out some cracks, particularly, in the
We very much recognise that throwing more public money 4

SG Global Economic Outlook: ‘Good, Bad or Ugly Rebalancing’ –
into the system (options 1 and 2) is not a panacea, especially 18 November 2010
December 2010 7
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strength of the manufacturing cycle. Chinese imports (used Graph 5. Foreign central banks love Treasuries too
for assembling) dropped sharply in October; production in
South Korea has been falling of late; car production in Japan
has started to pull back. The inventory cycle seems to be
maturing, and this should soon lead to softer manufacturing
trends (Graph 4).
Graph 4. Manufacturing boom about to subside (US)
- Banks likely will continue to crave safe government bonds.

New liquidity standards in particular will force banks to hold
more assets that could be liquidated rapidly (liquidity
coverage ratio to be introduced in 2015, but observation
starts in 2011). Both the economic cycle and regulation are
likely to give government bonds a more prominent place in
Our economists still see China, and more generally Asia, as bank portfolios.
continuing to provide welcome support to the world
Graph 6. US and Eurozone banks can still buy more
economy. Emerging Asian central banks, however, are behind
government bonds (holdings, as a % of total assets)
the curve and need to tackle inflation more seriously. We
expect a good deal of catch-up in 2011, which could cause
further flattening in the 2-5y CNY curve (see our Asia-Pac
section). We address the broader implication of PBOC
tightening on Asian markets here 5. This, along with the
aforementioned factors supporting an upward repricing of
risks, could also undermine the appetite for risk 6 seen in H210
– to the benefit of G4 bonds into spring.
 Hard to believe, but there is unlikely to be enough

Treasury supply around.
With the US federal government still producing fat deficits,
there is no shortage of Treasury supply. We expect net
issuance of coupon and TIPS in H1 to be in the region of
$690bn (new cash). But the Fed has planned to buy back
some $660bn over the same period – unless it decides to
scale back QE2 (which we do not believe it will do). So
issuance net of redemption and Fed buying will be - Outflows from money markets continue, and bond funds still
microscopic (0.4% of GDP). Yet there are buyers lining up benefit (see for instance European flows analysis here 7).
behind the Fed.
So we find supply-demand supportive for now. That may
- Emerging market central banks, particularly in Asia, may change after the spring, and we fear that private investors will
accept a slightly larger degree of currency appreciation going then be far more price sensitive than the likes of the Fed and
forward (inflation fighting) but will continue to intervene, and Asian central banks. That is when the threat of a Treasury sell-
place their proceeds in western bonds. off likely will grow. Don’t go short too early.
vincent.chaigneau@sgcib.com
5
‘What should you do if the PBOC is behind the curve?’ Guy
Stear, SG Asia Cross Asset Research – 1 December 2010.
6
‘Ignore the slumping Chinese leading indicators at your peril’
7
Albert Edwards, SG Alternative Research SG FI Weekly – 26 November 2010, p14.
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Summary of SG’s Macro and Financial Forecasts
Real GDP Inflation

2008 2009 2010 Oct-2010 2011 Oct-2010 2008 2009 2010 Oct-2010 2011 Oct-2010
World (current $ weights) 1.1 -2.6 3.6 3.3 2.7 2.7 4.7 1.4 2.4 2.5 2.5 2.6
World (PPP weights) 2.6 -0.8 4.7 4.5 3.9 3.8 5.6 2.2 3.4 3.3 3.4 3.4
Developed countries (PPP) 0.0 -3.4 2.5 2.3 2.0 1.9 3.2 0.0 1.4 1.4 1.4 1.6
Emerging countries (PPP) 5.5 2.2 7.1 7.0 6.0 5.8 8.4 4.6 5.6 5.4 5.5 5.5
North America 0.0 -2.6 2.8 2.7 2.3 2.2 3.6 -0.2 1.6 1.7 1.5 2.1
USA 0.0 -2.6 2.7 2.6 2.3 2.1 3.8 -0.3 1.6 1.8 1.5 2.1
Canada 0.5 -2.5 3.1 3.1 2.5 2.5 1.2 1.3 1.5 1.5 1.8 1.9
Europe
EU 27 0.7 -4.2 1.6 1.6 1.5 1.6 3.6 0.9 1.9 1.9 1.8 1.6
Euro area 0.3 -4.0 1.6 1.6 1.2 1.2 3.3 0.3 1.5 1.4 1.4 1.2
Germany 0.7 -4.7 3.5 3.2 2.4 2.0 2.8 0.2 1.1 1.0 1.2 1.0
France 0.1 -2.5 1.6 1.5 1.3 1.1 3.2 0.1 1.7 1.6 1.1 1.0
Italy -1.3 -5.1 1.0 1.0 0.8 1.0 3.5 0.8 1.6 1.5 1.9 1.5
Netherlands 1.9 -3.9 1.6 1.9 1.1 1.3 2.2 1.0 0.9 0.8 1.3 1.1
Spain 0.9 -3.7 -0.2 -0.4 0.5 0.2 4.1 -0.2 1.6 1.5 1.1 0.8
Denmark* -0.9 -4.7 1.9 1.5 1.9 1.8 3.4 1.3 2.2 2.0 2.0 1.7
Norway* 0.6 -1.3 1.5 1.5 2.6 2.6 3.8 2.2 2.4 2.4 1.5 1.6
Sweden* -0.6 -5.1 4.3 4.0 2.9 2.7 3.5 -0.3 1.2 1.2 1.9 2.0
Switzerland* 1.9 -1.9 2.7 2.6 1.8 1.8 2.4 -0.5 0.7 0.8 0.8 0.9
UK -0.1 -5.0 1.7 1.6 2.1 2.1 3.6 2.2 3.3 3.3 3.1 2.6
Eastern Europe 4.5 -6.7 3.8 3.7 2.7 2.7 12.1 8.9 5.5 5.5 6.7 6.6
Russia 5.2 -7.9 5.5 5.5 2.5 2.5 14.1 11.8 6.5 6.5 8.5 8.5
Poland 5.0 1.8 2.5 2.5 3.5 3.5 4.2 3.5 2.5 2.5 3.0 3.0
Czech rep. 2.5 -4.0 2.1 1.9 1.7 1.3 6.3 1.0 1.5 1.5 2.1 2.4
Hungary 0.4 -6.2 1.9 1.8 3.8 3.8 6.0 4.2 4.7 4.8 3.1 3.1
Turkey 0.7 -4.7 7.3 6.7 4.5 4.3 10.4 6.3 8.6 8.5 6.5 6.3
Asia-Pacific -0.9 -3.9 3.9 2.9 2.5 2.5 1.9 -0.8 -0.3 -0.2 0.4 0.3
Japan -1.2 -5.2 3.6 2.8 2.0 2.2 1.4 -1.4 -0.9 -0.9 -0.3 -0.3
Australia 0.9 2.6 5.6 4.0 4.9 3.8 4.4 1.9 3.0 3.4 4.1 2.8
New Zealand -1.7 0.9 1.9 1.5 3.6 3.5 4.0 2.1 1.7 2.2 2.3 3.2
Asia ex Japan 6.5 6.2 8.9 8.8 7.8 7.6 6.7 2.4 4.9 4.5 4.8 4.7
China 9.6 9.1 10.0 10.0 9.0 9.0 5.9 -0.7 3.1 3.1 4.5 4.5
HK 2.1 -2.8 6.7 5.7 6.1 4.6 4.3 0.5 2.3 2.6 3.9 3.0
India 5.1 7.7 8.5 8.3 9.0 8.3 8.3 10.8 11.5 9.5 7.5 6.8
Indonesia* 2.1 4.6 6.0 6.0 6.1 6.1 10.1 4.6 5.1 5.1 6.1 6.1
S. Korea 2.3 0.2 6.1 6.1 3.6 3.6 4.7 2.8 2.9 2.8 2.8 3.3
Malaysia* 4.7 -1.7 7.1 7.1 5.0 4.9 5.4 0.6 1.7 1.9 2.5 2.6
Philippines* 3.7 1.1 6.7 6.3 4.9 4.7 9.3 3.2 4.0 4.2 4.0 4.3
Singapore* 1.9 -1.4 14.4 14.5 4.7 4.8 6.6 0.6 2.8 2.8 2.5 2.4
Taïwan 0.7 -1.9 10.0 8.1 5.3 4.2 3.5 -0.9 0.8 1.2 1.4 1.7
Thailand* 2.5 -2.3 7.5 7.5 4.3 4.3 5.5 -0.9 3.4 3.4 2.9 3.0
Latin America 4.1 -2.4 5.9 5.6 3.8 3.7 7.7 6.3 6.5 6.7 6.4 6.4
Brazil 5.1 -0.2 7.4 7.2 4.4 4.4 5.7 4.9 5.0 4.9 5.2 5.0
Mexico 1.5 -6.5 5.3 5.1 3.0 3.0 5.1 5.3 4.1 4.1 3.8 3.8
Chile 3.7 -1.5 5.4 5.4 5.0 5.0 8.7 0.4 1.4 1.3 2.6 3.1
Source: Datastream, SG Economic Research, Consensus Economics (*), EIU
December 2010 9
F27071
Monetary Policy - Key Rates

Grow th Inflation Fiscal Financial Currency Neutral
06 Dec Mar 11 Jun 11 Sep 11 Dec 11
policy stability rate
United States = - + = = 0.25 0.25 0.25 0.25 0.25 4.00

Canada + = = = - 1.00 1.25 1.50 2.00 2.25 3.50
Brazil + + + + = 10.75 11.75 12.25 12.25 12.25 11.00
Mexico - = = = = 4.50 4.50 4.50 4.50 5.00 7.00
Euro area = - - - = 1.00 1.00 1.00 1.00 1.00 3.75
UK - + -- - - 0.50 0.50 0.50 0.50 0.50 4.50
Japan + - = = - 0.10 0.10 0.10 0.10 0.10 1.75
Korea + + - = - 2.50 2.50 2.75 3.00 3.25 5.00
China = ++ = = - 5.56 6.06 6.06 6.31 6.50 7.25
India ++ ++ ++ = = 6.25 6.75 6.75 7.00 7.00 7.00
Taiw an + + - = ++ 1.50 1.75 1.88 2.00 2.00 2.50
Australia ++ ++ + = = 4.75 5.00 5.25 5.50 5.75 5.50
New Zealand + + ++ = - 3.00 3.25 3.50 3.75 4.00 6.00
Long Government Bond Yield (10Y)

Grow th Inflation Monetary Fiscal Capital Trend
exp. policy policy account fair value
United States = = - + + 2.94 2.00 2.30 2.75 3.00 4.75

Canada = + + = = 3.19 2.90 3.10 3.50 3.65 5.00
Brazil (7 YR) + = = + + 11.79 12.50 12.00 12.00 11.75 12.00
Mexico - = = = + 6.82 5.75 6.00 6.25 6.75 7.50
Euro area (Bund) + = - + = 2.83 1.75 2.00 2.25 2.65 4.50
UK - = - + = 3.37 2.50 2.80 3.20 3.65 5.00
Japan = - - + - 1.17 0.95 1.05 1.20 1.45 2.50
Korea = + = - = 4.32 4.60 4.70 4.80 5.00 6.00
India + + + - ++ 7.24 8.40 8.50 8.50 8.30 8.50
Taiw an + + + + - 1.42 1.43 1.43 1.49 1.55 2.25
Australia + + + - ++ 5.40 5.35 5.40 5.50 5.50 6.00
New Zealand + + + + - 5.72 5.50 5.60 5.70 5.80 6.50
Foreign Exchange
Grow th Inflation Monetary Trade Capital Trend
policy balance account fair value
EURUSD EUR - = + + = 1.33 1.35 1.35 1.42 1.50 1.20

USDCAD CAD + = + - - 1.01 1.00 0.99 0.98 0.97 1.20
USDBRL BRL + - + + ++ 1.69 1.70 1.70 1.75 1.80 1.80
USDMXN MXN + = + + - 12.38 12.30 12.20 11.75 11.50 11.50
EURGBP GBP + - + - = 0.85 0.84 0.84 0.85 0.88 0.75

GBPUSD GBP - - - + - 1.57 1.60 1.60 1.67 1.71 1.60
USDJPY JPY + + - + + 83 80 80 77 75 95
AUDUSD AUD + + + -- ++ 0.99 1.05 1.05 1.06 1.07 0.80
NZDUSD NZD = = = + = 0.76 0.78 0.79 0.80 0.82 0.65
USDKRW KRW - + - + - 1133 1050 1000 975 950 950
USDCNY CNY + ++ + + + 6.65 6.50 6.50 6.35 6.25 5.75
USDINR INR ++ ++ ++ -- ++ 44.95 43.50 43.00 42.00 41.00 38.00
USDTWD TWD + + + = ++ 30.14 29.63 29.25 28.88 28.50 22.00
Footnote - The "neutral rate" for key rates and the "trend fair value" for bond yields give our estimate of "fair value" assuming an output gap of zero and inflation at trend. The trend fair
value for currencies reflects a PPP based valuation. For interest rates, a +sign indicates that the factor in question points to higher rates. On currencies, the sign refers to the currency
indicated next to the parity, i.e. for EUR/USD, a + implies a factor favouring euro appreciation.
10 December 2010
F27071
End of End of End of End of

3-Dec
Q1:11 Q2:11 Q3:11 Q4:11
US Forecasts
2-year Treasury yield 0.56% 0.50% 0.60% 0.70% 0.80%
2s10s slope 247 150 170 205 220

2s5s slope 116 50 60 80 85
5s10s slope 132 100 110 125 135
10s30s slope 125 75 85 103 110
EUR Forecasts
2-year Bund yield 0.87% 0.70% 0.90% 1.10% 1.40%
5-year Bund yield 1.86% 1.10% 1.35% 1.60% 2.00%
10-year Bund yield 2.88% 1.75% 2.00% 2.25% 2.65%
30-year Bund yield 3.35% 2.25% 2.50% 2.80% 3.25%
2s10s slope 201 105 110 115 125

2s5s slope 99 40 45 50 60
5s10s slope 102 65 65 65 65
10s30s slope 47 50 50 55 60
JPY Forecasts
2-year JGB yield 0.19% 0.12% 0.13% 0.15% 0.25%
5-year JGB yield 0.44% 0.35% 0.40% 0.50% 0.70%
10-year JGB yield 1.22% 0.95% 1.05% 1.20% 1.45%
30-year JGB yield 2.16% 1.90% 2.00% 2.10% 2.15%
2s10s slope 102 83 92 105 120

2s5s slope 25 23 27 35 45
5s10s slope 77 60 65 70 75
10s30s slope 94 95 95 90 70
UK Forecasts
2-year Gilt yield 1.04% 1.00% 1.25% 1.50% 2.00%
5-year Gilt yield 2.10% 1.75% 2.00% 2.30% 2.80%
10-year Gilt yield 3.44% 2.50% 2.80% 3.20% 3.65%
30-year Gilt yield 4.37% 3.40% 3.70% 4.00% 4.40%
2s10s slope 240 150 155 170 165

2s5s slope 106 75 75 80 80
5s10s slope 134 75 80 90 85
10s30s slope 93 90 90 80 75
December 2010 11
F27071
Global Inflation-Linked Markets
Disinflation threat shifts from US to Euro area
The disinflation threat is subsiding in the US but Graph 1. US Core CPI, with and without rents
underappreciated in the euro area. Switch OATei 2012 into
July 2012 TIPS on either real yield or breakeven. 3.5 Core CPI
Extreme curvature differences suggest opposing 2s10s30s 3.0 Core CPI, ex Rents & OER
real curve flies in US and euro (long centre in euro, short it
in US). One attractive component trade is 2s into 10s euro 2.5
real curve flatteners or “receiving” 2y8y real yields.
2.0
Being bullish euro nominals and concerned about
disinflation are both breakeven negatives, but this is least 1.5
true of the 10-year area, suggesting 2s10s breakeven
steepeners. 1.0
0.5
 The deflation threat is fading in the US. This seems a 0.0
rather rash thing to say at a time when core CPI inflation 99 00 01 02 03 04 05 06 07 08 09 10
has just printed a 0.6% yoy rate (the lowest since the
Source: Datastream, SG Cross Asset Research
series began in 1959). Deflation is certainly “close to the
money”, and we cannot exclude the possibility of a
downward lurch into (mild and brief) deflation delivered by Graph 2. Rental vacancy rate leads US CPI rent
a sharp fall in the oil price, but the risk of more persistent, components
underlying, deflation looks to be greatly diminished for at 5 -0.8
least two reasons…
4 -0.4
 If we’re talking about the US CPI, then the rent
components are always front and centre. The rent and 0.0
3
owner equivalent rent series, taken together, comprise
about a third of core CPI, and the sharp fall in rents 0.4
2
inflation is behind the record low core number. Graph 1
0.8
shows core inflation with and without rents and the ex- OER, %y/y
rents core rate, though low, is still above the previous 1
1.2
cyclical trough. Rents, %y/y
0 1.6
Why should rents inflation turn up with the housing market y/y change in rental vacancy rate,
still in the doldrums? First, it is worth remembering that -1 RHS (inverted) 2.0
rents did not really participate in the housing bull market. 95 98 01 04 07 10
For us, a key leading driver of rents is rental vacancies,
Source: Datastream, SG Cross Asset Research
which have now turned down sharply, tightening up the
market (Graph 2). So if you’re looking for deflationary
threats, this is one (big) thing you should be able to worry
less about.  The other area where deflation risk should be abating in
the US is on the labour cost side. Labour cost cutting was
first about the imperative to arrest the precipitous drop in
corporate earnings and then about the restoration in
profitability. It is something the flexible US economy does
very well, as is shown by the V-shaped earnings-per-share
rebound in Graph 3. Note how this compares with the (less
flexible) European situation, where there has been a bigger
fall and (thus far) a smaller, slower bounce in eps. Graph 3
12 December 2010
F27071
shows 1-year trailing eps, so the passage of time should These cash-and-duration neutral flies are inversely
see the US eps line climb to the prior peak in 2011. proportionate to the spread between the 2y8y forward real
yield (1.03% in TIPS and 1.84% in euro) and the 10y20y
This is an astonishing earnings recovery (also explaining
real yield (2.33% in TIPS and 1.78% in euro). So the spread
the “jobs-light” nature of the rebound), but as companies
between the forward real yields is very positive in TIPS but
clear prior-peak earnings hurdles, the labour cost-cutting
inverted in euro. The US fly, using TII Jan 20s in the centre
motive dissipates and hiring becomes the goal.
to give us more history, drops 69.5bp (risk weightings: -
Graph 3. Equity earnings per share in the US and euro 12.2% July 12/+100% Jan 20/-87.8% Feb 20). The OATei
area, Datastream total market indices (rebased) fly picks up 3.5bp (-12.6% ’12s/+100% ’20s/-87.4% ’40s).
500 Graph 4. OATei and TIPS 2012/2020/2040 cash-and-

450 duration neutral flies (see text for weights)
400 40
bp
350
20
300
250 0
200 -20
150
Euro Area -40
100
50 US -60 OATei TIPS
0
90 92 94 96 98 00 02 04 06 08 10 -80
Source: Datastream, SG Cross Asset Research -100
07 08 09 10
US manufacturing unit labour costs (ULCs) which were Source: Datastream, SG Cross Asset Research
down 7% in the year to April have been flat since, lifting
the y/y rate to -3%. And whole economy US ULCs in Q2
 What does the gulf between the two flies tell us? A lot:
were up by 1.3% more than in the Euro area, reversing the
relative trend. The Euro area is way behind on profitability- • That front end euro linkers are expensive (outright and
repair, so the disinflationary threat on the labour cost side relative to US), as we discussed earlier.
would have been shifting to Europe even without the
current systemic stresses and forced fiscal retrenchment. • That the QE2 impact on 10s30s in nominal USTs has
had a disproportionately large pass-through to the real
 For euro inflation, a complication is the extent to which curve.
fiscal repair comes via revenue-raising (like VAT) which lifts
inflation. Firstly, we doubt whether this issue is big enough • That the asset allocation shift into TIPS (and structured
to counter the austerity headwinds. Secondly, it is a inflation) which has lifted breakevens, has shown a
second derivative question. The current 0.3% gap between strong benchmark preference for the 10-year area.
the HICP inflation rate and the constant tax HICP rate is • That extreme supply concentration in the middle of the
large, so new one-off measures have to more than offset euro inflation curve has taken its toll.
the ones that will wash out of the year-on-year rate.
US/euro curvature differences are more extreme in real
 So be bullish front end US linkers and bearish on them than in nominal terms. As said, the extent to which the
in euro. As a real yield spread trade, there are three 10s30s TIPS real curve has felt the QE dislocation is
attractions: this macro view, the 40bp yield pick-up from unusual. As unusual is the fact that 30-year euro issues
OATei 7/12s into TII 7/12s and the term financing spread. have maintained their richness on the curve as pension
In this view, we are comfortably aligned with our fund appetite for inflation hedging has dwindled.
economists who are well above market with their US
inflation call for 2011 and below market with their Euro call. Here we revisit a component of the euro fly: the cash-for-
Cash flow should help. Although we have 10-year TIPS cash extension from OATei 2012s into OATei 2020s,
supply in January, of course, January also returns $14bn receiving the forward yield of 1.84% in between. This 2y8y
(by value) from a redemption and $4.7bn in coupons. This, real yield compares to an interpolated spot 8y real yield of
plus perhaps a classic “New-Year-fresh-start-risk-on” about 1%, giving an attractive entry level and roll-down.
mood, should be constructive US breakevens.
Recommendation
 A tale of two flies. The divergent behaviour of the cash-
and-duration neutral 2s10s30s real yield flies in TIPS and Extend cash-for-cash from OATei 2012 into OATei 2020, to
OATeis is interesting, but difficult-to-implement as a cross receive forward yield of 1.84%. Target 1.4%; stop 2.1%.
market trade. However, it encapsulates several local and
cross-market features and opportunities.
mark.capleton@sgcib.com
December 2010 13
F27071
Euro linker supply at record high will not rattle the markets
Euro linker supply is expected to hit €50bn in 2011. Issuers In terms of new lines, a new 15-year OATei with maturity in
should continue the process of completing the curve and 2026 or 2027 is widely expected for 2011Q1. This bond
maintaining or slightly increasing the share of linkers within would take advantage of the richness of the 2032. The AFT
total debt. is not under much pressure to open additional new lines:
the outstanding on the OATei 2022 (long 10-year first
We expect France to remain a strong issuer, Italy to step
issued in 2010) is just €7.5bn, and the outstanding on the
up a bit from 2010 levels and Germany to consolidate its existing 30-year, the OATei 2040, is €6.8bn. Regarding the
position as a regular, significant inflation issuer.
OATi lines, the new OATi 2019 is just €5.9bn, and with the
As for new lines, we expect new 15-year OATei and BTPei OATi 2023 at €8.2bn and the OATei 2029 at €7.5bn there is
bonds, and possibly a new 5-year BTPei. We think the enough capacity that no new lines need to be opened.
issuance of a new 30-year Bundei would be a very positive
While we see an increase in French gross supply, our
step for both the market and the issuer.
central scenario would imply a small but significant
The cash picture will be supportive. The OATi 2011 will decrease in net supply. In 2010 we had the redemption of
redeem for about €14.5bn (inflated principal). Also, a the BTANei 2010, for €9.3bn nominal (€10.2bn inflated). In
massive €28.3bn (inflated principal from the OATei and 2011 we will have the redemption of the larger OATi 2011,
BTPei 2012) will fall out of the indices. for €12.9bn nominal (we expect an inflated amount of
€14.6bn). Hence, €21bn in gross supply in 2011 should not
put much pressure on the market.
We expect euro linker supply in 2011 to hit €50bn for the
first time, after a record €46.1bn in 2010. We put the low
issuance scenario for next year at €42bn and the high Graph 5. Z-spread vs nominals
issuance scenario at €57bn. Our central case is based on
50
projecting the 2010 issuance policies of the three active
issuers in euro linkers (France, Italy and Germany) and
assuming a net linker market growth (i.e. after 40
redemptions) in line with that of 2009 and 2010. The 10-year sector:
still the sweet spot
various debt management offices will release their 30
for France and Germany
guidelines for debt issuance for 2011 in the second half of
December, and we will adjust our forecasts accordingly. big OATei and BTPei
issuance gap and
However, it is unlikely that the guidelines for linkers will 20 opportunity
deviate significantly from previous years, thus supply will
continue to contribute to the liquidity of the real yield 10
curve, and their share in the stock of debt will be
consolidated.
0
OATei 12
OATei 15
OATei 20
OATei 22
OATei 32
OATei 40
BTPei 12
OBLei 13
BTPei 14
BTPei 17
BTPei 19
BTPei 21
BTPei 23
BTPei 35
BTPei 41
OATi 11
OATi 13
OATi 17
OATi 19
OATi 23
OATi 29
BUNDei 16
BUNDei 20
Table 1: Summary of our supply views for 2011 -10
Low Central High Com m ents Source: SG Cross Asset Research

FRANCE 18 21 24 Another strong year
OATi 8 9 11 Expect €6bn in 2019s
OATei 10 12 13 Focus on 22s, some 40s. New 15-year Italy. We expect €17bn in 2011, with a low issuance
ITALY 14 17 19 Focus on 21s, new 5-year and/or 15-year
GERMANY 10 12 14 Expect €4bn in 2020s. Need new lines.
scenario at €14bn and a high issuance scenario at €19bp.
Total 42 50 57 This would be higher than the €14.7bn sold in 2010, and
closer to the average between 2007 and 2009. We see two
downside risks. One supply deterrent might be sovereign
credit instability (which will not subside quickly) – BTPei
France. We expect €21bn for 2011 (€18bn in the low have been disproportionally impacted by past flight-to-
scenario and €24bn in the high scenario). Our central quality episodes relative to nominal BTPs. Second, most
scenario is €9bn in OATi, with €6bn in OATi 2019, €2bn in BTPei lines are full, and opening new inflation-linked lines
2023, €1bn in other lines and €12bn in OATei, with €5bn in in stressed markets might be unappealing. In normal
a new 15-year, €5bn in 2022s, and €2bn in 2040s. This conditions, we would most likely see two new lines, a new
OATei/OATi split would be similar to that in 2010, with 5-year and a new 15-year. At a minimum, we think that one
issuance roughly a 60%/40% mix. The expected total new line is absolutely necessary. If that is the case, it
amount would be slightly higher than the €20.4bn in 2010, would take us to the low issuance scenario. But we are
a strong year. positive BTPei and our central case scenario calls for a
14 December 2010
F27071
moderate pick up in issuance, with two new lines and taps nominal, inflated to an expected €17.33bn on July 2011)
of the 2021 and the 2041. and the BTPei 2012 (outstanding of €10.438 nominal,
inflated to an expected €11.27bn on September 2011). All
In effect, all BTPei lines except the 2021 and 2041 appear
in all, more than €28.6bn. In the past, these index events
full or nearly full. We see the need for a new 5-year (2016)
have generated strong flattening of the real yield curve in
and a new 15y (2026-2027). At least one additional line
the 5y-10y sector. We expect this seasonality to remain in
should be open to fulfil the funding requirements and
place and support the areas where sovereigns are more
consolidate the BTPei share in the stock of debt. The case
likely to issue – from 10y to 15y.
for the 15y is stronger given the distorted valuation of the
2035 due to its extremely low float. Regarding the current
lines, with the 2021 notional at €7.7bn (all issued in 2010)
All in all, we expect another strong year for linker issuance,
we could easily have another €7.5bn in 2011, before
with new lines dispersing the focus from the 10-year sector
getting a new 10-year in 2012. Also, the 2041 has only
slightly and with substantial redemptions and index
€6.4bn notional issued, hence plenty of scope to grow.
extensions providing support.
As a final point, we would highlight that the net supply in
2010 has been very small, after allowing for the redemption
of the BTPei 2010, with nominal at €14.3bn and inflated david.mendez-vives@sgcib.com
amount at close to €16bn. Hence we expect somewhat
higher net issuance than in 2010 (with crisis-related
provisos).
Germany. We expect €12bn from Germany in 2011, with a

low scenario at €10bn and a high at €14bn. This comes
after the €11bn in 2010 – a record for Germany, if slightly
short of its initial target of €3-4bn per quarter (modified
explicitly on the lower side in the last quarter). The most
important change in 2010, in our opinion, was that
Germany is issuing regularly – every month or two months
at most – a policy we expect to remain in place in 2011.
With a more regular auction calendar, for higher total
amounts, we think that the main problem for Germany
comes from the lack of lines. The Bundei 2016 is at €15bn
and virtually full, in our opinion. The OBLei 2013 and the
Bundei 2020 are at €11bn and €12bn respectively, or near
completion.
If Germany keeps its 2010 policy, with at least €10bn sold
in 2011, then they almost certainly need a new line. For
instance they could do €5bn between 2013s and 2020s
and €5bn or more of a new Bundei. But it is not obvious
which maturity would be chosen. A new 15-year is very
unlikely, as Germany does not issue that maturity in
nominal space. And market hopes for a new 30-year have
been repeatedly disappointed. We still believe that a new
30-year Bundei would be very beneficial for the market, as
a reference point for the 30-year real rate, and to the
Finanzagentur, as a logical way to achieve its issuance
target. Otherwise, there is the option to do a new long 10-
year Bundei (say a 2022), although with France seeking to
build OATei 2022s and Italy its 2021s, an April 2022 Bundei
sitting between the two could mean a lot of supply hitting a
10-month maturity interval on the curve.
Overall, the cash picture will be supportive for linker

issuance. We have just one redemption in 2011, the OATi
2011 for a principal of €13bn, inflated to an expected
€14.7bn at redemption. The amount redeemed is lower
than that in 2010, when the redemptions of the BTANei
2010 and the BTPei 2010 added up to €26.2bn. The more
significant topic in 2011 will be, we think, the falling from
the indices of the OATei 2012 (outstanding of €14.494
December 2010 15
F27071
Global Volatility
EUR gamma : a déjà vu ?
The year 2010 is coming to an end with some memories of average 1.5bp/d higher than the realised 2y rates vol
late 2008. Will 2011 look like 2009? (Graph 1).
We recommend profiting from the recent spike in swaption Graph 1. Long-rates realised volatility is well above
vols to position for lower rates in early 2011. short rates vol – as in early 2009
8 bp/d
 A déjà vu. As we write, EUR swaption volatility in most
parts of the grid is trading at YTD highs and above the 90% 7
historical percentile (Table 1). Only vols in the upper-left-
corner (ULC), short expiry and short rates, remain relatively 6
low, but generally above their YTD averages. Yet the year 5
started with a sharp decline in swaption vols, on the back
of the “normalisation” trend towards pre-Lehman average 4
levels and a neutral-to-bullish bond market orientation.
Things changed dramatically in late April with the onset of 3
the European sovereign debt crisis and its second wave in
November. In between, long rates volatility was supported 2
by the August bonds rally in anticipation of the Fed’s QE2. Jan-09 Jul-09 Jan-10 Jul-10
Each time, crazy flattening moves at the ultra-long-end of EUR 2y EUR 10y
the EUR swap curve were adding to the panic and
Source: SG Cross Asset Research. Realised volatility is estimated as exponential standard-
exacerbating realised volatility. The year 2010 is coming to deviation on a 66-day rolling period.
an end with some memories of late 2008. Will 2011 look
like 2009?
This configuration is similar to the one observed in early
Table 1. EUR swaption vol – historical percentiles 2009, when the central banks were globally expected to
remain very accommodative for a long time. Falling short
1Y 2Y 3Y 4Y 5Y 7Y 10Y 20Y 30Y
rates vol was then leading the overall decrease in rates
1M 36 28 37 48 61 78 90 92 92
vols – helped by the post-Lehman mean-reversion. An
3M 41 36 47 64 73 87 93 94 93
6M 41 51 65 72 81 89 94 94 94
important difference is that short rates vol is now much
1Y 64 77 84 86 91 94 95 94 93 lower than in early 2009. So it cannot decrease by a
2Y 86 92 94 98 99 99 97 96 94 comparable amount. Yet by remaining low, short rates vol
3Y 91 95 99 99 100 99 99 97 94 would still contribute to moving long-rates vol lower.
4Y 92 95 98 100 100 100 99 96 93
Given the low levels of short rates, their volatility tends to
5Y 92 95 98 100 100 100 100 95 93
decrease when rates move down and tends to increase
7Y 91 96 99 100 100 100 100 97 95
10Y 86 96 99 100 99 99 99 96 93
when rates move up. This directionality is reflected in the
20Y 84 93 97 98 98 99 99 96 94 shape of the swaption smile – strongly skewed towards
payers in the ULC, while remaining quite balanced in long
Source: SG Cross Asset Research. Current volatility in comparison to its history since June
1999. A 10 percentile level means that since June 1999, the volatility traded below the
rates (Graph 2).
current level 10% of time (volatility is cheap). A 90 percentile level means that since June
1999, the volatility traded below the current level 90% of time (volatility is expensive). Levels
Short rates vol to remain low. A significant move higher of
of 100 correspond to historical maximum. short rates volatility would require a hawkish repricing of
medium-term central bank expectations. We do not expect
this to happen in H1 2011. Our scenario is for the ULC to
Long EUR rates are now significantly more volatile than
remain low, or even revisit levels close to the lows seen in
short rates. Since the Greek crisis in April/May, EUR 2y
2010 – as the market is far from pricing any material
rates realised vol exceeded the 10y rates realised vol only
monetary policy tightening over the medium term. The slow
very temporarily in June/July, around the expiration of the
(possibly very slow) exit by the ECB from its non-standard
first 1y LTRO. Otherwise, 10y rates realised vol was on
16 December 2010
F27071
liquidity provision measures would be insufficient to drive smile configuration suggests selling the implied vol for
short rates vol significantly and durably higher. scenarios targeting 10y rates remaining below the current
ATMF+30bp level in the next six months. As suggested
The volatility at the long-end of the curve will very likely
above, an attractive way to benefit from current high levels
remain above short rates vol – at least in H1 2011. The
of swaption volatility in EUR long tails, without taking on
spread between both should narrow provided we see
too much risk (except the one of losing the premium paid
some stabilisation in the European sovereign debt crisis.
at inception), is to buy receiver condors.
This is independent from the direction of the rates market.
We favour, however, a scenario of lower rates and lower Graph 3. EUR 6m2y smile
vol. In particular, it is definitely too early to consider
conditional bear-flatteners. We also for now exclude 9
outright short gamma positions. Instead, we recommend EUR 6m2y vol, bp/d
profiting from the recent spike in implied short expiry vols – 8
both in ULC and URC – and selling it via non-delta-hedged
directional strategies. We recommend 1x2 receiver 7
spreads in short and intermediate tenors and condors in
6
10y rates. We also suggest selling short expiry OTM 2y
payers to finance 10y receiver spreads (see Curve section). 5
Graph 2. EUR 100bp-wide vol risk reversals 4

EUR 2y, %
bp/d 3
1.25
1 1.5 2 2.5 3
1.00
Current EUR 6m2y smile
0.75
Source: SG Cross Asset Research. Grey points are daily since 1/1/2009, red points are daily
0.50 since 1/1/2010.
0.25
0.00 Graph 4. EUR 6m10y smile
-0.25
9 EUR 6m10y vol,
-0.50
04 05 06 07 08 09 10 bp/d
8
EUR 6m2y EUR 6m10y 7
Source: SG Cross Asset Research. A 100bp-wide vol risk reversal is the difference between 6
the implied volatility of an ATMF+50bp payer and an ATMF-50bp receiver.
5
 Is the smile correctly pricing the relationship between 4
rates and volatility? Graphs 3 and 4 compare scatter-plots EUR 10y, %
of ATM 6m2y and 6m10y vols vs the underlying swap rates 3
with the current shape of the volatility smile. 2 2.5 3 3.5 4
ULC. A sharp increase in short rates seems underpriced Current EUR 6m10y smile
relative to past 6m2y vol directionality, while the scenario
Source: SG Cross Asset Research. Grey points are daily since 1/1/2009, red points are daily
of a rates decrease towards the low end of their recent since 1/1/2010.
range is correctly integrated in the smile (Graph 3). So the
vol market does not subscribe to a scenario of a massive
short rates increase in the coming months. However, OTM Recommendations - profit from the recent spike in
puts trade at a significant premium. This offers value in swaption vols to position for lower rates in early 2011:
strategies targeting EUR 2y rates below 2.15% in the
coming six months. Buy EUR 3m10y 2.90/2.70/2.50/2.20% receiver condor,
indicative price 3bp running (indicative fwd. 3.23%).
URC. Because of the recent sovereign jitters, vols are high
compared to 2010 levels – except in deep OTM receivers Buy EUR 3m5y 2.25%/1.88% 1x2 receiver spread,
(Graph 4). So, naively and obviously, there is room for a indicative price 6bp running (indicative fwd 2.50%).
decrease in long-tail vol once the jitters fade out and EUR
Buy EUR 6m2y 1.78%/1.54% 1x2 receiver spread, close to
10y rates remain in a 100bp-wide range around the current
zero cost (indicative), indicative fwd 1.79%.
forward. Graph 4 shows that the slope of the 6m10y smile
is slightly too steep compared to the 2010 regression line.
Therefore deep OTM payers trade at some premium given
past year vol directionality but seem cheap compared to adam.kurpiel@sgcib.com
2009 vol levels. The latter were, however, to large extent
impacted by end-2008 dislocations. All in all, the current
December 2010 17
F27071
Impact of QE2 on USD volatility to be negligible
While SOMA portfolio purchases cause a slight change to  The supply side of USD volatility is also affected by
supply and demand of volatility, the effects are widely SOMA positions. Fed purchases of Treasury securities
offsetting each other, causing no systematic change to the adversely impact investors’ search for yield in three ways:
USD volatility market.
- The larger percentage of outstanding Treasuries in
the SOMA portfolio increases the scarcity
premium of Treasuries and drives their yield lower.
 The demand side of USD volatility is impacted by the
roughly $32bn/month roll-off of MBS securities from the - The preference for “cheap” Treasuries creates
SOMA portfolio. The Fed is currently holding some $1tn in fewer opportunities for investors to enhance yield
MBS securities on an unhedged basis (i.e. no volatility through switches (from a rich to cheap Treasury).
8
product is used to hedge the negative convexity). Roughly - The focus on the 4- to 10-year sector creates yield
87% of those MBS securities are Fannie Mae and Freddie curve flattening, reducing opportunities to
Mac 30-year mortgages. On average, SOMA holdings increase yield by duration extension (see Graph 2).
account for roughly 31% of the total outstanding collateral,
although for 4% coupons it is above 50% (see Graph 1). Graph 2. Value of a 3-month duration extension of
Treasuries with an average duration of 2 years
Graph 1. FNMA & FHLMC 30y collateral
40
FNMA & FHLMC 30yr collateral
800
Other outstanding 30
SOMA
600
20
bp
400
$bn
200 10
0
0
3 3.5 4 4.5 5 5.5 6 6.5 7 7.5 8
Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
Coupons
Source: SG Cross Asset Research, Bloomberg

Source: SG Cross Asset Research, Bloomberg, Federal Reserve
To compensate for the limited opportunities to increase
yield on the Treasury curve, many investors will boost yield
While a significant portion of mortgage securities migrating by assuming credit risk and/or convexity risk.
from the Fed’s balance sheet into the private sector will We illustrate this with a simple estimation:
find a new home with investors who are non-hedgers as
well, we expect only some 10-20% to be picked up by - Roughly $3.5tn of coupon Treasuries with a
relative value accounts which do hedge. remaining maturity of less than 5 years are in
circulation.
Our calculations suggest that $32bn in MBS requires a - We assume that 10% are held by investors who
convexity-hedge to the tune of $3.5m Vega. Thus, will seek to enhance yield, i.e. $350bn.
assuming that 10-20% of all mortgage purchases are being - We assume the desired yield pick-up to be 10bp
hedged, the expected monthly buying of volatility should running. The NPV of this yield pick-up equates to
equate to roughly $350k-700k in Vega. This is not a roughly $30m per month.
dramatic amount, given that the weekly Vega “production” - This is the roughly upfront premium of a $2.5bn 1-
from Agency callables alone is anywhere from $2m to month-into-5-year swaption straddle.
$10m, but it creates some upward pressure on implied - The quarterly Vega selling, assuming this
volatility nonetheless. Shrinking the mortgage holdings in structure, then equates to about $500k.
the SOMA portfolio creates some upward pressure on
volatility product typically used for mortgage hedging. This The estimated monthly Vega supply of $500k is roughly in
includes 3-month to 2-year swaptions on 5- to 7-year tails. line with the additional Vega demand of $350k-700k
calculated for the roll-off of MBS securities from the SOMA
portfolio. Net-net, the impact of QE2 on volatility is
minimal.
8
Agency mortgage-backed securities purchases were part of the first round of fidelio.tata@sgcib.com
quantitative easing (QE1), with the purchase phase completed on 31 March 2010.
18 December 2010
F27071
EUR vega – friendly flows
The friendly flows picture for EUR vega will not change Graph 1. EUR vega – back to end 2008 highs
soon. We follow our long-only-or-neutral systematic rule.
bp/d
7
6
 Friendly flows. EUR vega vols increased back to end-
2008 highs. The influence of gamma vols on vega has been 5
significant in 2010 – with the 1y10y vol explaining more
than 50% of the evolution in both the 5y2y and 10y10y. 4
Nonetheless, end-user demand for caps around 5y expiry
was supportive for vega vols in 1y and 2y columns 3
throughout the year. More recently, renewed appetite for
CMS rate-linked structures (most often receiving a coupon 2
linked to 10y CMS) has been supportive for the bottom- Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
right vega.
EUR5y2y EUR 10y10y
This friendly flows picture will not change soon. Hedges Source: SG Cross Asset Research.
against higher short rates in the future will yet again have
to be rolled. Moreover, given the current perception of
risks in long-maturity nominal rates and given the recent Graph 2. EUR CMS issuance
flattening at the ultra-long-end of the EUR curve, CMS
rate-linked coupons will remain appealing to investors. € millions
Admittedly, this friendly-flow story can be nuanced by 1000
ongoing demand for simple callables – mostly with short
800
(below 5y) and intermediate (5-10y) maturities – exerting a
negative pressure on intermediate-expiries in 1y to 5y 600
columns. Moreover, at current high level of vol, caps are
almost systematically embedded in new-issued CMS rate- 400
linked notes – hence limiting their positive impact on vega.
200
 In search of predictability. An increase in CMS rate-
linked issuance tends to positively impact the EUR 10y10y 0
vol the following months. The hit ratio of this simple model Jan-09 Jul-09 Jan-10 Jul-10
has been of 66% for the last two years. See our SG
Volatility Monthly – November 2010 for details. CMS-rate CMS rate linked Total CMS
linked issuance continued increasing in November – but at
much slower pace than in September or October (Graph 2). Source: SG Cross Asset Research, Total Derivatives. CMS rate-linked refers to products
Moreover, much more of structures contained a cap. So linked to one CMS rate (most often 10y CMS in EUR), as opposed to CMS spread linked
products.
the positive CMS issuance impact on the EUR bottom
rates vega may be waning at the turn of the year. Any
correction lower in vega vols would however increase the Graph 3. A systematic strategy for EUR vega
attractiveness of CMS-rate receivers in early 2010.
 A systematic strategy to trade vega with a positive
exposure bias. In our SG Volatility Monthly – May 2010, we
presented a systematic long-or-neutral-only strategy to
trade EUR vega, developed by our Quants. It was designed
for investors who prefer trading vega with a positive
exposure bias, ahead regulatory uncertainties. The out-of-
sample performance since then has proved satisfactory
(Graph 3). The rule combines mean-reversion and trend-
following signals on vol. The basic idea is to cut long
volatility positions when a decline in volatility is anticipated
and buy volatility when it is seen as being cheap. For now,
the model remains long EUR vega.
adam.kurpiel@sgcib.com Source: SG Cross Asset Research.
December 2010 19
F27071
Sovereign credit
Time for governments to choose – Austerity, Inflation, Default?
Monetary and fiscal actions in the US and Japan will help Our dictionary tells us that the opposite of austerity is
postpone sovereign credit worries over 2011. plenty or opulence. The West remains rich – even opulent-
but much of its public do not see it that way. We prefer the
The European authorities are failing to tackle the root 14
causes of the recurrent crises. As long as that remains the term “hysterity” to describe the belt tightening that the
case, we prefer AAA credits or swaps. citizens of the richest economies need to achieve, but are
15
mostly failing to do so in any convincing way .
As long as that is the case, as long as the West lives far
 Austerity, inflation, or default - which option is the least beyond its means, with a disjoint between expectations
painful? and reality, and a crowding out by government of the
economy, sovereign credit in Europe and the US will remain
The UK has an ambitious austerity plan; the US may be challenged.
going down the reflation road; the eurozone is flirting with A state of hysterity also supports ever more prudence on
default. The long-term prospects for each economy are so the part of bond investors, as imprudent sovereigns fail to
poor that draconian policies are needed. Between grasp the need for a strong dose of AID. We will see more
Austerity, Inflation or Default (AID), what is the best road to mini crises, like over the past three years. However, they
follow? likely will become more acute as times passes, unless there
Our long-term view – for years now – has been that the is sharp move towards AID, be that meaningful austerity in
multi-year outlook is bleak for Europe and the US, given the public finances, or some form of inflation or default.
unwinding of the excesses of the period leading up to the
subprime crisis. That is against the backdrop of ever  Our outlook for US and Japanese sovereign credit
16
greater structural difficulties: worsening demographics ,
9 remains negative . But in contrast to the eurozone, we see
heightened globalisation and competition, combined with no immediate threats to their ability to fund themselves.
10 Pressures on the credit front continue to build, as in past
out of control public finances in the West . This has years. However their size and institutional stability protect
prompted private consumption to run amok for the past them for now. In our scoring model (see Scoring section),
decade, with the bank crises of the past three years just a the US and Japan are ranked 7th and 9th respectively. But
symptom of more profound ills. they price at richer levels, consistent with their ability to
Today’s ongoing sovereign crises are regional, hitting the attract and retain investment capital.
eurozone and the US the hardest. Global imbalances are
playing in favour of Asia, with catch-up growth in evidence,
11
as it approaches the technological frontier . The US and
Europe in contrast, remain hamstrung by vain and ever http://ec.europa.eu/economy_finance/eu/forecasts/2010_autumn_foreca
more desperate attempts to maintain living standards. The st_en.htm which equates to well over 12% vs GNP. Government
forecasts are barely more optimistic
public, egged on by politicians, have unrealistic http://www.budget.gov.ie/The%20National%20Recovery%20Plan%2020
expectations. They are told they are in “austerity”. We 11-2014.pdf
disagree strongly. Next year again, Ireland – excluding bank 13
Paul Krugman says Ireland is in its third year of “austerity”.
12 http://www.nytimes.com/2010/11/26/opinion/26krugman.html?_r=2&hp
support – will have a deficit to national income (GNP) ratio
Wrong. Next year will be third year where the budget deficit (mostly ex
13
of well above 10%. And yet it is lauded for “austerity” . banks) is still in the double digits against national income (GNP), and is
barely falling. Yet the IMF and the EU labels the budget plan as
9
appropriate” and “praiseworthy”.
The deleterious impact of long-term structural factors demographics 14
From Greek husterēsis coming late, or coming after cf. hysteresis
and competition is an area explored by economists like Timothy Dyson the lag in a variable property of a system with respect to the effect
and David Foot e.g.
producing it. Not to be confused with a similar medical term for
http://www2.lse.ac.uk/researchAndExpertise/Experts/t.dyson@lse.ac.uk inflammation
and http://www.chass.utoronto.ca/~foot/ 15
10 Japan and the US will barely see improvements out to 2012 – see the
Research from our economists also supports that view – see e.g.
data in our Scoring model, while Germany is pulling away from many
“Central banks cannot offset the damages of globalisation forever” or eurozone other sovereigns – see Euro Issuance section
“World demographics: the challenges facing the world economy”
16
11
Among many papers, see e.g. the research of Prof Kevin O’Rourke et For much the same reasons expressed by the IMF in its Article IVs on
al http://www.irisheconomy.ie/index.php/2010/08/10/after-catch-up/ the USA http://www.imf.org/external/pubs/ft/scr/2010/cr10249.pdf and
12
GNP is very different to GDP in Ireland and in our view better measures Japan http://www.imf.org/external/pubs/ft/scr/2010/cr10211.pdf, both
taxable income. The EC foresees a budget deficit of 10.25% to GDP in published last July, with Moody’s latest AAA Sovereign Monitor saying of
2011 (mainly before bank support) the US, its “debt metrics are among the most challenged”.
20 December 2010
F27071
The more immediate risk, for both the US and Japan, is on These remedies can paper over the cracks for a while (the
the macro front. Both inflation and default involve a transfer ECB’s buying of PGBs on 2 December led to a 50bp rally in
of wealth from savers to the public. Of the two, inflation, 10y PGB). But only a sharp reversal of the upwards spiral in
facilitated by exchange rate flexibility, is our preferred route. public liabilities will provide a cure. Bigger and ever greater
17 crises in 2011 and beyond are likely as long as the tenets of
SG's economists have long espoused it as way of easing
the after effects of the subprime crisis. And the IMF's the SGP are flaunted – and it just takes one country to
Blanchard recently suggested a loosening of official flaunt them.
18
inflation targets . The US is taking a modest risk in that  Hysterity thus drives us inexorably towards default. Our
direction with QE2. Should the medicine fail to work, then preferred policy solution, given hysterity and no inflation,
sovereign credit will be weakened. But that risk is some has been “tough love”, with default as the ultimate penalty.
time off. The US authorities have acted courageously in allowing
Lehman and many other banks to fail. That never
 The outlook for Europe is different. The ECB has undermined the AAA of the federal government.
eschewed QE and inflation. Europe’s institutions over the
crises have been found wanting. Worse, several countries Nor would allowing private sector default have ever
are making slow progress in cutting their budget deficits, undermined Ireland or other European sovereigns (though
and the gaps with Germany are at or near their widest since officials assured us time and again that it would). Indeed,
the creation of the ERM. strong action in containing public liability for private losses
A state of hysterity – in the absence of inflation or burden would likely have helped sovereign ratings (and certainly
sharing – inexorably leads to some form of default. improved our scores). Alas, suggestions to the authorities
Europe's response to its “crisis”, like Japan before it, has along those lines have (so far) fallen on deaf ears.
been denial. The welfare state has to be saved and no bank In sum, the West has to fund living standards that are far
in Europe (except one, so far) has been allowed default on above the capacity of Western economies to sustain them.
senior debt or even put into liquidation. So default has been Among the culprits, excess government consumption is the
ruled out, or so it might have seemed. Yet default has never prime suspect. Public deficits in the US and Ireland, for
been closer. example, are still running at close to 10% of GDP. Greece
With hysterity, and no inflation, we see the logic in the and Ireland already have reached the infamous tipping
reprivatisation of risk. The German authorities, sensibly, are point for bondholders, while Portugal and maybe soon
20
suggesting changing European law to facilitate debt Spain , are close unless we see a strong dose of AID. The
resolution. US will hit that tipping point too at some point unless it
sees AID bearing fruit soon - say in the next two to three
While this could stabilise sovereigns over the coming years, years.
we fear that the reprivatisation of risk in Europe could prove
very traumatic during the course of 2011.  We wrote in this Outlook two years ago, given the
absence of austerity in Europe, “Either the Union breaks up,
The risk might be sweetened by ever larger bond buying and the troublesome sovereigns inflate their way out of the
19
(the SMP programme) or bailout funds (EFSF, EFSM…) . mess. Or they default. Or the European Union somehow
But it would be a grave error to think that such generosity comes to their aid.” For now, aid is being extended. But it
will stop the rot. Default on senior bank debt helps cannot be a permanent response, or remedy the underlying
reprivatise liabilities. But only in Ireland, Spain and Germany troubles.
can that still make a big impact (and even in Ireland, it does
nothing to close the yawning gap between welfare Over 2011, in euro, we prefer to hold AAA sovereigns in this
spending and tax collection, ex banks, as foreseen by the context, or swaps, or bonds in foreign currency swapped
EC out to 2012). For other countries that do no respect the into euro.
SGP, banks are not the problem; it’s overly big public
We would adjust our views more positively if we were to
spending, although the authorities would like us to believe
see:
otherwise.
1) Real austerity - the governments running deficits in the 5-
 We sometimes are asked by officials how the current 10% GDP range show evidence of achieving their
sovereign tensions can be eased. A meaningful dose of AID objectives in 2011 and substantially improving on them for
is our answer. But that isn't what the authorities want to 2012.
countenance. Today, they still think that there must be 2) QE - The ECB finally embarks on unsterilised liquidity
some quick fix. An “improvement in communication” is one. injections for size.
Bailouts or large bond buying are seen as other options. 3) A tough line is taken on failed enterprise, including
banks, and a re-profiling of non-government debt is finally
allowed. Some TARP-like fund would isolate financial
17
See “2009 and beyond: Eurozone... audacity required or doldrums problems. Combined with greater burden sharing across
ahead” states, it could be a game changer.
http://www.sgresearch.com/p/en/2/3182/0/E6F6E8FCA30AEE13C125754
600602666.html?sid=d0fa932d0d030467072debc464bc4a77
18
See e.g. Rethinking Macroeconomic Policy; by Olivier Blanchard
19 ciaran.ohagan@sgcib.com
The EFSF’s €440bn rescue package is too small, would not cover
contagion to Spain, as we have discussed in our EFSF special, and also
in the press
20
http://online.wsj.com/article/SB1000142405274870452650457563491351 See our Special - Next stop Spain: firemen now, plumbers later’ 30
6773290.html Nov.
December 2010 21
F27071
Can the eurozone hang together?
We do not see eurozone breakup as all or nothing. - “dual currencies”. Greek or California-style IOUs, or
Insidious moves towards instability are happening Montenegro-type currency circulation are all
however. possibilities (the recent Greek issuance of zero
coupon bonds resembles more reprofiling of debt
The risks are too great to ignore, and investors should
however).
look for protection.
- Capital controls just might be part of a wider
solution 26
- “revalorisation” of local bank deposits
 Can the eurozone hang together? The simple answer - Etc.
is that yes: the eurozone has the economic resources to
ensure that monetary union can hang together. But
political will is needed too. A strong dose of political Some of these responses are very hard to implement.
cooperation and co-ordination is required to solve But all “solutions” today are difficult to implement for
today’s challenges. Without that, fears that Europe can governments that choose hysterity over austerity. Some
step up to the task will grow. of the alternatives would have less upfront or less
obvious costs, and just might help.
 Often eurozone “breakup” is painted as black and
white – a member state is either in or it is out 21. The More integrated fiscal policies would do wonders for
problem with the “break-up” papers is that they see stability. But that would involve a good deal of
either full EMU (like today) or no EMU at all for one or redistribution of wealth and income. There are doubts
more countries (either the very weakest or the very that the electorates in core Europe will allow this, or that
strongest) 22. This leads them all to say breakup is not politicians would take up the mantle of leadership. And
possible. That is most likely true if the choice is between where politics is involved, the uncertainty becomes too
stark in / out scenarios. great for fixed income investors.
Before we arrive at Armageddon, however, there are  In a few years’ time, the eurozone will either be more
many possible scenarios where a member state might integrated fiscally, or will have broken up, it is said. In an
have one foot in and one foot out. What we need is some editorial “Don’t Do It” 27, the Economist argues 28
imagination in terms of half way houses, or even “Breaking up the euro is not unthinkable, just very costly.
quarter/tenth of the way ones, when the going gets too Because they refuse to face up to the possibility that it
rough for some member states. might happen, Europe’s leaders are failing to take the
measures necessary to avert it”.
Among the shades of grey, we can see many, ranging
from the mild and benign to the insidious: We wouldn’t be quite so negative. AID (Austerity, Inflation,
Default) is what is needed. The ECB may be excluding
- It is possible to envisage a somewhat differentiated Inflation as a solution. But some countries – Germany,
monetary policy across states. 23. Austria, Finland etc are going down the Austerity road,
- “Differentiated regional tax policies” is a recent idea 24. while the EU as a whole is introducing mechanisms to allow
- Alternative means of exchange might devalue internal for the risk of Default. Economic governance is being
prices 25. ameliorated 29. That just might be enough. Full breakup is
not likely, at least not for many years yet, and probably
never (it is interesting to note that despite the fairly quick
21
breakup of the Irish-sterling monetary union, sterling
One of the better papers on this theme is by Wolfgang Münchau currency continued to circulate quite a while after in Ireland
http://www.eurointelligence.com/uploads/media/Euro_Area_Meltdown_
Web_Edition.pdf – see below).
22
"Save Our Money!", by the former head of the Federation of German
Industries, Hans-Olaf Henkel, suggests splitting the euro zone into a
25
hard-currency union led by Germany and a French-led southern group { Joseph Stiglitz advocates this
NSN LCTMHQ3T6SQO <GO>} { NSN LCTMIF3T6SQO <GO>} http://www.irishtimes.com/newspaper/finance/2009/1009/1224256255558.ht
23
This is a theme that doubtless the ECB is already considering – see ml
26
here http://imarketnews.com/node/23229 - “One option would be to Recent talk in Ireland of credit restrictions appears to be sporadic
introduce a two-tier system in which weak banks could still receive responses by private banks http://www.rte.ie/radio1/marianfinucane/ 28
unlimited 3-month funding in separate operations, perhaps at a penalty Nov.
27
rate. Another option would be for national central banks to provide {LCTMIF3T6SQO}
emergency credit lines as Ireland's central bank did recently for Irish
banks and the Bundesbank did for Hypo Real Estate in 2008”. There are 29
See here
also occasional academic analyses e.g. Gregory O’Connor in http://europa.eu/rapid/pressReleasesAction.do?reference=IP/10/1199
http://www.irisheconomy.ie/index.php/2010/12/01/regional-quantitative- with yet more ideas here
easing-in-the-eurozone/ http://www.europarl.europa.eu/activities/committees/editoDisplay.do;jse
24
This is a theme explored by Rainer Maurer http://www.rainer- ssionid=3335984E968463EA2EBC479E87739319.node1?language=EN&m
maurer.com/pageID_9428110.html enuId=2061&body=ECON&id=1
22 December 2010
F27071
 How can investors protect against severe eurozone payments crisis, a deep recession and much higher
turbulence? With great difficulty, is the simple answer. emigration.
We can envisage scenarios in which both cash deposits
in core Europe and even Bund holdings could come The second was in the late 1970s, and was to prove
under pressure. The only sure option is to hold physical fatal. Fiscal policy became super expansionary, and loan
assets in core Europe - possibly equities. In a way, this financing led the local economy to strongly overheat.
could be beneficial for the economy. Uncertainty of this This episode was about to threaten the sterling parity.
kind encourages investors to invest cash in riskier, But before markets forced the issue, the government
productive enterprise. Or it ought to if they think hard fairly suddenly abandoned parity for the attractions of
enough about it. But we are not at that point yet. the EMS.
That was just as well, as sterling strengthened in the
 We wrote the section below for our Outlook two early months of the EMS. It was buoyed by Thatcher’s
years ago. We think it is a salutary experience to bear in new tight monetary policy and North Sea oil revenues. A
mind, like the more recent Czech Slovak monetary union continuation of union with sterling into 1980 would likely
split. Splits can occur, and more easily than many seem have proved unfeasible in any case. Political relations
to think, if governments do not take extraordinary firm between the governments at the time were difficult. And
action (i.e. AID) to avoid them. the Irish economy would not have held up against the
loss of competitiveness as a member of the sterling
zone.
When Ireland last left a monetary union
Indeed, it would have made no sense to continue with
the strong fiscal expansion, as it would mostly have
1978: When £1 pound sterling in Ireland
benefited the UK economy. That was already visible in
early 1978: the large fiscal boost was mostly being
exported to the UK.
At first in 1978, there was hope that the Irish punt’s value
could be held close to one pound sterling, and at the
same time, hold within the EMS bands. Effectively, after
joining the new exchange-rate mechanism, the punt was
more or less stable at first, and even appreciated
momentarily. This calm before the storm greatly
facilitated a rapid resolution of the legal issues around
the redenomination of liabilities and assets into punts
became £1 punt. and pounds. Financial markets were of course a lot
simpler back then. So no great trauma from that
redenomination has been handed down to policy makers
today. And they are likely still fairly pragmatic, if myopic.
A sizable 69% majority voted to join the euro in the 1992
Maastricht referendum. Professional economists were
more divided. A majority may have favoured EMU, but
opinions were nuanced, and few saw a large economic
net advantage to abandoning the national currency.
Political aspirations were - and remain - key.
Can it be done again?

In 1978, the realisation that the unsustainably large fiscal
boost was just being exported and wasted went hand in
hand with the break-up of Ireland’s union with sterling
How did the break-up go the last time?30 that year, along of course with the attraction of the
The Irish pound had full monetary union with sterling nascent EMS. Might a more flexible sterling now again
before breaking away in 1978. That link, like the euro prove a more stable partner for the punt, in deference to
later on, provided worthwhile discipline for Irish the discipline of the eurozone?
government policy. Only twice did the Irish government How Ireland adjusts now to a slowing world economy
attempt to loosen policy. over the coming years shall be an important test case for
The first was in 1955. Irish interest rates were held down the project of European Monetary Union.
just as UK rates were rising. That decision provoked a
ciaran.ohagan@sgcib.com
30
For more, see The Irish Pound: From Origins to EMU, 2003,
http://www.centralbank.ie/data/site/spring8.pdf
December 2010 23
F27071
Is European default legislation to be feared?
We welcome measures that will limit moral hazard. If That same logic now should apply to other sovereigns
effective, ratings for riskier credits will be lower. 33
and to other ratings . The credits most at risk of course
However, investors appear unclear as to how the new are those which are already exposed to moral hazard.
legislation will work. Prudence is warranted.
This environment will make it harder for investors to
Subordination of investor holdings to political interest return to riskier sovereign markets.
introduces uncertainty, and this is yet to be priced in.
 The Eurogroup, after its meeting at the end of
34
November, stated:
 Is European default legislation to be feared? The simple
answer is yes. Subordination of investor holdings to 1) collective action clauses to facilitate sovereign
political interest introduces unwelcome uncertainty. default will be introduced by changing the EU Treaty
now, in EGB prospectuses, effective mid-2013
31 32
Portugal and Greece have now been put on credit onwards;
watch negative, with Ireland to follow in a multi-notch 2) the ESM will replace the EFSF “In all cases, in order
downgrade. For the first time, the reason given explicitly to protect taxpayers' money, and to send a clear
by S&P is the risk that “private creditors will be signal to private creditors that their claims are
subordinated to public creditors”, given the probable EU subordinated to those of the official sector, an ESM
treaty changes. loan will enjoy preferred creditor status, junior only
to the IMF loan”.
Hence some may not be surprised to see pre-ESM pre-
2013 debt be re-profiled as well. S&P says, “We believe Part of the plan is to shift from the current EFSF to a
that such subordination could hurt the prospects of permanent resolution mechanism, the ESM, by mid-
timely and full repayment of non-ESM sovereign debt 2013. The press stresses that Germany had to
and would likely lower recoveries on such non-ESM backpedal on this: a rescue would not necessarily mean
sovereign debt, since the share of preferred creditors in a contribution from investors; instead a case-by-case
the total debt stock will increase--all else being equal-- approach will prevail, depending on whether the country
in the transition from the EFSF regime to the ESM”. faces a liquidity or a solvency crisis. This is unlikely to
reassure investors: the politicisation of the process is
Moreover, “European policymakers might, in the midst hardly more appealing than its original rigidity.
of a future crisis, make uncoordinated and even
contradictory statements, potentially causing market Distinguishing between a liquidity and a solvency crisis
distortions and jeopardizing funding access of individual is a very political choice indeed. For now, the authorities
sovereigns” says S&P. seem to want to believe that today’s crises are more of
the liquidity type, even if the facts on the ground do not
substantiate this.
The law can change quickly too. Treaty changes in
Europe now look easier than before, given the new
flexibility afforded by Lisbon’s Article 48 (as explored by
Bruegel, and reviewed here).
31
S&P - Portugal A- Rating Placed On Watch Negative On Uncertainty
Regarding The Effects Of The Proposed EU Treaty Change
The ESM may be designed to rank ahead of private creditors in any future
debt restructurings beginning in 2013. As a result, debt that European
Monetary Union member states issue might not rank pari passu with debt
that the ESM issues. We think that this treaty change would represent a
move away from the original design of the EFSF.
We expect to resolve the CreditWatch within the next three months. If Portugal
does seek an external support program and if we believe private creditors will be
subordinated to public creditors, or if Portugal's fiscal or growth prospects
weaken further, we could lower the long- and short-term ratings.
If Portugal does not seek an external support program because of better-
than-anticipated fiscal performance or the passage of growth-enhancing
reforms, we would view the likelihood of it needing external official support 33
as reduced. As a result, we could affirm the ratings at A-. Also see Fitch on the same topic
https://www.globalcreditportal.com/ratingsdirect/showArticlePage.do?rand http://online.wsj.com/article/SB1000142405274870399490457564721213877
=mPhCQFDWD9&articleId=834436&from=MRA 7780.html
32 34
30 Nov 2010,
https://www.globalcreditportal.com/ratingsdirect/showArticlePage.do?rand http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofi
=9qH109Hkh2&articleId=835153&from=CR n/118050.pdf
24 December 2010
F27071
What should we make of the clear affirmation that EU We believe, like the authorities, that these proposals are
loans will enjoy preferred creditor status? Some see this .
reasonable and necessary to re-inject fiscal and
as a sharp contrast to current EFSF arrangements, investment responsibility into the system. But the re-
where EU loans are said to be pari passu with privatisation of the risk – whatever its form and pace –
government debt by some of the authorities and some likely will leave investors nervous.
investors. So investors are left with the risk that, if
It is thus necessary to take action that will reduce the
countries such as Greece and Ireland remain unable to
risk that investors all now rush to the exit (i.e. by selling
access wholesale funding, they would face costly
non-core debt or shutting funding to banks). At the
restructuring and/or new EU loans that would be senior
same time, for example:
to government debt at some future point.
- far more substantial ECB purchases would be one
In addition, we fear that these proposals could be option, and
added to or accelerated as circumstances dictate over - enlarging the umbrella would be another. In this way
35 investors might have some confidence for a while that
2011-12 . So re-profiling of European sovereign debt
may well come to be before 2013. Affirming the contrary further contagion might be addressed, and thus put off
currently is making it easier to pass legislation and a systemic crisis for a time.
helping to calm investor nerves. Restructuring might well This however does not change the underlying trend
be an option for the next 2 years, although ongoing access towards the alleviation of moral hazard. We will retain a
to EU/IMF funding makes that event less likely. Should the negative bias on the riskier sovereigns, at least until we
crisis spread further and become systemic, however, that see signs that specific actions are being taken - ECB
access might be in jeopardy. buying, enlargement of the umbrella - or until
If difficult decisions need to be taken, we do not see the courageous action improves the sovereign outlook -
logic in waiting until 2013 before taking them. austerity, or a haircut on senior bank debt.
Grandfathered debt would just acquire an unjustified
premium, and no one would buy new bonds with a ciaran.ohagan@sgcib.com
guaranteed haircut, unless they paid a yield in
36
compensation . We do not see either how a two-tiered
market could work. Making the new bonds (with
Collective Action Clauses) de facto junior to old bonds
would surely leave the weaker countries incapable of
accessing market funding.
Nor do we see it as much of a solution to offer lines of
liquidity – through the ESM – when solvency itself is the
key issue at stake, should there not be substantial
changes in policy. More liquidity will put off the day of
reckoning, and worse, raise moral hazard. So the sooner
the uncertainties are lifted, the better for everyone,
governments as well as investors.
35
What if a country goes bust sooner? Some lawyers note that nothing in
the outline of the ESM prevents the restructuring of debt issued before
2013. Lee Buchheit of Cleary, Gottlieb, Steen & Hamilton in New York
argues that countries could change their laws on domestic bonds to impose
collective-action clauses retroactively. All this makes restructuring more
likely {LCTMGF3T6SQO}
36
This is what the recent Bruegel report had to say about past attempts at
“private sector involvement”. “it was argued that private creditors had to be
‘bailed in’. PSI was the official response and was incorporated into IMF
policy, to the effect that, in the event of crises in which official (especially
IMF) money was used, private lenders should contribute to (be ‘involved in’)
crisis resolution. In the event, it proved difficult to achieve meaningful
private-sector involvement. When IMF lending was directed to financial
support in an effort to head off a crisis (by providing enough support so that
private lenders would be reassured and be willing to roll over loans and
perhaps provide new money), the very fear that the official sector would
attempt to require private lenders to roll over debt and/or extend additional
credits was likely to drive private lenders to reduce or eliminate their
exposure before such a requirement was set. It would simultaneously
precipitate the very phenomenon the IMF was trying to help the debtor to
avoid”. Pages 9/10
December 2010 25
F27071
Sovereign risk: a quantitative ranking
Our scoring models continue to outperform sovereign  What are the inputs and what has been updated?
agency ratings. The models take fundamental data from
the rating agencies, and the results continue to better
1. Debt criteria
correlate with ASW and CDS than ratings do.
- Budget deficits & gross debt (European Commission) –
DSL-Bund spreads are too tight according to our model.
we took the 2012 forecast. We hesitate to use gross
We recommend setting flatteners on non-core bond debt, as government balance sheets can now be very
curves, especially the PGB one. complex (particularly in the USA, UK, Ireland and Japan).
Notably, assets are ignored;
- The percentage ratio of government interest payments to
 Why do we score sovereigns? To obtain a ranking that
revenue (Moody’s): This is Moody’s fetish metric and
is understandable, can be rationalised and explains to
actually quite a revealing indicator, though it changes
some extent how the market is pricing sovereigns.
little from year to year;
Ratings are of course designed to summarise risk. But - Private debt (Eurostat): The sum of non-financial
investors do not understand why markets and ratings corporate debt and household debt, all as a % of GDP;
continue to diverge so widely and why ratings are adjusted
so late. - Percentage of government debt held abroad: Data
available from OECD for 2010.
Our rankings diverge sharply from the ratings - e.g. Ireland
is still rated Aa2 (negative review), yet it comes second to
last in our scoring. The agencies have clearly been too 2. Economic criteria
37
slow to adjust to fundamentals .
- Change in unemployment, 2009-2012 (EC): This
We take data from the rating agencies and from other
underscores a country’s vulnerability to the changes in
bodies, and examine how our rankings are correlated to
its economy, and is a key driver of welfare benefits.
asset swaps and CDS. We think the results are impressive.
Of course, summarising individual sovereign risk with any - GDP per capita (IMF): This gives us an idea of income
single number is oversimplistic, given the complexity of and wealth, which is vital to help explain a sovereign’s
public finances and the qualitative elements of criteria resistance to shocks (we use the IMF forecast for 2012).
such as the institutional context and fiscal flexibility. What
it does do, however, is provide a structure to frame our - Projected age-related spending as a share of GDP (see
38
more intuitive ideas on sovereign risk. S&P) : We switched the source from EC to S&P. We did
not see an update from EC. In addition, we used a
Our model for this publication uses the same criteria as the forecast as far out as possible: 2050.
last publication (Bond Outlook H2 2010), each of which
belongs to one of three categories: debt, economy or - A real harmonised competitiveness indicator “ULC in
bank. This allows us to see the impact of a change of data 39
total economy deflated” (see the ECB ). The latest data
on the scoring. available are for Q2 2010.
We updated our model with the new fresh data published
by Moody’s, S&P, the European Commission (European 3. Bank criteria
Economic Forecast – autumn 2010), and the IMF (World
- Contingent financial liabilities (S&P): Clearly of key
Economic Outlook Database October 2010).
importance. The figures look like an underestimate to us.
We use forecasts as far out as possible (if the data are
But we couldn’t find a better objective source for the
available) - often 2012, not current levels - in order to
same risk.
capture expectations.
- Banking Industry Country Risk Assessment (BICRA, S&P):
This is not highly discriminatory (the variable increases in
steps: 1, 2, 3, etc.) but is of key importance for us.
38
https://www.globalcreditportal.com/ratingsdirect/GlobalAging2010AnIrreversibleTrut
37
It was only on 30 Nov that S&P first mentioned the risk of subordination h.articlePDF
explicitly in putting Portugal on negative watch
https://www.globalcreditportal.com/ratingsdirect/showArticlePage.do?rand 39
http://sdw.ecb.europa.eu/browseSelection.do?DATASET=0&FREQ=Q&CURRENCY=Z
=mPhCQFDWD9&articleId=834436&from=MRA 57&CURRENCY_DENOM=ITL&node=6374972
26 December 2010
F27071
 What’s new in the results of the scoring? Graph 1. Scoring vs. 10-year ASW
Changing the criteria or updating data will produce slightly D

700 10Y ASW, bp
different results. However, with our criteria, no single GR
variable has huge influence. And they all make some sense 600 R² = 0.9855
to us. 500
The rankings are broadly similar to our last publication in IR
June 2010. The ranking remains the same for countries 400
with high scores (Italy, Spain, Portugal, Ireland and Greece, 300 PT
in that order). The Netherlands and Austria are joint third. 200
AAA France and AA+ Belgium are joint fifth, for the first IT
time (Table 1). 100 BE SP
FI GE AT average score
0
NE FR
Table 1: ranking results -100
2 3 4 5 6 7 8
EMU-11 EMU-11, UK, US, JP
Average Average
Score Ranking Score Ranking
Finland 2.09 1 2.55 1 Graph 2. Scoring vs. 5y CDS
Germany 2.64 2 3.00 2
D
Netherlands 3.91 3 3.91 3 950 5Y CDS, bp
Austria 3.91 3 4.00 4 850 GR
R² = 0.9807
France 4.00 5 4.00 4 750
Belgium 4.00 5 4.18 6 650
Italy 4.45 7 4.82 9 550 IR
Spain 5.27 8 5.64 11 450 PT
Portugal 6.18 9 6.18 12 350
250 BE IT
Ireland 6.82 10 6.73 13 SP
150 GE AT
Greece 7.91 11 7.91 14 FI
50 NE FR average score
UK 4.45 8
-50
USA 4.27 7 2 3 4 5 6 7 8
Japan 5.00 10
Graph 3. Scoring differential vs. ASW differential between

 Our scoring vs. market pricing two countries
Our scoring better reflects market pricing than ratings do. We D
match the results to ASW and CDS with a polynomial 300
function. The higher a country’s score, naturally the wider its ASW Diff.
GR-IR
ASW or CDS levels. Greece and Ireland are at the bottom of
our ranking and indeed trade at much cheaper ASW levels 200 IR-PT
than the other countries.
PT-SP
If we look at the position of each country compared with the 100 BE-FR
regression line, we come to much the same conclusions SP-IT NE-GE
whether using CDS or asset swaps. AT-NE IT-BE
0
Our model shows Portugal is slightly expensive and Italy FR-AT GE-FI Scoring Diff.
looks cheap. In addition, Belgium looks cheap relative to
France, Netherlands and Austria in asset swap terms (Graph -100
1). 0.0 0.5 1.0 1.5
In CDS terms (Graph 2), Ireland, Netherlands and France look

cheap (buy protection). In contrast, Belgium and Italy look Source: SG Cross Asset Research
expensive.
December 2010 27
F27071
Graph 3 compares the differential of scoring between two Recommendations

countries ranked next to each other and the differential of
their 10-year ASW. The ASW spread between DSL and Bund - Buy PGB/Bund 2020 spread vs. PGB/Bund 2014 spread
appears too tight relative to the large scoring differential. This around @ 0bp (ASW).
analysis also suggests that the GGB-IRISH spread is too
- Buy 10y Bund vs. DSL. The Bund 3% July 2020 is trading
wide. Finally, RFGB appear cheap relative to Bund. Finland is
at only -22bp (ASW) relative to DSL 3.5% July 2020.
penalised by the chronic lack of liquidity of RFGBs. However,
our model continues to score Finland no.1. Buy and hold - Buy and hold investors should continue to overweight
investors should continue to overweight RFGBs. RFGBs.
 Our relative value recommendation

Graph 4 shows that the IRISH/Bund and SPGB/Bund
spreads are inverted in the 4y-10y of the curve (-100bp and
-30bp respectively). That reflects the fear of investors that
they will be disproportionately haircutted on the short end.
That fear is legitimate (see the Sovereign Overview
section). So no surprise then to see that the inversion of
the IRISH 2014-2020 curve is far more pronounced than
that of the SPGB curve (Graph 4).
In contrast, the PGB/Bund curve is almost flat in the same
sector. We think that the PGB-Bund curve is abnormally
flat.
We therefore find that the potential for further PGB
cheapening is larger in the belly of the curve, given the
market should focus on the risks around late 2013/2014.
The PGB curve will thus flatten and invert if the sovereign
crisis deepens.
We recommend putting a flattener of the PGB-Bund
spread on the 2014-2020 part of curve.
Graph 4. PGB/Bund spread curve is too flat relative to both

the SPGB/Bund and IRISH/Bund spread curves
80
ASW , bp
60
40
20
0
-20
-40
-60 IRISH-Bund 2014/2020
-80 SPGB-Bund 2014/2020
PGB-Bund 2014/2020
-100
Feb-10 May-10 Aug-10 Nov-10
aro.razafindrakola@sgcib.com
ciaran.ohagan@sgcib.com
28 December 2010
F27071
Criteria for the model

Reflecting commonly used and forward-looking metrics by rating agencies
Debt Economy Bank
Levels in Real
projected harmonised
Change in Age- competitive
Gen.Gov. Unemploy related ness
Int.Pymt ment expenditu indicator
Public Gross / Private Gen. Gov Rates GDP per re as a ULC in total Financial
Deficit (% debt (% of Gen.Gov.R debt (% Debt Held (2009- Capita share of economy Cont.Liab
Denomination GDP) GDP) evenue GDP) Abroad % 2012) (USD) GDP deflated BICRA* /GDP (%)
Year 2012 2012 2011 Eurostat OECD 2009-2012 2012 2050 ECB 2010 2012
source E.C EC Moody's 2009 2010 E.C IMF S&P Q2-10 S&P S&P
Germany 1.8 75.2 8.4 96 50 -1.2 42.5 29.5 84.6 2.0 16
France 5.8 89.8 5.7 93 68 -0.3 42.0 31.9 101.5 1.0 19
Netherlands 2.8 67.3 5.5 135 70 0.6 47.6 28.2 105.2 1.0 35
Finland 1.2 53.0 2.8 90 44 -1.0 44.5 28.8 100.2 1.0 15
Austria 3.3 73.3 6.3 103 80 -0.8 44.7 29.6 93.3 3.0 30
Spain 5.5 73.0 7.9 172 40 1.2 30.3 28.6 110.9 3.0 32
Ireland 9.1 114.3 11.4 192 72 0.8 47.6 22.0 116.6 4.0 68
Belgium 4.7 102.1 7.3 64 60 0.8 44.2 32.8 102.3 2.0 16
Portugal 5.1 92.4 8.4 159 77 1.6 21.0 27.9 103.0 3.0 34
Italy 3.5 119.9 11.1 89 52 0.4 34.6 28.8 109.9 2.0 25
Greece 7.6 156.0 15.4 80 70 5.7 26.3 36.6 106.3 5.0 21
UK 6.4 86.6 6.3 212 30 0.2 39.6 23.7 81.0 3.0 41
USA 7.9 102.1 7.3 195 48 -0.3 50.0 18.5 81.0 3.0 35
Japan 6.3 199.0 9.7 193 7 -0.3 46.3 26.7 99.0 2.0 36
* Banking Industry Country Risk Assessments
Scoring results
Debt Economy Bank
Levels in Real
projected harmonised
Change in Age- competitive
Gen.Gov. Unemploy related ness
Int.Pymt ment expenditu indicator
Public Gross / Private Gen. Gov Rates GDP per re as a ULC in total Financial
Deficit (% debt (% of Gen.Gov.R debt (% Debt Held (2009- Capita share of economy Cont.Liab
Denomination GDP) GDP) evenue GDP) Abroad % 2012) (USD) GDP deflated BICRA* /GDP (%)
Germany 1 2 5 3 6 1 3 7 1 3 1
France 6 3 3 2 9 2 3 8 6 1 1
Netherlands 3 1 3 5 9 3 1 6 7 1 4
Finland 1 1 1 2 6 1 2 6 6 1 1
Austria 3 2 3 3 10 1 2 7 4 6 3
Spain 6 2 5 8 5 4 7 6 9 6 4
Ireland 10 5 7 9 9 3 1 2 10 8 10
Belgium 5 4 4 1 8 3 3 8 6 3 1
Portugal 5 3 5 7 10 5 10 6 7 6 4
Italy 3 5 7 2 7 3 6 6 9 3 2
Greece 9 8 10 2 9 10 9 10 8 10 2
UK 7 3 3 10 4 3 4 3 1 6 5
USA 9 4 4 9 6 2 1 1 1 6 4
Japan 7 10 6 9 1 2 2 5 6 3 4
December 2010 29
F27071
EMU-11 vs. factors selected for our scoring model
Fact 1 Public Deficit (% GDP) Fact 6 Change in Unemployment Rates (2009-2012)

Fact 2 Gross debt (% of GDP) Fact 7 GDP per Capita (USD)
ECO
Fact 3 Gen.Gov. Int.Pymt /

Gen.Gov.Revenue
DEBT
Fact 8 Levels in projected Age-related expenditure as a share of GDP

Fact 4 Private debt (% GDP) Fact 9 Real harmonised competitiveness indicator ULC in total economy deflated
BANK
Fact 5 Gen. Gov Debt Held Abroad % Fact 10 BICRA*

Fact 11 Financial Cont.Liab /GDP (%)
30 December 2010
F27071
Fact 1 Public Deficit (% GDP) Fact 6 Change in Unemployment Rates (2009-2012)

Fact 2 Gross debt (% of GDP) Fact 7 GDP per Capita (USD)
ECO
Fact 3 Gen.Gov. Int.Pymt /

Gen.Gov.Revenue
DEBT
Fact 8 Levels in projected Age-related expenditure as a share of GDP

Fact 4 Private debt (% GDP) Fact 9 Real harmonised competitiveness indicator ULC in total economy deflated
BANK
Fact 5 Gen. Gov Debt Held Abroad % Fact 10 BICRA*

Fact 11 Financial Cont.Liab /GDP (%)
December 2010 31
F27071
USD Markets
QE2 expectations remain front and centre in 2011
Changing expectations about QE2, not the actual SOMA Lastly, in the strong-form market hypothesis, by the time QE2
purchases, will be a main driver of interest rates in 2011 is confirmed, the entire effect of QE2 is already fully priced-in.
This hypothesis appears to reflect the realities of the market
best, in our view. During the five months prior to Bernanke’s
 Expectations of QE2, rather than the actual SOMA speech at the conference in Jackson Hole, 10-year rates
purchases, drove interest rates lower in 2010. Depending on dropped some 110bp. On the day details about QE2 were
assumptions regarding the market’s efficiency in pricing in released (3 November), 10-year yields were virtually
expectations, one can formulate three hypotheses: unchanged from where they traded during the Jackson Hole
1. Weak-form market efficiency hypothesis: Interest rates fall speech. By the time actual SOMA purchases were carried out,
on the day of SOMA purchases. yields were already some 30bp higher.
2. Semi-strong-form market efficiency hypothesis: Interest Graph 2: 10-year swap rate

rates fall on the day of the announcement of SOMA
purchases (3 November).
3.9
3. Strong-form market efficiency hypothesis: Interest rates
fall in anticipation of QE2 up to the point that QE2 is con-
firmed (27 August, Bernanke’s speech in Jackson Hole).
3.4 Buy-
The weak-form market efficiency hypothesis assumes that
%
backs
prices adjust at the time of the Treasury purchase (although
the approximate purchase amount has been known for days Jackson
2.9
or weeks already). There is little, if any, evidence supporting Hole
such a supposition. QE2
In the semi-strong-form market efficiency hypothesis, one details
2.4
would expect that the announcement of the details of the
SOMA purchase program on 3 November would cause a rally Apr M ay Jun Jul Aug Sep Oct N ov
in the market. While it is true that interest rates in the 4- to 7-
year sector rallied some 3bp on the day of the announcement
 The dynamic will remain the same in 2011. SOMA
and an additional 8bp on the following day, by the time the
purchases alone will create some relative value opportunities
first SOMA purchase was conducted, rates were 25bp higher.
along the Treasury curve, but fail to trigger a renewed leg
While there may have been a marginal “announcement
lower in interest rates. Changing expectations about the
effect”, it was dwarfed by the subsequent cheapening of
duration and extent of QE2, on the other hand, will push rates
Treasuries going into the actual buy-backs.
towards 2% in Q1 2011.
Graph 1: Cumulative change in 7yr swap rate since 11/1
The fact that the buy-backs have not triggered a significant
rally in the market has caused some frustration with investors,
Cumulative change [bp]
30 but constitutes a good buying opportunity for those who

believe that QE2 will last for longer than initially expected.
15
Recommendation
0 We expect QE2 to extend beyond what is currently priced into
the market and recommend Treasuries in the 5- to 10-year
-15
sector. Our Q1 2011 target for 10-year Treasuries is 2%.
01
02
03
04
05
06
07
08
09
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
Day of N ovember
Source: SG Cross Asset Research, Bloomberg, highlighted point marks SOMA purchase of 5/16 to
fidelio.tata@sgcib.com
11/17 Treasury paper on 15 November
32 December 2010
F27071
Elasticity of demand for Treasuries is rapidly declining
Treasury securities are now concentrated in the hands of  Price elasticity of demand. Price elasticity of demand
investors that are less price sensitive. As a result, large measures the change in demand for a change in price.
price fluctuations are possible. Elasticity of demand is high if a very small price fluctuation
causes a major reaction on the demand side; this was true
In the long run, Treasury yields could overshoot to the
for Treasuries when micro-arbitrage investors reacted to a
upside.
small change in relative value on an asset swap spread
basis. Elasticity of demand is low if demand is independent
on the current price level, as it is the case when the Fed
 From Treasury ownership of choice to one of necessity. executes SOMA purchases as part of the quantitative
A large class of relative value investors used to be owners easing program. When the elasticity of demand is low,
of Treasuries by choice. Treasury yields were closely linked large price fluctuations have little impact on demand. Put
to the LIBOR curve in the sense that the funding differently, large price fluctuations are possible without
40
differential explained most of the swap spread. When 30- major investor classes taking the “other side of the trade,”
year swap spreads turned negative in October 2008, causing a price reversal.
followed by 10-year spreads in March 2010, Treasuries
The problem is amplified by the fact that not only is the
essentially de-coupled from other investment classes and
elasticity of demand very low, but also supply of Treasuries
started to trade in their own universe. Treasury asset
is completely inelastic. This is because Treasuries are sold
swapping declined significantly, as a consequence. Real
in auctions where the Treasury is purely a price-taker.
money investors that used to like Treasuries for their carry
When an inelastic supply curve is met by an inelastic
and roll-down became less inclined to grow their Treasury
demand curve, small changes in demand cause a huge
portfolio when 2-year yields dropped below 1% in 2009
change in price (see Graph 2).
and traded as low as 0.33% in 2010. Replacing those
former owners by choice are increasingly owners by
necessity: Graph 2: Supply and demand curves
1. Foreign central banks placing funds deriving from the P

US current account deficit (roughly $380bn in 2008). A small change
S (Elasticity = 0)
in demand …
2. Foreign central banks buying Treasuries after exchange
rate interventions.
… causes a huge
3. SOMA purchases of Federal Reserve as part of
change in price.
quantitative easing ($850-900bn between Q4 2010 and
P0
the end of H1 2011).
P1
These are reluctant buyers of Treasuries, as they picked
Treasuries for a lack of practical alternatives, not because D (Elasticity very low)
yield levels looked attractive to them (see Graph 1). Q
Graph 1. Ownership of Treasury securities Source: SG Cross Asset Research
2000 2010
 Price volatility increasing. As a result of decreasing
elasticity of demand in Treasuries, Treasury yields have
Financials become more volatile compared to other asset classes.
Households One way to visualise this phenomenon is by looking at the
Financials Federal
Reserve
annual trading range (high minus low) of 10-year Treasury
Households
State and Business yields compared to that of 10-year swap rates (see Graph
Local Gov't State and
Local Gov't 3). In 2005, Treasuries were only 73.5% as volatile as 10-
Federal
Reserve Foreigners year swaps, when measured in their high-low range. Since
Foreigners then, Treasuries have become increasingly volatile relative
to swaps. In 2010 (YTD), Treasuries are 102% as volatile as
swaps.
Source: SG Cross Asset Research, Federal reserve
40
The difference between the interest rate of an uncollateralised loan
between banks (LIBOR) and that of a collateralised loan (general
collateral in a repo transaction) is one of the main reasons why
Treasury yields have historically been lower than swap yields.
December 2010 33
F27071
Graph 3: Annual range of 10-year Treasury and 10-year swap

yield
250 TSY
200 Swap
High - Low [bp]
150
100
50
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
 Volatility is a double-edged sword. While a low

elasticity of demand has caused yields to overshoot in the
rally, there is an equally significant risk of an accelerated
increase in Treasury yields once demand for Treasuries
slows down. While this is not an immediate threat, given
the ongoing SOMA purchase program and continuing
buying from foreign investors, in the long run Treasury
yields could move higher very quickly. We expect a roughly
100bp increase in 10-year Treasury rates in 2011 (from 2%
to 3%).
Recommendation
Once 10-year Treasury yields have entered the 2%-2.3%
trading range, start establishing 50-100bp OTM high-strike
protections. For example, buy 75bp OTM 1-year-into-10-
year swaption payers for roughly 800bp once 10-year
Treasury rates moved below 2.3%.
34 December 2010
F27071
Carry is King
Comparing carry and roll-down to the P/L of the worst Table 1. Month of carry and roll-down destroyed by
month in 2010, the 2-year point looks most attractive most adverse 1-month move in 2010
We recommend LIBOR-OIS convergence trades to benefit 1-year 2-year 5-year 10-year 30-year
from roll-down in 2011
Avg. 1m carry & roll 5bp 6bp 6bp 4bp 2bp
Worst 1m move -30bp -21bp -37bp -55bp -58bp
“Lost” months 6 3.5 6.2 13.8 29
 Hunt for carry and roll-down. 2010 was a difficult year
for investors seeking carry and roll-down. The back end of
the yield curve exhibited dramatic movements that caused
significant mark-to-market volatility. In October and
November alone, TSY 10s30s slope moved from 120bp to This analysis highlights why many investors were drawn to
160bp and back to 135b. The 30-year point on the curve the front end of the yield curve. The 2-year point turned out
has essentially become an asset class in itself. The belly of to be the least risky investment under the risk framework
the curve was hardly any more predictable. The concen- presented here. The most attractive carry and roll-down
tration of SOMA purchases in the 4- to 7-year part of the opportunities often present themselves in parts of the yield
curve caused that sector to be everyone’s darling during curve where the absolute yield level is actually very low.
the rally of Q2 and Q3, but quickly turned into the location
of maximum pain once the sell-off materialised in Novem-
ber.  Convergence in LIBOR-OIS. The LIBOR-OIS is a good
The very front end of the curve, widely considered to be measure of financial market stress. It is widely immune to
well behaved due to being “anchored” by a Fed on perma- changes in the general level of interest rates, as those
hold, is not exactly a sweet spot either. With yields as low affect both LIBOR and OIS. Typically, spot LIBOR-OIS
as 33bp at times and an unexpected 50% jump higher spreads only widen doing actual banking crises, while
within two weeks in November (to 52bp), there is hardly forward LIBOR-OIS spreads are always significantly higher
any stability either. Many market participants chose to than spot, reflecting the potential of such crises in the
move to the sidelines in 2010. This will not be an option for future. Forward LIBOR-OIS spreads offer exceptional roll-
2011, as minimum return requirements will force many down. This is illustrated in Graph 1, which depicts how the
investors to aggressively look for carry and roll-down 3-month LIBOR-OIS spread to the December IMM date
41 moved from 25+bp at the beginning of September to sub-
opportunities.
15bp levels in December.
Looking ahead, the steepest roll-down in LIBOR-OIS is
 Carry and roll-down offers only marginal protection now realized to the March 2011 IMM forward date (see
against adverse market moves. The main problem with Graph 2).
carry and roll-down trades is that adverse market
movements often create mark-to-market losses that offset Graph 1. 3m LIBOR-OIS spread, spot and forward (1)
many months of expected carry and roll-down. This is
shown in Table 1, in which we compare the average 35 Forward
monthly carry and roll-down of an investment into a 1-, 2-, to Dec
5-, 10- and 30-year swap with the most adverse 1-month 30
IM M date
move (incline) in interest rates. The ratio between those 25
8-Sep
Spread [bp]
two quantities gives us the number of months for which

carry and roll-down has been lost. 20 2-Sep
15 2-Dec
The most adverse move in 1-year swap rates destroyed
10
half a year of carry and roll down. For the 10-year point on
the curve, more than one year of carry and roll-down was 5
eliminated in the worst month. The most risky point on the Sep-09 Dec-09 M ar-10 Jun-10 Sep-10 Dec-10
curve was the 30-year, where 2½ years of expected carry
and roll-down were wiped out in a single month.
41
For example, most of the state-sponsored pension plans use an 8% discount rate for
their future liabilities. If the realized return of a plan is below this ambiguous implicit yield
target, the plan’s shortfall increases.
December 2010 35
F27071
Graph 2. 3m LIBOR-OIS spread, spot and forward (2)

40
35
30
Spread [bp]
25
20
15
10
5
Sep-09 M ar-10 Sep-10 M ar-11 Sep-11
 Unless a global banking crisis causes a spike in spot

LIBOR-OIS, roll-down on the March 2011 IMM forward
spread is almost 10bp/month. We view this as one of the
best roll-down opportunities in the USD market. As
detailed in a recent trade idea, the maximum downside of
spread widening on the back of a potential banking crisis
can be limited by spending half of the expected roll-down
on Eurodollar puts.
Recommendation
Receive LIBOR-OIS spread to March 2011 IMM date at
29bp. Target 15bp to March, stop-out at 40bp. Limit
downside with Eurodollar puts.
36 December 2010
F27071
GSEs: No reforms soon
Neither a quick privatisation nor a return to a funda- Graph 1. Flow of funds from June 2007 to June 2010
mentally flawed business model is an option for GSEs.
Corporate bond issuance
Government ownership is here to stay for 2011 and maybe +0.9tr
Corporates CP issuance
beyond. That’s good news for holders of GSE paper. Bond issuance
-0.1tr
+0.8tr
Banks CP issuance
+0.1tr
ABS issuance
 GSEs are one of the unsolved issues of the crises of
ABS -1.8tr
the past years. The vast majority of issues that led to the
great financial crisis have been dealt with by now. Debenture & MBS
GSEs +0.9tr -0.4tr
Investment banks defaulted, merged or converted to
commercial banks: the auto industry got back on its feet +1.3tr
after significant government support; financial oversight
was put in place to limit reckless financial practices. Fed
-0.01tr
Still to be addressed is the future of the government-
sponsored enterprises (GSEs). While the two largest GSEs,
Fannie Mae and Freddie Mac, used to be privately owned, Treasury +3.7tr +3.7tr
putting them into conservatorship in 2008 effectively
Σ = +3.2tr
nationalised the US housing market.
The costs of the GSE bailout to the taxpayer are massive.
We estimated that the cumulative commitment until 2013 is Source: SG Cross Asset Research, Federal Reserve
to the tune of $224-$360bn. Unlike the government’s
support to the private banking and automobile sector, little
of those funds will be returned.  The end for a fundamentally flawed business model? It
is now widely agreed that the traditional GSE model failed
The Treasury Secretary is required (under the Dodd-Frank precisely because of the inherent incentive to monetise the
Act) to deliver a GSE reform proposal to Congress in implicit government guarantee. At times, the GSE business
January 2011 (the Obama administration already missed resembled that of a hedge fund. While we believe that
out on its promise to deliver proposals by April 2010). The GSEs will continue to play a critical role in the
major differences between the Democrats and Republicans securitisation and guaranteeing business of mortgages,
on what role the government has to play will now likely they will ultimately be prevented from holding large
complicate the process. investment portfolios and from promoting the affordable
43
 Too big to privatise right away. One possible proposal housing agenda.
for the GSE reform is a complete privatisation of Fannie
Government ownership. With both alternatives of full
Mae and Freddie Mac. However, this scenario is not likely
privatisation and a return to their private-public form
to play out any time soon, given the sheer size of their
impracticable in the short run, the default situation of full
portfolio. Currently, Fannie and Freddie own or guarantee
government ownership remains the most likely scenario for
close to $5tn of the $11tn US mortgage market.
2011, in our view. While the government’s involvement is
An attempt to put such a massive portfolio back into the one of great reluctancy, the lack of any credible exit
private sector would dwarf all major capital flows the strategy makes the taxpayer the sole owner of the GSEs
market has experienced during the financial crisis (see for some time. As time drags on before reforms are
Graph 1). Besides the portfolio’s gigantic size, the potential tackled, that raises the contingent liability for the US
for further losses would likely scare away private investors. taxpayer. But that cost is likely to manifest itself beyond
Without an implicit (or explicit) government-guarantee, the 2011. For 2010, government ownership is a positive for
private sector is not likely to catch a falling knife. holders of GSE debenture.
There is also growing dissension between the exercise of Recommendation
the GSE’s mission and other financial firms, notably banks 42.
This will continue, but should not impact pricing in 2011. In a bull-flattening scenario, Agencies offer good value to
investors seeking a yield pick-up. We recommend FNMA
We believe that it will take many years for private sector and FHLMC paper in the 5-year sector that trades close to
players to slowly increase their engagement, before the LIBOR-flat.
GSEs have a chance to progressively withdraw from the
market. fidelio.tata@sgcib.com
42 43
See, for example http://www.bloomberg.com/news/2010-11-30/banks- See, for example, http://economics21.org/commentary/whither-
in-u-s-resisting-calls-to-repurchase-fannie-mae-freddie-mac-loans.html fannie-and-freddie-proposal-reforming-housing-gses
December 2010 37
F27071
EUR Markets
Bank stress means ECB can’t pull the plug
Our economists see no hike from any of the G4 central Some of the non-core banks cannot access the market,
banks in 2011. and are left with no choice but to tap the ECB. The ECB is
not pleased, and has warned those banks that they cannot
Banks remain dependent on ECB liquidity, which will
dependent on it ad vitam eternam. The ECB reportedly put
remain ample in H1. Q2 ECB meetings will be repriced
pressure on those banks last summer to find alternative
lower still.
funding routes. This worked to some extent, with Spanish,
We are biased towards larger EUR Bor/Bor bases for now. Portuguese and Greek banks all reducing their borrowing
Flattening basis trades offer good risk-reward. from the ECB from July to October. But the reliance of Irish
banks increased. The sovereign crisis will undoubtedly
have made the matter worse. Typically, the Greek finance
 ECB just cannot pull the plug ministry in early December 2010 allocated a further €20bn
On 2 December the ECB 44 announced the continuation of ($26bn) of state guarantees to the banks, so that they can
its full-allocation fixed rate tenders into Q1. It will conduct use them as collateral for funding by the ECB.
its Main Refinancing Operations at fixed rate and full
allotment for ‘as long as necessary, and at least until the  Forward ECB meetings too high still over H1
end of the third maintenance period of 2011 on 12 April
2011’. Same for the 1-month tenders, at least until the end The curve of ECB meetings over the coming year is
of the first quarter of 2011. Additional 3-month tenders remarkably linear (Graph 2). We find this surprising. In
(LTROs) will be allotted on 26 January, 23 February and 30 particular, the positive slope over H1 is such that June is
March 2011 as fixed (indexed in this case) rate tender still trading nearly 15bp above the January meeting. With
procedures with full allotment. the ECB running full allocations till the end of Q1, liquidity
is likely to remain ample into the middle of the year. At
This hardly comes as a surprise, given the nasty 0.855%, June is pricing excess liquidity at just €15bn, our
developments in sovereign markets in late November, and model says (Graph 3). This looks too pessimistic.
signs of contagion towards the bank funding markets.
Graph 2. Pricing of next 12 ECB meetings
Graph 1. Sovereign crisis leads senior bank spreads up
Source: SG Cross Asset Research Source: SG Cross Asset Research
This fits our view, indeed, that a segmented funding market

leaves a number of banks dependent on ECB funding. We thus like to receive June outright, at 0.855%, with a
target around 0.70% (implying excess liquidity around
€40bn). Needless to say, the trade would do even better in
44
2 December 2010 - ECB announces details of refinancing the (still unlikely) case that the ECB finally embarks on QE
operations with settlement from 19 January to 12 April 2011 to support the sovereign bond market. The ECB has said
http://www.ecb.int/press/pr/date/2010/html/pr101202_1.en.html they disassociate the liquidity and rate tools, i.e. they may
38 December 2010
F27071
raise rates before they unwind their exceptional Eonia/BOR bases wider (BOR less reactive). In this case,
operations. That looks very unlikely for the near future, however, QE would cause relief and likely push the bases
however, given that since December they no longer see tighter.
the inflation risks skewed to the upside.
Overall, the outlook for bases looks uncertain. But we need
For now we also like to receive June vs Jan at 15bp, with to see decisive action from policy makers, which does not
January being at risk of nervous trading after the large penalise the banks, before we can be biased towards
expiry of 23 December. Or receive June vs Jan and Nov, at tightening. We venture into tightening trades only when
flat. The ECB is not committed to full allocation tenders carry is tempting, and with some precaution (hedging the
beyond Q1, so once the March 3-month tender matures, crisis risk) – see our US section.
excess liquidity in the system may diminish. This should
In EUR, we continue to favour widening trades for now.
make the ECB meeting curve steeper over H2 than H1.
The widening of the Bor/Bor basis complex has been
Graph 3. Link between excess liquidity and EONIA naturally more severe at the front end, as stress on bank
risk has made term funding more difficult (especially with
the ECB no longer running 6-month and 12-month
tenders). That being said, the 1Y-5Y Bor/Bor slopes have
been remarkably resilient – flattening trades still offer good
risk reward. Our preference is for the 1Mv6M bases (rather
than 3Mv6M) but liquidity may require a split of that trade
(1Mv3M and 3Mv6M).
Graph 4. 1Y-5Y 1Mv6M basis flatteners offer good risk-

reward
 Cheap widening basis trades still available

As we argue in other sections (Editorial, Sovereign), one
way to relieve pressure on weak sovereigns would be to
free them up from the potentially enormous costs
associated with bank rescues. This can be done in two
ways:
1) by imposing haircuts on senior bank debt holders, or
2) by setting up a European rescue fund for banks.
The two solutions would have dramatically different
Recommendations
impacts on the market. Haircuts on senior debts were
reportedly ferociously opposed by the ECB – they would Receive February meeting at 0.85%, target 0.70%, stop
cause immense stress in the whole European bank funding 0.92%.
markets and lead the basis complex (OIS/Bor, Bor/Bor)
much wider. A TARP-like fund for banks, instead, would Or receive Feb vs Jan and Nov at flat, target -10bp (net
most likely ease stress in bank funding markets, if it could spread), stop +5bp.
be done without causing a systemic crisis among
Buy EUR 1Y 1Mv6M basis vs 5Y 1Mv6M basis at +5bp,
sovereigns (as they throw more money at the system).
target 20bp, stop flat (this may need to be split equally
What about massive government bond purchases by the between 1Mv3M and 3Mvs 6M, for liquidity reasons).
ECB? The large liquidity injection would push term Eonias
to the downside (unless the ECB sterilises those
purchases). Falling term Eonias have tended to push vincent.chaigneau@sgcib.com
December 2010 39
F27071
EUR curve – trapped in one dimension
EUR 2-10y curve will remain driven by the long end in H1  Driven by the long end. The EUR yield curve tends to
2011, possibly longer. steepen in a bear market and flatten in a bull market
(Graph 2), as short rates remain less volatile than long
Our bullish directional scenario suggests targeting 100bp maturity rates. Over the last six months, almost 80% of
for the EUR 2-10y in early 2011.
daily moves in the EUR 2-10y spread were driven by the
In outright swap terms, we now prefer 2-5y flatteners. We long end – a record since 1999.
also recommend selling OTM 6m2y payers to finance
6m10y receiver spreads. Graph 2. EUR 2-10y spread directionality index
The belly will outperform the wings in a rally: so we still like EUR 2-10y curve directionality index
buying 5y receivers against 2y and 10y. 1.0
0.9 bull-steepening / bear-flattening
0.8
 EUR curve – trapped in one dimension. For almost two 0.7
years now, yield curves in major currencies – and EUR in 0.6
particular – have been dominated by moves in long- 0.5
maturity rates. Despite its progressive exit from 0.4
unconventional liquidity-providing measures, the ECB is far 0.3
from considering monetary tightening. This is “anchoring” 0.2
the front-end of the EUR curve at the current low levels. 0.1 bull-flattening / bear-steepening
This picture is unlikely to change in H1 2011.
0.0
The common trend in different EUR curve spreads remains Jun-99 Jun-01 Jun-03 Jun-05 Jun-07 Jun-09
particularly strong and is highly correlated with bond
market direction. The first principal component of weekly Source: SG Cross Asset Research. The index shows the relative strength of daily 2-10y bull-
changes in 2-5y, 5-10y, 1-10y and 5-15y slopes accounts flattening/bear–steepening moves vs bull-steepening/bear-flattening with a 6-month rolling
period. A value above 0.5 means bull-steepening/bear-flattening (curve driven by the front-
for almost 85% of all moves observed over the past six end), a value below 0.5 means bull-flattening/bear–steepening (curve driven by the long-
months. This level is at the high-end of the historical range, end).
significantly above the 73% average (Graph 1). This
principal factor remains strongly correlated with changes
Curve to remain directional – at least in H1 2011, possibly
in the 10-year swap rate (correlation of 84% compared to
longer. For given Refi rate expectations, possible moves in
historical average correlation of 14% only). Graph 1 shows
Eonia (related to fluctuations of excess liquidity in the
that this correlation has never been higher since 1999.
European money market) are insufficient to generate
Graph 1. EUR interest rate curve still essentially driven enough volatility for the 2-10y swap curve to become
by just one factor: bond market direction durably driven by the front end. Only a significant change
in monetary policy expectations would alter the current
Explanatory power, % Correlation directionality of the EUR yield curve. In the current context
100 1
of escalating sovereign debt crisis, the market is unlikely to
90 price in the near term any significant monetary tightening
0.5 in the coming years. This excludes bear flatteners. The
80
market is also far from considering another extreme
70 0 scenario – i.e. an additional significant monetary easing.
60 Even in this case, any surprise bull steepening, if any,
-0.5 would be temporary and limited.
50
 Scenario analysis for EUR 2-10y. If the market prices
40 -1 Eonia/Refi normalisation in Q2 2011 and a beginning of
Jul-99 Jul-01 Jul-03 Jul-05 Jul-07 Jul-09 rate hiking in late 2011 – the EUR 2y rate may increase
towards 2.00% in Q1 and 2.15% in Q2. On the other hand,
Explanatory power of the first curve PCA factor
no Eonia/Refi normalisation until late 2010 and rate hikes
Correlation between the factor and 10y rate expected from mid 2012, would suggest the 2y swap rate
Source: SG Cross Asset Research. The graph shows the explanatory power, in %, of the first remaining around 1.60/1.70% in H1 2011. Finally, ample
PCA (principal component analysis) factor applied to weekly changes in EUR swap 2-5y, 5- liquidity conditions until Q2 2012 (with Eonia trading on
10y, 1-10y and 5-15y slopes, with a rolling observation period of 27 weeks (i.e. around half a average 25bp below the Refi rate) and no rate hikes for the
year). Correlation between this first PCA factor and weekly changes in EUR swap 10y rate is
computed over the same rolling periods. foreseeable future, mean targeting the 1.30/1.35% level for
EUR 2y rate between now and June next year. In the first
case, an over-simplistic extrapolation of last year’s
40 December 2010
F27071
correlation would suggest a risk of bear steepening up to  Trade recommendations. EUR 2-10y flatteners are
170/180bp for the 2-10y. This is definitely not our central slightly carry and roll-down negative. Moreover, bull
scenario – and thus we are willing to sell a cap on the 2- flatteners are costly, as 2y rates volatility is lower than 10y
10y spread. On the other hand, our directional scenario of rates vol. In outright swap terms, we now prefer 2-5y
10y Bund yield moving below 2% in early 2011 suggests flatteners – roughly neutral in terms of carry and roll-down.
that the EUR 2-10y may well challenge a break below the In line with our bullish scenario for Q1, we target 2-5y
100bp level. flattening to 40bp.
 Directionality strength is not uniform in different Sell OTM 6m2y payers to finance 6m10y receiver spreads –
segments of the yield curve. All the segments of the EUR zero-cost. Given the scenario analysis above, we
swap curve have been on average dominated by the long- recommend selling EUR 6m2y payers strike 2.15%
end over the past months. The strength of directionality (ATMF+33bp at the time of writing) to finance PV01-
varies however between different curve sectors (Graph 3). weighted amount of 6m10y receiver spreads strikes
In particular, 5-10y and 10-30y spreads are less directional ATMF/ATMF-25bp (the whole structure is close to zero-
than 2-5y and 2-10y. So a bond rally we expect for the cost – indicative).
coming months will very likely flatten the 2-5y spread more
Buy 5y receivers vs the wings. The evolution of the 5y
than the 5-10y.
swap rate has explained 92% of the 2-5-10y fly variance
Graph 3. EUR swap curve directionality, by sector for the last year (Graph 4). Buying 5y receivers against the
wings was one of the well-known performing trades this
1.0 year – in EUR and in USD. Receiving 2-5-10 remains
EUR swap curve directionality index
moderately carry and rolldown positive. With a 3-month
0.9
expiry, a conditional 2-5-10y fly via ATMF receivers can be
0.8 1M done close to zero-cost (indicative). Given the directionality
bull-steepening / bear-flattening
0.7 6M of the fly, the risk/reward of the trade is very attractive. If
0.6 the market turns bullish again in the coming months, as we
0.5 expect, the trade will make money as long as the 2-5-10y
0.4 bull-flattening / bear-steepening fly is at expiry below its current 3m fwd. If we are wrong
with our scenario on rates and bonds continue selling off,
0.3
all the receivers of the trade will expire out of the money.
0.2 This trade also avoids being exposed to some unexpected
0.1 panic rally in the 30y segment.
0.0
2-5y 2-10y 5-10y 10-30y Graph 4. EUR 2-5-10y: buy 5y receivers vs the wings
Source: SG Cross Asset Research. The index shows the relative strength of daily bull- bp %
flattening/bear–steepening moves vs bull-steepening/bear-flattening over last one month 30 3.2
and six months.
20
2.8
The 5-10y and 10-30y spreads also tend to bear-flatten 10
more easily at this stage of the cycle – in the event of any 2.4
optimistic repricing of medium-term growth prospects and 0
medium-term rate hike expectations (like in the second half
of October). Moreover, the value of convexity increases 2.0
-10
when the rates outlook becomes more uncertain. So higher
rates volatility tends to flatten the 10-30y spread relative to -20 1.6
the shorter end of the curve. This is one factor which Nov-09 Mar-10 Jul-10 Nov-10
prevented the 10-30y spread from steepening in last
November’s sell-off. 2*5Y - 2Y - 10Y 5Y
 Belly to outperform the wings in a rally. Weaker Source: SG Cross Asset Research.
directionality of 5-10y and 10-30y spreads as compared to
2-5y and 2-10y just implies yet another directional
behaviour … the one of flies, like 2-5-10y or 2-10-30y, or Recommendations
condors (2-5y/10-30y). The belly tends to outperform the EUR 2-5y flatteners above 80bp, target 40bp, stop 95bp,
wings in a rally and underperform them in a sell-off. carry and rolldown +2.5bp/3M.
The 5-10-30y, on the other hand, continues to follow rates Sell €100m 6m2y payers ATMF+33bp, buy €22.5m 6m10y
volatility. The 10y segment tends to underperform 5y and
ATMF/ATMF-25bp receiver spreads, zero-cost (indicative).
30y when volatility increases (we had four such episodes in
2010: early February 10-30y jitters, April/May Greek crisis, Buy €100m 3m5y ATMF receivers, sell €125.5 3m2y ATMF
end-August rally, second wave of European debt crisis in receivers and €27.1m 3m10y ATMF receivers, zero-cost
November) and outperform 5y and 30y when rates volatility (indicative).
fades.
adam.kurpiel@sgcib.com
December 2010 41
F27071
What outlook for eurozone issuance?
We will see a sharp fall in net bond issuance as austerity Graph 1. Budget deficit forecast for 2011 (EC)
begins to bite somewhat. Gross issuance however will
remain elevated. 0.0 BE
AT
Sovereigns would prefer to issue more on the long end in -0.5 dow nward
change vs. 2010, pp

GE revision
2011 if demand can be tapped. -1.0 IT FR
FI
-1.5
NL GR
 Lower deficit forecasts will lead to falling net bond -2.0
PT
issuance. However, gross issuance will decline by less as -2.5 SP
redemptions remain large. Table 1 collates the figures -3.0
currently being presented in the different national budgets
when they are available (otherwise they are forecast from -3.5
the European Commission), listing redemptions, net 1 2 3 4 5 6 7 8
borrowing or budget deficit, gross funding needs and an Def. % of GDP (2011)
estimate of gross bond issuance for 2011 compared with
2010.
Source: SG Cross Asset Research / European commission
In terms of budget deficits, most countries fall into the 3- Table 1: EMU-11 funding needs for 2011
7% area. Ireland stands out as an exception (and that is
Gross
before factoring in supplementary bank support). If we add Central gvt
Budget Funding
Only
Bond Deficit / BOND change
deficit to redemption, we estimate total gross funding 2011 Redemption New
Deficit % needs,
Issuance vs 2010
needs for EMU-11 at €917bn. This amount will be revised in €bn borrowing
of GDP excl.
for 2011 (€ bn)
(EC) Bills Roll
lower given the pre-funding of some Treasuries in late 2010 in €bn
in €bn
(estimate)
(France and Belgium, for instance). (a) (b) (a+b)
Austria * 10 9 3.6 % 19 19 -1
How many bonds will be sold? We forecast €809bn of Belgium 28 14 4.6% 42 37 -2
bond issuance, assuming Greece, Ireland and Portugal do Finland 8 6 1.6% 14 11 -3
France * 97 92 6.3% 189 186 -2
not issue bonds in 2011. Germany * 147 48 2.7% 196 196 -11
Greece 29 17 7.4% 46 - -
Ireland will need some €23.5bn and Portugal €18bn on a full- Ireland * 7.5 16 10.3% 24 - -
year basis (Ireland’s number is larger despite lower Italy 162 67 4.3% 229 225 -25
redemptions and a much smaller population, and a good Netherlands * 28 23 3.9% 51 51 -1
Portugal 9.6 9 4.9% 18 ? ?
deal of bank funding needs are not covered by this Spain * 47 43 6.4% 90 84 -9
estimate). Hence the EFSF, EFSM and IMF would need to Total EMU -11 573 917 809
inject at least €41bn the first year. We estimate €14bn will (a) : bond redemption including FRN, Foreign currencies, other …
come from EFSF for 2011. Overall, we estimate total gross Ireland redemption includes 3.1bn of bank's Promissory Notes
(b) central government deficit or ,new borrowing estimate
bond issuance at €823bn (including EFSF), down by 9% * central government deficit : Official announcement
compared with 2010. Bund issuance will be higher if Soffin redemption will be funded by bond issuance
Source: SG Cross Asset Research/ European commission
Italy will see a good fall in bond sales thanks to the
combination of lower redemptions (especially BTPs) and Graph 2. Lower net issuance in 2011
an improvement in its deficit. However, we note that Italian
redemptions will increase in 2012.
1000 Gross bond 500
In terms of net issuance, we estimate €267bn. That is issuance, 450
down 32% compared with 2010. This improvement reflects 900 EUR bn
400
the countries’ efforts to cut their budget deficits. For
example, France plans on only €89bn of net bond issuance 800 350
(€186bn of gross issuance less €97bn of redemptions) in 300
700
2011 compared with €105bn in 2010. This is a €16bn 250
decrease or 15%. Net borrowing is also expected to 600
decline in Spain and Germany with €43.3bn (-43.6% Net bond 200
compared with 2010) and €48.4bn (from an initial estimated issuance, 150
500
at €55bn), respectively. EUR bn 100
400 50
99 00 01 02 03 04 05 06 07 08 09 10 11
42 December 2010
F27071
Debt roll-over to remain high in coming Graph 4. Redemption profile for 2011-2015
years 700
Portugal
 There will be more debt to roll over in the coming years. 600 Ireland
Governments have sold ever larger quantities of bills of Spain
late. At the same time, bond redemptions will be high on 500
the whole in 2011. Netherlands
400 Italy
Our calculation of the rollover ratio is very simple. We
estimate redemptions in 2011, including bills, and calculate Greece
300
the ratio relative to total debt (just treasury debt, not bank
Germany
guarantees).
200
We remain worried about the US as its 2011 rollover ratio is France
likely to be well above 30%. But should investors be Finland
worried about Europe too? 100
Belgium
The Netherlands and Finland have the highest rollover 0 Austria
ratios in Europe (see Graph 3). In 2011, the outstanding 2011 2012 2013 2014 2015
number of bills will be very large in both countries.
- Austria’s rollover ratio is below 10%, reflecting low Source: SG Cross Asset Research
outstanding bills (only €4.2bn).
Graph 3. Rollover ratio estimates for 2011 (EMU-11, US, UK)

What kind of debt will be sold in 2010?
35%  We see stronger issuance at the long end than the

short end. In 2010, issuance rose in the 10y sector and fell
30% in the 1-3y area (see Graph 5). This should continue in
2011. In 2010, issuance in the 8/11y and 12y+ sectors
25%
totaled €264bn and €131bn respectively, up 18% and 5%
20% compared with 2009. In contrast, 1/3y issuance was down
by 10% compared with 2009.
15%
Graph 5. Higher issuance at the long end than the short
10% end in 2010, which could remain the case in 2011.
5% EUR bn
300
0%
US JP NE FI GE FR SP BE IT PT GR UK IR AT 250
Sources: SG Cross-Asset Research, Bloomberg.

200
150
100
Graph 4 shows the debt outstanding in the eurozone (all
bonds included). It shows redemption levels will be higher in 50
2012 than 2011 (we forecast €630bn in 2012 or +10% 0
compared with 2011). The current outstanding of 2013, 2014 1/3Y 4/7y 8/11Y +12Y Infla FRN
and 2015 will also increase with bonds issued over the next
2009 2010
few years. Redeemable debt will be close to €575bn in 2013,
assuming €100bn of 2y bonds are issued in 2011. Sources: SG Cross-Asset Research, Bloomberg
 Longer average duration. Some issuers said they will

45 46
extend their duration in 2011, e.g. Italy and Belgium . So
the duration and outstanding amount of euro-denominated
government bonds should continue to increase in parallel.
Graph 6 shows the outstanding value of the EFFAS index is
just below €4,000bn, up from €3,250bn in 2009. As for
average duration, it has increased from 6.25% to 6.5% in
2010.
45
{LAXUOD3V2800}
46
{LAXUQW3V2800}
December 2010 43
F27071
Graph 6. EFFAS Index

Inflows remain high in 2011
€ bn %
4000 7.00
 Avalanche of issuance in Q1 2011. We expect front-
3750 6.75 loading to continue in 2011 with the launch of a new line by
the EFSF. Issuers should profit from large coupon
3500 6.50
payments and redemptions to issue new benchmarks.
3250 6.25 Moreover, we expect above-average inflows in March
3000 6.00 mostly thanks to CTZ and GGB redemptions. Overall, we
forecast €191bn in Q1 2011 up from €184bn in Q1 2010.
2750 5.75
New RAGB and BGB benchmarks might be launched by
2500 5.50 syndication in January 2011. In January 2010, we saw the
Nominal Value
2250 Average duration 5.25 syndicated launch of five new bonds from Austria (€4bn of
7y), Belgium (€5bn of 10y), Spain (€5bn of 10-year), Ireland
2000 5.00 (€5bn of 10y) and Greece (€8bn of 5y).
00 01 02 03 04 05 06 07 08 09 10 11
Sources: SG Cross-Asset Research, Bloomberg. Graph 7. Above-average inflows in January, July and
September.
Inflation-linked bond issuance also rose strongly, up around 140 Inflows - bln
40% compared with 2009. By contrast, we saw a fall in FRN-
type products. 120
100
 Why a longer duration? One reason is to reduce rollover
80
risk, given the eurozone’s troubles. The large outstanding
at the short end (Graph 4) reflects this. Also the flattening 60
of the curve in 10s30s pushes issuers to issue at the long 40
end, if they can find buyers.
20
We expect strong issuance of 15- and 30-year bonds (or
0
longer) in 2011. However, this will all depend on whether the
J F M A M J J A S O N D
funding markets remain open and the sovereign crisis gets
worse. Av erage 2008-2010 2011
- The Belgian agency plans to launch a 10-year bond and a Source: SG Cross Asset Research
15- to 20-year bond in 2011.

- A new 30-year BTP is possible as the current benchmark -
the BTP 5% Sep. 2040 - already has a large outstanding.  EUR bond indices will see their duration increase in
January, April, July, September and October. During these
- A new 30-year RAGB is also likely as the current periods, durations will extend by around 0.15 year.
benchmark – the RAGB 4.15% Mar. 2037 - is no longer a
true 30-year benchmark. Inflows will reach a year high in July at €122bn of which
€34bn of coupon payments and €88bn of redemptions. This
Other countries with 2041 and 2042 benchmarks will likely is in line with the average. Over the last two years, in July,
reopen them in early 2011. For instance, we expect a Bund spreads narrowed strongly thanks to large reinvestment
2042 tap in January. flows.
44 December 2010
F27071
Core covered bonds offer value
Covered bond supply to fall in 2011 to €165bn Graph 1. Issuance forecast €bn
Stay long core covered bonds with pick-up.

Stay short agencies as increased competition is expected.
Basel process is positive for covered bonds in long run.
This article is a summary. Please find full text of Covered

bond and Agency outlook here.
 Lower covered bond issuance ahead. 2010 was a
record year - with €185bn of issuance. 2011 supply should
be some €20bn lower. Issuing banks have more
alternatives available, such as issuance in USD, RMBS or
senior unsecured. Supply will be stronger from Italy and
the UK.
 UK and Dutch covered are attractive. We see UK and For 2011 we expect covered bond issuance of around
Dutch covered as attractive. We like UK covered bonds in €165bn – over €20bn less than in 2010. There are several
particular, as they have only partially followed the factors that will limit supply:
improvements in sovereign risk. Dutch covered bonds have
1) We expect other funding alternatives to gather steam.
an attractive pick-up vs Obligations Foncières, while the
Several issuers see the benefits of issuing in USD. For
Dutch CDS trades through the French. Stay short
one, the basis swap can be attractive. Some issuers
peripheral covered bonds as they trade too closely vs
now need to attract a broader investor base given that
sovereign bonds.
a number of European investor accounts are restricted
on the amount of paper they can buy of some names.
 Agencies impacted by EFSF. EIB funding needs are So far, French and Nordic issuers have the best
falling slightly while KfW’s are rising slightly and Cades’ are developed plans to cross the Atlantic. In addition,
up strongly. The EFSF structure is close to that of EIB as a RMBS has risen from the dead, and is now a valuable
credit, with a number of European countries supporting funding alternative for UK and Dutch issuers.
both agencies. Thus, both institutions compete for the
same type of investors, and carry somewhat similar risks. 2) In Spain, the covered bonds of the major banks trade
very closely to senior unsecured spreads.
Consequently, these issuers will tend to issue senior
Basel process is positive for covered bonds in the paper instead of Cédulas as investors do not attach
long run. But the impact in 2011 will be limited. sufficient value to the collateral within the Cédulas.
Issuance from other credit institutions might be
 Covered bonds issuance outlook 2010 and 2011 hampered by volatile headline news.
Issuance reached an all-time high in 2010. Low interest 3) Sovereign spreads just might be contained and that
rates have forced investors to look for pick-up, which has would help peripherals. But we expect more sovereign
sparked more demand for covered bonds. Issuance year- mini crises during 2011 which limit the capacity of
to-date is around €180bn and we just might see a billion banks located in the riskier countries to sell paper.
more (although December is typically moribund).
4) Several peripheral countries trade very closely to their
respective sovereigns. In such market conditions,
investor demand is limited.
5) Covered bond redemptions are lower in 2011 than in
2010. However, redemptions for government
guaranteed are high (around €50bn), mitigating the
impact.
December 2010 45
F27071
Graph 2. Redemptions €bn  What does supply mean for performance of individual
market segments?
In terms of redemptions, Spanish and German markets will
contract. For Germany, this is similar to recent years. It
means that Pfandbriefe will remain expensive. For Spain this
outlook is new. We find it supportive for Cédulas spreads.
There will be strong supply from the UK and Italy. In both
countries there is a significant amount (around €40bn of
senior unsecured bonds maturing in Italy and €56bn in the
UK) and new players such as regional banks are entering the
covered bond arena.
 Secondary market movers
Covered bond spreads have been heavily impacted by
sovereigns. Wide sovereign spreads automatically lead to
wide covered bond spreads as can be seen in the
following graphs. Our impression is that many risk
Source: SG Cross Asset Research departments set limits by country and then decide which
asset class to invest in, whether covered or sovereign.
There are also positive factors for covered bond issuance.
1) We expect yield levels to remain low. Investors will Graph 4 Sovereign CDS, bp
continue to hunt for pick-up and covered bonds will be a
valuable alternative to sovereign bonds.
2) New countries are getting ready. New Zealand is setting
up a programme and Cyprus has passed legislation.
3) New issuers will enter the market e.g. regional banks.
4) Credit institutions that are not highly rated cannot issue
senior unsecured. The only funding alternatives they
have are covered bonds.
5) In the long run, regulatory changes will favour covered
bonds over senior unsecured.
6) Covered bonds remain the most economic funding tool
for most credit institutions.
7) Around €40-€45bn of senior debt is maturing in Italy, with
€56bn in the UK. Some of it will be replaced by covered
bonds.
The second step then is to decide in which credit
Taking these factors into account, we still see major
institution to invest. For example, Irish senior unsecured
issuance out of France, followed by Germany, Italy, the UK
AIB CDS is trading wider than Portuguese BES. A similar
and Spain. The shares of issuance should be relatively
picture can be observed in the graph below which shows
evenly distributed.
covered bond spreads. We observe the same pattern for
Banco Santander whose bank CDS trades relatively tight
Graph 3. 2011 issuance per country, €bn compared to Spanish CDS, as does its covered bond.
Graph 5. Bank CDS, bp
46 December 2010
F27071
Covered bond specifics do not seem to count much, given Graph 7. Country CDS performance, bp
that we consider the Portuguese covered bond law as one
of the safest. Portugal did not have a real estate crisis
because prices did not rise strongly.
Graph 6. Covered bond spreads ASW, bp
Graph 8. UK covered bonds vs French covered bonds, z-

spread, bp
Covered bonds in the peripheral markets follow sovereign

bond moves more slowly as they are less liquid. There are
several explanations for this:
1) Market makers take sovereign bonds as a proxy to
determine where covereds should trade.
2) Some investors see sovereign bonds as a safer
instrument than covered bonds. Should the state have
problems, it can increase taxes, even on banks.
3) On the other hand, it could be argued that covered
bonds offer less risk of restructuring given the double
recourse to banks and the cover pool.
Peripheral spreads are still too tight from a historical
perspective. However, bid offer spreads are wide in such
circumstances so it is difficult to engage in arbitrage. We Graph 9. Dutch covered bonds compared with CFF and
see performance as being very difficult. Eurohypo, z-spread, bp
Spreads in core markets such as Germany, France, the

Netherlands and the Nordics remain stable as usual. This is
a striking contrast and underlines that sovereign risk is the
main mover currently in the covered bond world.
Covered bond recommendations
Buy UK covered bonds. Sovereign risk is still the main
driver of the riskier covered bonds. Let’s look to quieter
pastures among the AAAs. We see UK covered bonds as
offering value. Among AAAs, the UK CDS is rich, at some
20bp through France. And while UK covered bonds have
performed, their pick-up over French covered bonds still
remains very elevated, in sharp contrast to sovereign
performance.
Buy Dutch covered bonds. The bonds offer a relatively
high pick-up vs other core covered bonds such as Source: SG Cross Asset Research
Obligations Foncières or Jumbo Pfandbriefe. However,

Netherlands country CDS is currently trading through
France’s.
December 2010 47
F27071
 Agency issuance outlook of Cades bonds in 2011 compared to €4.25bn in 2010.

Cades might also fund a large part of its debt through the
Traditional agencies will get a competitor for funds this
USD.
year - the EFSF. Funding needs are now €17.7bn. The
EFSF may sell as much as €5-8bn of debt in 2011 Currently, the EIB and Cades curves do not trade in line.
according to its CEO Regling {LCQZU36S9729}, with a warning For shorter maturities, the two credit curves trade at
that the issuance will be front loaded. The bailout for almost identical levels, while for longer maturities the
Ireland was agreed at €85bn. At the moment, Ireland is the spread between EIB and Cades bonds has been wide
only country that will be supported by the EFSF. The UK, since June. This is the result of a large sale by one of the
Sweden and Denmark plus the IMF and EFSM will also main investors in Cades bonds. The spreads have
contribute to the bailout. The EFSF might be needed to remained wide since then.
support other countries as well, increasing its funding
Will spreads remain as wide as they are now? The key
needs proportionally (see EGB issuance section).
factor impacting performance is Cades supply, as
The EFSF can tap the whole interest rate curve, in EUR and described above. On the other hand, we believe EFSF
foreign currency. This has to be done carefully so as not to bond issuance will directly compete with EIB bonds, given
harm the performance of existing agencies. The EFSF’s that both issuers represent a mix of European countries.
credit quality is similar to EIB, KfW or Cades. So spread differences between EIB and Cades bonds
might fall.
 Cades, EIB and KFW
Graph 11. Agency bond performance z-spread, bp
EIB’s funding needs remain approximately stable at €65bn
for 2011. So we expect benchmark funding (2010 €19.30 bn)
to be stable next year also. The unknown variable – similar
for all other agencies - is how much will be issued in USD.
The EIB’s funding needs move in line with European growth
similar to KFW which moves in line with German growth.
Given the strong growth in Germany, funding needs could
rise to around €80bn in 2011 from €75bn this year.
Consequently, we could see slightly more € benchmark
issuance than this year’s €27bn.
Cades is a special case. Funding needs are rising strongly,

from €18bn in 2010 to €68bn. The French parliament has
voted on Cades. According to press reports, the agency
will gradually receive an additional €130bn of debt to
amortise (€68bn from 2009-2011 social security deficits
plus €62bn of age-related spending over 2011-2018, linked Source: SG Cross Asset Research
to pension reform). This will radically increase the supply of
bonds in the years to come.
 Will capital market rules impact spreads?
Graph 10. Agency bond issuance, €bn Will Basel 3, Solvency II, the ECB haircuts and CRD impact
spreads? We don’t think they will anytime soon. Of course,
the general rule is the higher the rating, the better the risk
weight. However, the impact of the changes will only be
felt over the next decade.
jose.sarafana@sgcib.com
Because the debt transfer is not fully covered by new

resources (in contrast to the 2005 law), Cades’ lifespan will
be extended from 2021 to 2025. We expect supply to
extend towards that maturity, so this would be negative for
longer maturities. On the other hand, Cades issuance will
not top that of the EIB. We do not expect more than €17bn
48 December 2010
F27071
GBP Markets
A time for giving? Be selfish – it’s better to receive
There is a long list of global and local reasons to be bullish  The bear pit.
gilts, but another list of worries to add caution. The
The market will have coped with an enormous block of
message is: be selective about where on the curve views
supply relatively comfortably in fiscal 2010-11, but it has
are expressed.
not been toll-free. The adjustment to a world without QE
At the front of the curve, a 2y3y GBP rate that is only has not prevented a rally across the whole curve. However,
17.3bp above its euro equivalent looks wrong and we the long end steepening in 10s30s has more than offset the
would re-enter cross-market wideners here. modest rally in long yields to lift long-term forward yields
over the course of the fiscal year. This compares with
We continue to promote a bullish view via extending
Bunds, for instance, where bullish flattening has collapsed
duration from the 10-year area to the 20-year area. Such
the same forward yields.
cash-for-cash extensions now “receive” a forward gilt yield
of 5.55%. This matters most because although the DMO has got
ahead of the pace on funding for this year, it will have to do
it all again in 2011-12. Heavy redemptions will mean that
 Feeling listless? It’s a time for reflection on the year gross gilt sales are expected to rise next year in spite of a
past and the year ahead, and a time for drawing up lists (of modest improvement in the CGNCR. In light of this year’s
seasonal cards, gifts and of New Year resolutions). It’s also curve response to heavy supply and its duration
time to question all your most entrenched views on distribution, we suggest it might make sense to lighten up
markets. Here’s how we see the pros and cons for gilts somewhat on the duration delivery next year (if for no other
stacking up for the next six months. reason than to take advantage of captive interest at the
front end from overseas investors and domestic banks).
 The bull ring.
We see no near term respite in the disappointing string of
We are strongly bullish Bunds, and cannot see gilts inflation prints. The Bank of England can “look through”
opposing such a move, although we do see them these for now, but there will be a price to pay down the
underperforming. There is the safe haven/risk aversion line. This reinforces one existing message – that it is very
aspect to this euro view but there is also the macro aspect attractive to be long 5-year gilts on a swap spread basis
– aggressive fiscal repair and the associated disinflationary but not at all attractive to be long outright.
forces (we note the ECB’s softer line on inflation prospects
in its new forecasts). Graph 1. GBP 2y3y less EUR 2y3y. Look for widening
The UK is facing its own macro headwinds, with demand from the current 17.3bp spread
set to be squeezed by a pincer attack from negative real 250
income growth and state retrenchment. Not for the first bp
time we must ask: can the UK have export- and/or 200
investment-led recoveries? Your analyst can’t remember
what they look like. 150
The other demand side positives include sterling’s – and
thereby gilts’ – ongoing popularity with overseas investors. 100
Foreign buyers have been taking down a
disproportionately large share of supply and that is unlikely 50
to change while fiscal repair remains on track, protecting
0
the “safe haven” perception.
And equity market strength improves the terms for pension -50
fund de-risking into bonds, while tighter credit spreads and 99 00 01 02 03 04 05 06 07 08 09 10
the approach of Solvency II should also combine to favour
gilts in the mix. Source: SG Cross Asset Research
December 2010 49
F27071
It also tells us that although there’s still life in the long- effect, the trade “top-slices” the hump in the forward yield
standing lower-for-longer mantra, “longer” is likely to mean curve (Graph 3).
much longer in the euro area than in the UK. The market is
giving you another opportunity to pay 2y3y GBP and Graph 3. Gilt yields versus duration, with forward yields
receive 2y3y EUR. We entered this trade at flat last time, in between adjacent issues. Extending from 2020 to
but do not expect to see that again, so would enter now at 2030 gilts “receives” the circled region.
+17.3bp (Graph 1).
6
Another lingering fear at this time of the year is adverse %
historic seasonality for sterling rates in H1. Seasonality 5
patterns rarely stand up to robust statistical testing, but
this tendency does appear more pronounced in the UK 4
than elsewhere. Graph 2 shows changes in 10y GBP in
calendar half-years since 1999. 3
Graph 2. 10y GBP rate changes over half-year periods –

2
an ominous pattern at this time of year.
100 1
modified duration
50 0
0 5 10 15 20 25
0
-50
-100  We say it’s a “cautious” approach because the forward

yield has attractive roll-down and any aggressive sell-off in
-150 gilts should be of a more conventional bear-flattening type,
H1 H2 we suggest, mitigating damage to the forward yield. We
-200 also like the swap spread component to the trade – with
the 10y10y GBP swap rate at 5.0%, the forward swap
-250 spread is large (and also rolls down well).
99 00 01 02 03 04 05 06 07 08 09 10
Recommendations
We take some comfort from two things – the strong Pay 2y3y GBP and receive 2y3y EUR at +17.3bp. Target of
violation of the seasonals last year and the fact that this
50bp and stop of 0bp.
seasonal sell-off has tended to be a Q2 problem more than
a Q1 issue. Extend cash-for-cash from 2020 into 2030 gilts (see text for
details). This “receives” a forward gilt yield of 5.55%.
 In summary. We emphasise the bull list for now. We
regard it as a cautious approach to take duration via cash- Target 4.5% and set a stop at 6%.
for-cash extensions from 10-year gilts into 20-year issues.
This “receives” what we regard as a very attractive forward
yield in between. A 5.55% forward yield between mark.capleton@sgcib.com
UKT3.75% 2020 and UKT4.75% 2030 is at pre-crisis levels
(something that is hard to find in global bond markets). In
50 December 2010
F27071
CEEMA Markets
Search for yield to continue to support EM bonds in H1 2011
Lower core yield and accommodative polices in the core weeks in both Latin America and Asia where central banks
markets justify our constructive stance on emerging market have introduced various measures (for example IOF tax on
debt as the search for yield continues into H1 2011. non-residents’ margin in Brazil and tax on interest income and
capital gains earned by foreign investors in Thailand) to deter
We identify six key themes for EM debt:
speculative capital inflows. A summary of those measures can
QE2 and EM – further inflows into EM bond markets and be found in ‘The currency war EM governments will lose’ in
flatter curves. Emerging weekly on 4 November. Although we do not think
that further intervention in EM in general will be effective, we
Intervention and EM – prefer markets where intervention expect it will remain high on the agenda for official authorities
risks are low. in coming months. To avoid unnecessary uncertainty, we
Euro Sovereign risks and EM – prefer dollar based EM to recommend, if possible, staying with EM bonds where
euro-based peers. intervention risks are relatively low such as Poland, the Czech
Republic and Turkey. Inter-region, CEEMEA tends to adopt
Diverging inflation between EM and core - value in linkers the least interventionist approach compared with the two
where inflation is high and the inflation premium is other regions. Hence from an intervention risks perspective,
insufficient. CEEMEA fares better than LatAm and Asian peers.
Monetary policy cycle – favour countries where easing
Graph 1. Scope for further flattening
bias remains or hikes are delayed.
EM asset bubble - not a concern for H1 2011 but 250
positioning still matters. current 10-2 IRS curve
200 6M Max
6M Min
6M Avg
150
 QE2 and EM – further inflows into EM bond markets and
flatter curves. The implementation of QE2 means that global 100
liquidity is to continue to remain abundant and yields are likely
to remain low for longer in the core markets. These are 50
positive factors for EM bonds as an asset class as investors
continue their search for yield. We expect these to lead to 0
further curve flattening in EM curves, especially for those EM PLN HUF CZK TRY ZAR ILS
countries where correlation with the US or Euro curves are
high such as Poland, Israel and Mexico. Despite recent
steepening in some EM curves (see Graph 1), we expect
flattening to prevail into H1 2011 for most EM countries
except for those where easing bias remains, such as South
Africa and Romania (see below). Taking into account  Eurozone sovereign risks and EM – prefer dollar based
mispricing in the short-end compared with our rates forecast, EM debt to euro-based peers. Although our central scenario
we still see value in flatteners in Poland. For Turkey, the is for eurozone sovereign risks to be contained, we expect
dovish bias of the central bank has kept the curve relatively these risks to remain in the background. Eurozone sovereign
steep. However, strong economic growth prompts us to think risks are likely to affect EM countries which are more closely
that the CBRT may run the risk of lagging behind the curve. connected to the Eurozone - such as CE3 and Romania - than
This means we look to position for a flattener in Turkey. We those which are more correlated to the US markets - such as
also advocate a flattener in Russia, as our bullish commodity Russia, Turkey and South Africa. This justifies our preference
view should benefit the long end more, while short end rates for dollar-based EM over Euro-based peers.
may come under pressure when Russia begins its tightening
cycle by Q2 2011 (see below). This is also consistent with our EM debt scorecard, which is
an extension of the fiscal solvency ranking and externality
 Intervention and EM - Prefer bond markets where matrix in our H2 2010 CEEMEA local rates outlook. Our
intervention risks are low. CEEMEA clearly fares better under revised scoring includes additional considerations such as
this category. We have seen many examples in the past few funding, scope to tax and trim, and potential for growth to
December 2010 51
F27071
produce more comprehensive scoring as our economics team with our average inflation forecast of 7.03% for three years.
has used in ‘Global Themes: Tri-policy – getting the mix right’ Our long favoured Polish IZ0816 now has become less
on 7 June 2010 (see EM Fixed Income Special to be released attractive in relative terms following the recent back up in
soon). The overall result is similar to our previous finding in yield in the like-maturity conventional.
June: CEEMEA fares worst amongst the three regions on
overall scoring, while Asia comes out the best, followed by Graph 3. Inflation forecast for 2010 and 2011
LatAm. We note that our scorecard does not include the
%
political dimension. CEEMEA countries bode worst in all areas 12
apart from the metric potential for growth, where LatAm 10
2010 2011
scores worst. The Asia region as a whole does best in almost
8
every area, with the exception of debt dynamics, where
LatAm does best. 6
4
At country level, China does best while Turkey does worst,
2
followed by Hungary and Poland, but here we need to stress
that the scoring of Poland was negatively influenced by the 0
South Africa
Taiw an
Israel
Mexico
Brazil
HK
Russia
India
Poland
South Korea
Hungary
Turkey
Czech Rep.
China
Chile
Romania
implementation of the pension system reform, which added
around 14 percentage points to the public debt level and
deepened the deficit to GDP by around 1.5 percentage points.
Within CEEMEA, Russia and South Africa have the best
scoring overall in our basket. This justifies our bullish stance
on South Africa bonds. For Russia, it is worth mentioning that Source: SG Cross Asset Research, IMF, Central Banks, Bloomberg
despite the negative real yield, our bullish commodity outlook
(our commodity team forecast Brent ICE @ $95/b in Q4 2011)
is also positive for the budget deficit outlook for Russian  Monetary policy cycle – favour countries where easing
bonds. Our Russian economist Vladimir Kolychev expects the bias remains in place or hikes are delayed. Due to the
budget deficit to shrink to 2.0% in 2011 from 3.5% in 2010 postponed hiking cycles in the core markets and capital
(see Emerging Weekly: Russia: bullish on FX but less so on inflow concerns, most central banks in EM have also
bonds on 30 July). postponed or slowed down their hiking cycles. This certainly
bodes well for local rates especially in certain countries, for
example Mexico, which is very closely related to the US.
Graph 2. Overall scoring* While most EM central banks are back in the neutral to ready-
to-hike mode, there are two countries where easing bias
Overall evaluation
0.0 0.2 0.4 0.6 0.8
remains in place. They are South Africa and Romania. This
should be positive for ZAR and RON short-end local rates and
China
Korea keep a steepening bias in these curves at least until end Q1
Taiw an 2011. This also justifies our preference for long short-end
Thailand
India
Indonesia Romania local debt DBN11.25 10/12.
Philippines
Czech EM asset bubble - not a concern for H1 2011 but positioning
Hungary
Israel still matters. We do not think that this is a concern for H1
Poland
Romania 2011, but we acknowledge that positioning is becoming
Russia
S. Africa heavier given the continuous inflows into EM bond funds
Turkey since April 2009. Our central scenario (see EM Outlook on 29
Mexico
Argentina November) is that the EM bubble will not burst in H1 2011, but
Brazil
Chile this risk is likely to rise later in the year. Hence, countries
Venezuela where non-resident holdings are back to pre-crisis levels -
such as Israel, the Czech Republic, Poland, Turkey, South
Source: KB, SG Cross Asset Research, Bloomberg, Moody’s, IMF. * The lower the score, the better.
Full report will be published soon. Africa and Egypt - are likely to be more impacted by a change
in global sentiment though this is unlikely to be a threat in H1
2011.
 Diverging inflation between EM and core markets - value
in linkers where inflation is still high and the inflation premium Recommendations
is not sufficient. ‘Decoupling revisited’ is one of our 1.PLN 2y5y IRS flattener. Target +25bp
Economics team's anchor themes (see Global Economic 2.Turkey 2y5y CCS flattener. Target +40bp
Outlook November 2010). It highlights that the diverging 3.Russian 6m5y CCS flattener. Target +150bp
trends in growth and inflation between developed and
4.Buy South African bonds (R186). Target 7.8%
emerging economies will continue into 2011. In CEEMEA,
5.Long Romania DBN11.25% 10/12. Target 7%
inflation in Turkey and Russia tops the region (see Graph 3).
An examination of breakeven spreads in the key CEEMEA 6.Buy Turkey linker TURKGB12 8/13 outright or vs
inflation-linked bond markets reveal that there is still value in TURKGB16 8/13. Target +730bp
the inflation-linked TURKGB12 8/13 from a relative value esther.law@sgcib.com
perspective compared with like-maturity conventional peers.
anne_bluher@kb.cz
The bond shows the smallest breakeven at 693bp, compared
52 December 2010
F27071
Asia-Pac Rates Markets
Japan: odds of exiting deflation greater than that of sovereign crisis
Virtuous Asia cycle drags Japan out of deflation with QE2: provide a floor to risky asset prices to fight
deflationary expectations. This BoJ strategy raises concerns
JGB yields higher, curve flatter but risks abound
for the JGB market which, in spite of further buying from the
BoJ as part of CME, is at risk from a sell-off through 2011 in
our view.
 Macro: Japanese economy to outperform in 2011, pity
about the JGBs.  Flows: how a good Japanese economy is bad news for
JGBs.
An almost unnoticed development in 2010 is that Japan’s
GDP growth is likely to have outperformed both that of the US Over 2009-10, the strongest JGB buyers were Japanese
and Europe. This led our economists dub Japan the “G3 banks and the BoJ. The latter has the ability to print money to
Tiger 47.” How is this possible as Japan continues add to its JGB holdings and will do so to the tune of net ¥12tn
experiencing protracted deflation? Proximity to China and in 2011. Banks, however, get resources to buy JGBs mostly
Asia is (and will continue to be - expect Non-Japan Asia to from growth in their deposit base and some loan
grow 8% in 2011) a key supportive factor. Nevertheless, the deleveraging. This is the Japanese banks’ “surplus liquidity”
Japanese consumer is back, supported by strong pool which stands at ¥152tn (32% of GDP) and of which
employment and wage growth. ¥143tn is invested in JGBs. Strong growth in surplus liquidity
in 2010 meant that the net ¥42tn in JGBs and T-bills issued
Graph 1: Japan income growth supporting the economy were mostly (80%) absorbed by banks and the BoJ.
110 Dec 99=100 Graph 2: Stronger income leads to less surplus liquidity
fcast
Real Aggregate Income 4 Income growth (trend y/y, %) -20

105 Trend
Bank Surplus Liquidity (y/y ¥tn, inverted)
Potential 3
-10
2
100
0
1
95 0 10
-1 20
90 -2
30
-3
85 40
Dec-99May-01 Oct-02 Mar-04 Aug-05 Jan-07 Jun-08 Nov-09 Apr-11 -4
Source MIAC and SG Cross Asset Research estimates -5 50

Dec-99 May-01 Oct-02 Mar-04 Aug-05 Jan-07 Jun-08 Nov-09 Apr-11
Source: BoJ and SG Cross Asset Research estimates

This positive macro scenario prompted our equity strategists
to upgrade their view on Japan 48 as one of the markets best
positioned to benefit from QE2 globally - with significant help In 2011, this is likely to change: strong income growth drags
from the BoJ too. The latter is in the early stages of surplus liquidity down as economic agents become less risk-
implementation of a new “Comprehensive Monetary Easing averse and more willing to re-leverage. Thus, even as we
(CME) 49” strategy that goes beyond what the Fed dares to do project net JGB funding needs declining to ¥30tn in 2011,
banks may need to accumulate at least ¥12tn in surplus
47
http://www.sgresearch.com/p/en/2/109370/0/91C6F24637B249D1C12577
liquidity to (proportionally) absorb as many JGBs as they did
DF005ED673.html?sid=a30b755f8975157bb133f6f166bba991 in 2010. This will be difficult and is a key supply-demand risk
48
http://www.sgresearch.com/p/en/2/109370/0/D0D620C0C703711CC1257 for sectors held by the BoJ and banks (up to 10y JGBs). On
7E300631B39.html?sid=b1b5dc20ad1d20611af00659430f8442 the other hand, if GDP growth is strong, we could expect
49
http://www.boj.or.jp/en/type/release/adhoc10/k101005.pdf Japan’s Ministry of Finance (MoF) to reduce T-Bill issuances
December 2010 53
F27071
in 2011 - by over ¥10tn according to our cyclical measure of This is because of the link 50 between equity holdings and
net issuance (funding requirement implied by deviations from duration requirements of long-term JGB buyers. They need to
the output gap, Graph 3) – to avoid a disorderly increase in reduce equity exposure and increase the duration of their
JGB yields. bond-holdings. This link (see Graph 5) has become stronger in
recently as the time for accounting standards changes for
Graph 3: Net JGB issuance to decline but not enough to those investors draws nearer. Pressure about this issue
prevent sell-off. MoF may need to reduce bill issues should peak by end-Q1 2011 when regulators announce a
preliminary report on this matter. Thus we like long the belly of
60 JGB Net Issuance (annual, ¥tn)
Forecasts 10y-20y-30y JGB flys above +65bp.
50 Super-long JPY IRS receiving could be the preferred strategy.
Cash-constrained long-term buyers could prefer IRS to JGBs.
40 Structures like 2y fwd 5y-25y IRS flatteners around +120bp
could benefit from this preference.
30
Graph 5: 20y JGB to outperform in equity-driven sell-off
20
6000 80
10
8000 70
Cyclical
0 60
10000
50
-10 12000
Dec-99 Jun-01 Dec-02 Jun-04 Dec-05 Jun-07 Dec-08 Jun-10 Dec-11 40
14000
Source: SG Cross Asset Research estimates 30
16000
20
 Duration: JGB yields can drift lower in Q1 2011 helped by 18000 10

USTs and limited net issuance. Use this to go short.
20000 0
Dec-99 Jun-01 Dec-02 Jun-04 Dec-05 Jun-07 Dec-08 Jun-10
The mini-bubble experienced in Q3 10, when 10y JGB yields
traded sub-0.85%, was driven by a UST rally and low net Nikkei (inverted) JGB 10y-20y-30y
supply. We believe that only another sharp decline in 10y UST
Source: Bloomberg and SG Cross Asset Research
yields (SG expects 2.0% in Q1 11) could help revisit those
JGB yield lows in 2011. Supply is helpful into the New Year as  Short-term opportunities in JGB ASW only.
we expect only ¥3.0tn in net JGB issuance in Q1 11. However, JGB swap spreads are caught in the middle of declining ¥
this would cluster as much as ¥27tn in net issuance in Q2-Q4 money market fixings in response to BoJ easing and some
2011 amid a (potentially) stronger Japanese economy, waning improvement in JGB supply. Timing suggests long JGB ASW
deflation and higher UST yields. Tactically, we would enter could perform in Q1 2011 but, considering the issuance
2010 long JGBs if 10-years break above 1.2%. For outright outlook later in 2011, we would implement such positions only
positions, however, we prefer shifting longer, into the 20-year if we see inverted ASW. Long outright 15y JGB ASW (JL83) at
sector circa 1.95-2.0%. flat or as an ASW box vs 12y (JL59) at a spread of +6-8bp
could be attractive in Q1 2011.
Graph 4: 10y JGB can revisit yield-lows with UST help
Graph 6: Long 15y JGB ASW at flat or vs 12y at +8bp
2.0
15 15
1.8
10
5
1.6
0
10
-5
1.4
-10
-15
1.2
-20 5
1.0 -25
-30 10y JGB ASW (bp)
0.8 10y JGB -35
3m Repo-Tibor (bp) 0
+1 Std Dev -40
- 1 Std. Dev -45
0.6 Model JGB coupon issuance
-50 (3m/3m SAAR, rhs)
Model (ex US effects)
0.4 -55 -5
Dec-01 Mar-03 Jun-04 Sep-05 Dec-06 Mar-08 Jun-09 Sep-10 Dec-11 Dec-01 Mar-03 Jun-04 Sep-05 Dec-06 Mar-08 Jun-09 Sep-10 Dec-11
Source: Bloomberg and SG Cross Asset Research Source: MoF and SG Cross Asset Research estimates
 Curve: stronger growth and higher Nikkei should be

consistent with a flatter and less concave term structure.
50
http://www.sgresearch.com/p/en/2/109370/0/A0CCC451C4D3FEE9C1257
7380026BEC9.html?sid=10bb9d6958baa13757aa5899aff78c4e
54 December 2010
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 Risks – JGB crisis? Our scenario of higher JGB yields

and flatter curves after Q1 2011 relies on a sustained
macro recovery and short-term support from US
Treasuries. We do not see a real risk of a GIIPS-style crisis
in 2011. Thinking outside the box, however, there are a
couple of scenarios where such a JGB crisis could
materialise:
1. China over-tightens in response to inflation/asset
bubble - Asia virtuous cycle fails. This is the likeliest
way for a JGB crisis 51 to emerge. It would happen amid
inflation spill-overs into Japan, banks’ seeing their JGB
purchasing power fall amid ¥ deposit losses. Finally, a
loss of the current account surplus as Asia enters into
recession triggers a panic-weakening in the value of the
Yen. Solution: buy 5y USD JGB CDS protection at
+55bp or receive 5y USD/JPY CCS basis at -45bp on
signs of such crisis emerging.
2. USD crisis - Political gridlock in Washington leading to
inaction over the US debt limit leads to global fears
about developed-market sovereigns. Initially JGBs
benefit in a flight-to-safety away from USTs and into
Yen and JGBs. The global effects of USD crisis
eventually make Japan’s external surpluses disappear
and the JGB market crashes too.
Japan rates trade recommendations
Tactical
1/ Buy 20y JGB @ 1.95-2.0%.

2/ Long 15y ASW at flat or vs. 12y ASW 12y at +8bp.
Strategic
3/ Long the belly of 10y-20y-30y JGBs @ +65bp

4/ 2y fwd 5y-25y JPY IRS flatteners @ +120bp
Crisis scenario
5/ Buy 5y USD JGB CDS protection @ +55bp

6/ Receive 5y USD/JPY CCS basis at -45bp
christian.carrillo@sgcib.com
51
http://www.sgresearch.com/p/en/2/109370/0/7FC519AD0E5676B3C12577
15001C714F.html?sid=0d8a5737b54ae8e8b330aa1d2d5ad25e
December 2010 55
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Antipodes: (AU)ver N(Z)ormalisation?
RBA almost done – yields too high, curve too steep  The dual risks of inflation and credit: wider spreads
starting to hold back the RBA
RBNZ has much to do – pay NZD IRS outright or vs AUD
The fact that our economists expect much higher
 Australia Macro - RBA’s Governor Stevens, are we inflationary pressures (4.0% yoy) in 2011 is why SG’s
there yet? Nearly there...depending on inflation. official forecast is for 6.0% RBA cash in Q4 2011. The
reason why the market does not buy this (so far) could be
Like the rest of Asia, Australia has an inflation problem. either because it sees a huge (25%+) AUD NEER
This reflects (near) full employment, strong income growth appreciation dampening inflation risk or because other
and domestic capacity constraints. While the inflation factors outside of our Taylor rule could come into play.
problem will depend on China’s performance in 2011, the Credit could be such a dampening factor on the economy.
RBA has performed an outstanding job at normalising
monetary policy given the changing conditions. According In 2010, we argued that stronger banking regulations by
to our SG economists’ recent work 52 on the Taylor rule in the Australian Prudential Regulation Authority (APRA 54)
Asia, the RBA appears to be the model central bank, caused wider lending spreads but had not led to stress in
having adjusted rates almost perfectly in response to credit markets. For 2011, our opinion has changed
changing growth, inflation and exchange rate pressures. somewhat in as much as we are definitely seeing a slowing
of credit growth outside housing. Effectively, Australian
Governor Stevens confirmed 53 the importance of the value banks’ loan books are skewing towards more housing risk
of AUD in the RBA’s decisions in 2011. We agree, as business credit deleveraging continues. This could be a
especially in the context of other major economies’ QE, reason for Governor Stevens’ caution 55 about policy rates
which makes the AUD an especially attractive investment. for now.
Graph 1: AUD OIS pricing a “Goldilocks economy” – not Graph 2: Credit spreads widening again, businesses
too hot, not too cold deleverage, banks at greater risk from housing
9.0 9.0 30 9.5
2011 3m/3m (SAAR) Rate(%)
8.5 8.5 9.0
8.0 8.0 8.5
7.5 7.5 20 8.0
7.0 7.0 7.5
6.5 6.5 7.0
6.0 6.0 10 6.5
5.5 5.5 6.0
5.0 5.0 5.5
4.5 4.5 0
5.0
4.0 4.0 4.5
3.5 SG Taylor Rule (IR+Curncy) 3.5 Business 4.0
3.0 3.0 -10
Housing 3.5
2.5 RBA Cash Rate 2.5 3-year Fixed Mortgage 3.0
2.0 2.0 -20 2.5
Dec-00 Jun-02 Dec-03 Jun-05 Dec-06 Jun-08 Dec-09 Jun-11 Dec-00Mar-02Jun-03Sep-04Dec-05Mar-07Jun-08Sep-09Dec-10
Source: Bloomberg and SG Cross Asset Research/Economics Source: Bloomberg and SG Cross Asset Research/Economics
Simulating the behaviour of our SG Taylor Rule in 2011 we  How to play the AUD rates market in 2011? Money
note that an RBA “neutral” rate around 5.25% works only market convergence trades. ACGBs look attractive early in
in a scenario of happy stability: GDP growth of 3.5%, 2011. Curves set to re-flatten.
inflation a little under 3.0% and AUD NEER gains between
7-10%. The AUD OIS market seems to be a bit less Unless the RBA makes an uncharacteristic policy mistake,
optimistic than that, pricing (as of 30 Nov 2010) only a cash rates will rise in tandem with economic conditions.
5.07% RBA cash rate by the 6 Dec 2011 meeting. Inflation may rise, as SG economists’ project, but the RBA
will not let inflation get out of hand. Thus the market will
price a convergence to equilibrium rates and the money
market curve will tend to flatten. Trades like March 2011
1m OIS vs 1y1y IRS flatteners at +70bp are attractive going
into Q1 2011. We target a move to +30bp.
54
52 http://www.apra.gov.au/adi/ADI-Prudential-Framework.cfm
http://www.sgresearch.com/p/en/2/109370/0/A2701C4000868AFBC12577
E00022DEDB.html?sid=03e3001b5298debc48ea5b5131224b9b 55
http://www.smh.com.au/business/no-more-rate-increases-for-now-says-
53
http://www.rba.gov.au/speeches/2010/sp-gov-261110.html reserve-chief-20101126-18aki.html
56 December 2010
F27071
Graph 3: Short-end flatteners to perform as RBA finishes  Could supply be a meaningful risk in 2011? Yes, to the
its tightening cycle downside! Long EFP flatteners.
Indications from the government and IMF projections
2.50 250
suggest that the real risk is downside to AUD fixed income
2.75 225
supply in 2011 (see Table 1), especially if the economy
3.00 200 performs. EFPs should benefit from this: Long 3y EFPs
3.25 175 would be attractive around +30 as a medium-term
3.50
150 directional view. Relative-value investors could also benefit
3.75
125 from this trend via 3y-10y EFP flatteners if the spread
4.00
100 steepens above +20bp. We target a move to +55bp and
4.25
75 flat, respectively.
4.50
50
4.75 Table 1: AUD FI supply falls – wider and flatter EFPs
5.00 RBA Cash Rate (inverted,%) 25
1y1y IRS - 3m fwd 1m OIS 0 2007 2008 2009 2010 2011f
5.25
ACGB
5.50 -25 Issue 5.8 6.0 51.0 54.9 45.0
Nov 08 Mar 09 Jul 09 Nov 09 Mar 10 Jul 10 Nov 10 Maturity 4.2 5.1 6.0 7.0 10.0
Source: Bloomberg and SG Cross Asset Research
Net 1.6 0.9 45.0 47.9 35.0
ACTB
All things considered, ACGB yields look high and the curve Issue 0.0 0.0 36.3 42.3 15.0
Maturity 0.0 0.0 19.2 40.3 13.5
too steep. While AUD OIS pricing could be seen as
Net 0.0 0.0 17.1 2.0 1.5
complacent about inflation risks this is not true for long-
term ACGB yields. Even if we assume no recovery in US Semi & Agencies
Treasuries in Q1 2011 (our US colleagues see a rally to Issue 15.6 11.7 17.5 43.1 27.0
2.0% in 10y USTs). 10y ACGB yields are attractive at 5.5% Maturity 7.1 9.0 9.9 16.1 16.0
and above 5.65% they would be a buy early in 2011. Net 8.5 2.7 7.6 27.1 11.0
Graph 4: 10y ACGBs cheap at 5.5%, big buy at 5.65% Total 10.1 3.6 69.7 77.0 47.5
Source: IMF, AOFM and SG Cross Asset Research estimates
7.0 +1 Std Dev - 1 Std. Dev
Model 10y ACGB
6.5  New Zealand Macro – Things getting ugly for the RBNZ.
6.0 Faced with a housing-related deleveraging, the RBNZ kept
nominal and real interest rates at record lows in 2010.
5.5 However, as NZ commodity price gains accelerate and the
5.0
economy stabilises, the RBNZ will find itself in the
uncomfortable position of hiking rates just to prevent real
4.5 policy rates from falling in 2011. The market is pricing only
one OCR hike in H1 2011, but SG economists believe the
4.0 bank could deliver two hikes 58 in that timeframe.
3.5
Dec-00 Apr-02Aug-03Dec-04 Apr-06Aug-07Dec-08 Apr-10Aug-11
Graph 5: Commodity prices suggest RBNZ is lagging
Source: Bloomberg and SG Cross Asset Research 220 ANZ Comdty Px (NZD) 6
210 RBNZ OCR (adjusted by 1y infl. exp)
5
200
We are uncomfortable with the steepness of the ACGB
4
curve. Even if high inflation expectations 56 are sustained 190
next year, the RBA’s policy response should flatten the 180 3
curve. Our models show that both ACGB and AUD IRS 3y- 170
2
10y slopes are too steep at +40bp and +55bp, respectively. 160
We would recommend entering AUD 3y-10y IRS 150 1
flatteners 57 at current levels. 140
0
130
120 -1
Source: Bloomberg, RBNZ and SG Cross Asset Research
56
http://www.melbourneinstitute.com/miaesr/publications/indicators/cie.ht
ml
57 58
http://www.sgresearch.com/p/en/2/109370/0/71AFC9E3DF06692DC1257 http://www.sgresearch.com/p/en/2/109370/0/851353A88D593B6CC12577
7E000030D3C.html?sid=b4bdb6438b04d7343b059b6360e3a0f8 DF005FB41E.html?sid=e1bdedf955926f0628586167d5ebc8f7
December 2010 57
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 NZD rates outlook poor: Pay 5y IRS or trade

convergence to AUD. NZGB ASW is too cheap, however.
The market’s complacency derives from statements by
RBNZ Governor Bollard talking 59 down recent economic
data and NZD strength. However, we think the bank needs
to act to control inflation expectations thus the outlook for
NZD rates in 2011 is poor. We recommend paying 5y NZD
IRS outright at 4.65% or implementing 2y fwd 3y NZD-AUD
tighteners at -75bp with a target of -25bp.
The NZGB supply outlook is challenging and an outlook
downgrade by S&P does not help. Net supply will remain
around NZD12bn per year but even at such issuance levels
NZGB ASW would be too cheap sub -20bp (see Graph 6).
We would target a move to flat. This is consistent with our
choice to pay NZD IRS as a key duration view.
Graph 6: Long 5y NZGB below -20bp, target flat
-15 160
140
-10
120
-5 100
0 80
60
5 40
10 20
Net Issuance (NZDbn 3m SAAR, 0
15 inverted)
-20
20 -40
Source: Bloomberg, RBNZ and SG Cross Asset Research
Antipodeans rates trade recommendations
Australia
1/ Long 10y ACGB @ 5.5-5.65%
2/ Mar-2011 1m OIS vs. 1y1y IRS flatteners @ +70bp
3/ 3y-10y AUD IRS flatteners @ +55bp
4/ 3y-10y EFP flatteners @ +20bp
New Zealand
1/ Pay 5y NZD IRS @ 4.65%
2/ 2y3y NZD-AUD tighteners @ -75bp
3/ Long 5y NZGB ASW @ -20bp
59
http://news.smh.com.au/breaking-news-business/rb-governor-appears-
to-talk-nz-down-20101110-17mn0.html
58 December 2010
F27071
EM Asia: further policy normalisation with capital control risks
Capital inflows into Asia are expected to continue in 2011. probability on policy mistakes – such as China’s over-
Main uncertainties are ad hoc administrative measures and tightening in 2007 or Thailand’s ineffective capital controls
capital controls to curb foreign inflows. in 2006. The opposing forces to these bullish factors are
the inflation concerns in the region and further
Aggressive policy normalisation set to fight inflation. Asian
normalisation of policy rates. Despite inflationary fears, we
currency appreciation trend expected to continue.
see potential for EM Asia to outperform relative to
Bearish pressure in Asia rates, mainly in China, can be developed markets on a currency unhedged basis given
expected with the front-end pressured by Asia’s tightening our view that tightening pressure will be exerted via both
cycle while the longer end reacts to inflation concerns and policy rates and the appreciating currency in a measured
sporadic corporate issuance-related paying pressure. We way. Indeed, the belly of the interest rates swap curve is
prefer the belly of the curve. likely to be the best performer as the front-end is likely to
come under upside rate hike pressure while the longer-end
Despite the bearish impact of rising inflation, we remain is under upside corporate issuance paying pressure.
constructive for EM Asia rates, supported by overall
money inflows into the region and EM Asia’s relatively high  Inflation and asset bubbles are the main policy
yielding assets. challenges ahead – what is the right mix between policy
rates, currency appreciation and administrative
 The prospect of accelerating inflation and continued measures/capital controls?
capital inflows spurred by the global liquidity glut and Asian central banks and China in particular are expected to
Asia’s growth story are key challenges facing Asia in 2011. face significant inflationary pressures with y-o-y CPI
The main risks and uncertainties in Asia are whether forecast to be 3.1% in 2010 and rising to 4.5% and 5.0% in
central banks will over-react to inflation and over-tighten, 2011 and 2012 (see Graph 2). Food, energy and
and whether capital control measures could shake commodities-driven inflationary pressures 60 are global
investors’ confidence in the Asian fixed income product. themes but have an outsized impact on EM Asia owing to
The uncertainty around capital controls is, in our view, high oil-intensity for production and high weighting of food
higher than the actual threat from the capital control in the region’s CPI baskets.
announcement. Any negative reaction in EM Asian rates
would likely be short-lived and should not halt the trend of Graph 2. Asia-Pac inflation on rise
foreign inflows into the region. 10
CN SK SG
Graph 1. Asia net capital inflows 8 estimate
TW HK
800 6
Asia net capital inflows (USD bn)
600 4
Asia (ex Japan & China) net capital
400 inflows (USD bn) 2
200 0
0 -2
-200 -4
Dec02 Dec04 Dec06 Dec08 Dec10 Dec12
-400
2010E
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Source: SG Cross Asset Research, Economics
Inflationary concerns in the region are further complicated

by accelerating asset-price inflation, housing in particular.
The conventional route of rate hikes might not be sufficient
Net capital inflows in 2010 are expected to be around to ease inflation and credit growth. For example, the case
USD650bn (4% of GDP) a three-fold increase from last year of China shows that specific loan growth targets and
(see Graph 1). Capital inflows into Asia should remain reserve requirement ratio (RRR) hikes have proved more
buoyant in 2011 encouraged by the region’s growth effective (so far, at least).
prospects, higher-yielding assets and potential currency
gains helped by QE (in its various forms) in G3 economies.
A gradual diversification of global reserves into emerging
markets, and out of the US and Europe, should be key 60
http://www.sgresearch.com/p/en/2/161549/0/5FC1B0B762FB09FBC1257
factors driving local bond markets. We place a low 7DF004FD895.html?sid=7c91bd98d288af775fa134491336c573
December 2010 59
F27071
Faster currency appreciation could be a policy choice Long-end HKD and SGD curves are likely to be under
given the dislocation between the policy rates and banks’ pressure from corporate issuance-related paying flows.
funding rates reflecting surplus liquidity (deposits > loans). Both HKD and SGD 5y-10y spreads are at their widest
The clearest example of a breakdown in the policy transfer relative to USD (Graph 4.) Such dislocations in the long-
mechanism is Taiwan. Despite the Taiwan central bank’s end HKD and SGD IRS curves are expected to continue
(CBC) two 12.5bp rate hikes in 2010 to 1.50%, the O/N into 2011 driven primarily by sporadic corporate issuance
weighted average rate and the 90-day CP have only risen paying pressure. That being said, we do not foresee
by 4bp and 8bp from 0.19% to 0.23% and from 0.51% to sustainable extreme dislocation in the boxes and maintain
0.59%, respectively. With this, the determinant for Taiwan our strategy to trade around HKD-USD 5y-10y box spreads
TWD IRS is not CBC’s discount rate but market liquidity of flat/-20bp with a tight stop as mean reversion play.
conditions, and stocks and flows of funds.
Graph 4. Dislocation of long-end HKD, SGD vs USD IRS
 EM Asia rates set for bear-flattening pressures at front-
end and bear-steepening pressure further out 140
SGD 5y-10y
In China, heightened concerns over aggressive rate hikes 120
HKD 5y-10y
and removal of policy accommodation led to a significant 100
sell-off at the front-end. PBoC raised benchmark deposit y = 0.56x + 12.8
80
and lending rates in October, the first time since 2007 and R² = 0.84
increased the reserve requirement ratio (RRR) by 2.5 60
percentage points to 18% for major banks in 2010. SG
40
Economics forecasts the PBoC hiking again before year-
end and delivering three hikes in 2011, taking the 1-year 20 y = 0.81x - 3.37
deposit and lending rates to 3.50% and 6.50%, R² = 0.88
0
respectively. CNY 2y-5y IRS having steepened initially from
USD 5y-10y
70bp to 90bp post rate hike has since flattened -20
significantly to 47bp, spooked by hawkish PBOC rhetoric -20 0 20 40 60 80 100 120 140
and upside economic surprises. Expectations of ample
liquidity conditions were short-lived as the money market
(7-day repo fixings) rose by 140bp to 3.35% since October.
We do not recommend going against current bearish  Attractiveness of spreads and curve based on degree
sentiment in CNY IRS at the beginning of 2011. Interest of policy accommodation.
rate hike expectations are likely to accelerate if a further Based on our economists’ Taylor Rule analysis, Singapore,
rate hike is delivered before year-end. It is highly probable Hong Kong and China have the loosest monetary policies.
that the front-end of the curve will flatten to single digits We see the most risk in a bearish move in China rates.
towards the end of the rate hike cycle as seen in the CNY HKD is expected to continue to track USD movement and
IRS curve during the 2007-2008 tightening period. CNY 2y- we prefer range and mean reversion trades. In terms of
5y IRS spot at 50bp and 1-year forward remains relatively outright positioning, the trading range between HKD and
steep at +32bp, and there remains plenty of room for USD IRS is too wide, around 60bp and 80bp range with
potential flattening of the curve. It is a cheap bearish play HKD trading at a premium against USD. Box trades
compared with negative carry of more than 8bp per month between HKD and USD IRS have a smaller trading range,
of paying the 1y and 2yr tenors of the CNY IRS curve. We between 0-20bp where the HKD curve tends to trade flatter
recommend CNY 2y-5y flattener at 50bp, target 0bp, stop than its USD equivalent. We maintain a range trading
+65bp, negative carry 1.5bp a month. strategy on HKD / SGD IRS in both outright and curve
terms against the USD curve.
Graph 3. China CNY IRS curve and 7-day repo
The structural curve segmentation in SGD IRS is expected
1.2 120 to continue. The front-end of the curve is driven by the
1.4 SGD 6-month Swap Offer Rate Fixings (SOR) 61 which in
100
1.6 turn is determined by SGD currency valuation. A strong
1.8 80 SGD is expected to be supportive for the front-end, which
2.0 leaves the short-end curve directional, i.e. SGD strength to
2.2 60 lead lower front-end SGD IRS rates and vice versa. The
2.4 longer-end of the SGD curve is more supply/demand
40
2.6 driven and highly sensitive to corporate issuance flows.
2.8 20
3.0
7d repo fi xing 0
3.2 2y-5y IRS
3.4 -20
Nov09 Ja n10 Ma r10 Ma y10 Jul 10 Sep10 Nov10
Source: SG Cross Asset Research 61

SGD Swap Offer Rate (SOR): The USD/SGD swap offer rate (SOR) refers
to the cost of borrowing SGD synthetically by borrowing USD for the same
tenor and swapping out the USD in return for SGD
60 December 2010
F27071
Table 1. Policy stance implied by the Taylor Rule
considering growth and inflation only
Loose Neutral
SI IN HK CH SK TW TH ID AU MA
considering growth, inflation, and exchange rate
Loose Neutral
HK CH IN SI TW TH SK ID AU MA
EM Asia Recommendations:
China
1/ CNY 2y-5y flattener at 50bp, target 0bp, stop +65bp,
negative carry 1.5bp a month
Hong Kong
2/ Range trade 5y-10y HKD-USD box spreads between flat
and -20bp
wee-khoon.chong@sgcib.com
December 2010 61
F27071
Technical Analysis
UST 10yr yield to reverse towards the 2.05%-2.35% zone
4.00%
52-week MA
ST resistance channel
3.10%
2.98%
2.33%
2.03%
WEEKLY CHART
UST 10yr yield should turn lower in the coming weeks and return to the 2.30%-2.35% zone, or even
to the record low of 2.00%-2.05%, in H1 2011.
Given this week’s breach of the 2.98% resistance area1, the up-move initiated at 2.33% in early October
2010 is probably not over yet. That said, this up-move seems to be a consolidation of the downtrend which
started in the 4.00% region in April 2010.
The UST 10yr yield is therefore likely to rise to the 3.10% pullback level, or even to the upper end of the ST
rising channel coming at 3.14% this week (+7.8bp/week), before entering a lasting decline.
Once the lower channel line, which comes at 2.74% this week, is broken, the support levels at 2.72% and
2.45% should be the main steps on the way back to the 2.30%-2.35% zone, which should be reached in
mid-H1 2011.
The UST 10yr yield is then likely to extend the expected down-move to the record low posted in December
2008 at 2.03%, with a step at 2.15%-2.20% (target of major double top drawn in the 4.00% region).
(1) Fibonacci retracement and mid-November high.
Written on 2 December.
62 December 2010
F27071
Bund 10yr yield - ST upside risk before reversing downwards
4.70%
WEEKLY CHART
3.70%
Tentative resistance line
2
4
3.07%-3.10%
1
2.86%-2.88%
2.50%
LT support line
2.06%
3
13-WEEK RSI
Bund 10yr yield may break above the 2.86%-2.88% resistance zone, currently tested, and rise to the
3.07%-3.10% resistance area in Q111 before reversing downwards in Q211 and Q311.
From an Elliott-wave standpoint, we think that the decline initiated at 3.70% in June 2009 is an impulse,
i.e. a downtrend which should unfold into five waves.
At this stage, the first three waves of this impulse have been completed. The recovery initiated at 2.06% in
late August corresponds to wave 4 of this impulse.
The Bund 10yr yield has reached the 2.86%-2.88% resistance area1, but given the configuration of the 13-
week RSI which is far from being overbought, we cannot rule out a break above this resistance area and a
rise to the tentative resistance line, which comes at 3.05% this week (-0.8bp/week), or even the 3.07%-
3.10% region2 in Q111.
Since the top of wave 4 cannot overlap the bottom of wave 1, the 3.07%-3.10% region should force the
Bund 10 yr yield to reverse downwards.
According to this scenario, the bottom of wave 3 represents the minimum downside target of wave 5. So
the Bund 10yr yield should return at least to the 2.06% low, with 2.50%3 as the main step, or even to the
LT declining support line, which will come at 1.89% in Q211, before recovering lastingly.
(1) Pullback level and 2nd Fibonacci retracement of the decline from 3.70% to 2.06%.
(2) Pullback zone, 3rd Fibonacci retracement of the decline from 3.70% to 2.06% and 1st Fibonacci
retracement of the decline from 4.70% to 2.06%.
(3) Pullback level and support level.
Written on 3 December.
December 2010 63
F27071
64 December 2010
F27071
CROSS ASSET RESEARCH – FIXED INCOME & FOREX GROUPS

 
Global Head of Research   
Patrick Legland
(33) 1 42 13 97 79
patrick.legland@sgcib.com
Head of Fixed Income Strategy

Vincent Chaigneau
(44) 20 7676 7707
vincent.chaigneau@sgcib.com
Ciaran O'Hagan Adam Kurpiel Aro Razafindrakola Jose Sarafana

(33) 1 42 13 58 60 (33) 1 42 13 63 42 (33) 1 42 13 64 93 (33) 1 42 13 56 59
ciaran.ohagan@sgcib.com adam.kurpiel@sgcib.com aro.razafindrakola@sgcib.com jose.sarafana@sgcib.com
Mark Capleton Patrick Gouraud David Mendez-Vives Christian Carrillo (Asia-Pacific)

(44) 20 7676 7956 (44) 20 7676 7850 (33) 1 42 13 31 03 (81) 3 5549 5626
mark.capleton@sgcib.com patrick.gouraud@sgcib.com david.mendez-vives@sgcib.com christian.carrillo@sgcib.com
Fidelio Tata (New York) Wee-Khoon Chong (Hong Kong)

(1) 212 278 6213 (852) 2166 5462
fidelio.tata@sgcib.com wee-khoon.chong@sgcib.com
Head of Foreign Exchange

Kit Juckes
(44) 20 7676 7972
kit.juckes@sgcib.com
David Deddouche Peter Frank Cliff Tan Olivier Korber (Derivatives)

(33) 1 42 13 56 22 (44) 20 7676 7458 (852) 2166 5461 (33) 1 42 13 32 88
david.deddouche@sgcib.com peter.frank@sgcib.com cliff.tan@sgcib.com olivier.korber@sgcib.com
Head of Emerging Markets Strategy

Benoît Anne
(44) 20 7676 7622
benoit.anne@sgcib.com
Gaëlle Blanchard Esther Law

(44) 20 7676 7439 (44) 20 7676 7396
gaelle.blanchard@sgcib.com esther.law@sgcib.com
Technical analysis
Hugues Naka Fabien Manac’h
(33) 1 42 13 51 10 (33) 1 42 13 88 35
hugues.naka@sgcib.com fabien.manach@sgcib.com
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December 2010 65
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Outlook: Something Has Got To Give

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Outlook: Something Has Got To Give

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December 2010

Macro Commodities Forex Rates Equity Credit Derivatives

Please see disclaimer and disclosures at the end of this document

2011 Views & Trades

1. Bullish into Spring

2. Elasticity of demand for Treasuries is rapidly declining

3. Roll-down trade in USD, with protection

4. Global inflation: Disinflation pressures are shifting

5. EUR inflation: Receive those high forward real yields

6. EUR sovereign: Defensive on non-core, flatter curve

7. SG sovereign scoring: DSL-Bund spreads will widen

8. Bank stress means ECB can’t pull the plug

9. Cheap widening basis trades still available in EUR

10. EUR curve will flatten in a rally

12. Stay long core covered bonds with pick-up

13. UK: A time for giving? We’d rather receive

14. CEEMEA: Flatter curves and prefer dollar-based to euro-based EM debt

15. JPY: Briefly bullish and then out of deflation

17. EM Asia: Fighting inflation

Editorial: Something has got to give

 Austerity, Inflation or Default

described in ‘Shaping the new financial system.’ But the

Source: SG Cross Asset Research

Source: SG Cross Asset Research

We very much recognise that throwing more public money 4

Graph 4. Manufacturing boom about to subside (US)

Source: SG Cross Asset Research

- Banks likely will continue to crave safe government bonds.

 Hard to believe, but there is unlikely to be enough

Summary of SG’s Macro and Financial Forecasts

Real GDP Inflation

Monetary Policy - Key Rates

United States = - + = = 0.25 0.25 0.25 0.25 0.25 4.00

Long Government Bond Yield (10Y)

United States = = - + + 2.94 2.00 2.30 2.75 3.00 4.75

EURUSD EUR - = + + = 1.33 1.35 1.35 1.42 1.50 1.20

EURGBP GBP + - + - = 0.85 0.84 0.84 0.85 0.88 0.75

End of End of End of End of

2s10s slope 247 150 170 205 220

2s10s slope 201 105 110 115 125

2s10s slope 102 83 92 105 120

2s10s slope 240 150 155 170 165

Global Inflation-Linked Markets

Disinflation threat shifts from US to Euro area

500 Graph 4. OATei and TIPS 2012/2020/2040 cash-and-

Table 1: Summary of our supply views for 2011 -10

Low Central High Com m ents Source: SG Cross Asset Research

Germany. We expect €12bn from Germany in 2011, with a

Overall, the cash picture will be supportive for linker

EUR gamma : a déjà vu ?

Graph 2. EUR 100bp-wide vol risk reversals 4

Impact of QE2 on USD volatility to be negligible

Source: SG Cross Asset Research, Bloomberg

EUR vega – friendly flows

adam.kurpiel@sgcib.com Source: SG Cross Asset Research.

Time for governments to choose – Austerity, Inflation, Default?

Can the eurozone hang together?

Can it be done again?

Is European default legislation to be feared?

Sovereign risk: a quantitative ranking

Changing the criteria or updating data will produce slightly D

Graph 3. Scoring differential vs. ASW differential between