Global Perspectives Oct08

MORGAN STANLEY RESEARCH
Global Interest Rate Strategy

Morgan Stanley & Co. Incorporated
Jim Caron
Primary Analyst Head of Global Interest Rate Strategy Jim.Caron@morganstanley.com +1 (212) 761 1905
October 2, 2008 Interest Rate Strategy
Morgan Stanley & Co. International plc
Laurence Mutkin
Primary Analyst Head of European Interest Rate Strategy Laurence.Mutkin@morganstanley.com +44 (0) 207 677 4029
Global
Global Perspectives
Evaluating Systemic and Liquidity Risk Premiums
What has changed: Asset valuations have become extremely more sensitive to their funding properties the key tenet in our ReNormalization thesis. As a result, money market dynamics and short-term funding metrics are critical to evaluating systemic and liquidity risk premiums that drive our expectations for the performance of risk assets. In addition, an important inflection point has been reached whereby market support schemes have shifted from funding assets to actually buying them. Once fully implemented this will act to slow the delevering process to a more stable pace and ultimately restore confidence. Evaluating risk premiums: Valuing risk premiums is the key to identifying trading opportunities. We do this by gauging systemic and liquidity risk metrics and the potential impact of new market support schemes on risk assets. Heres where we see value: 1. Spreads: Swap spreads globally have become dislocated. We are awaiting a turn in systemic and liquidity risk metrics to signal an entry point. 2. Mortgages: We are adding risk exposure to this asset class. It fits the criteria of high quality, deep liquidity and benefits from government support. 3. Inflation: Market support schemes are inherently inflationary. We maintain a position for a rebound in inflation breakevens. 4. Europe: We highlight the best value opportunities for an economic slowdown. European volatility has been relatively orderly. We look at ways to fade high volatility and benefit from potential rate cuts. 5. Japan: Risk-aversion trades still offer value. Long asset swap spreads, long volatility and long the belly of the curve are the trades of choice. 6. AXJ: Monetary easing is likely to come earlier than is priced. We recommend defensive trades.
US Interest Rate Strategy

Jim Caron George Goncalves Bill McGraw Jason Stipanov Janaki Rao Corentin Rordorf
Europe Interest Rate Strategy

Laurence Mutkin Mayank Gargh Michelle Bradley Vincenzo Guzzo Owen Roberts Elaine Lin
Japan Interest Rate Strategy

Freddy Lim Atsushi Ito Sandeep Arora Tomohisa Fujiki
Asia ex-Japan Strategy

Linan Liu
Recent Reports
US The Treasury and the Fed Have Not Yet Begun to Fight US Interest Rate Strategy Sept 24, 2008 UK Buy Short Gilts Even Now Europe Interest Rate Strategy Europe From Systemic Back to Idiosyncratic Risk Europe Interest Rate Strategy Sept 29, 2008
Sept 26, 2008
Japan Oil Cycle Reversal, Economic Slowdown And Inflation Linkers Sept 26, 2008 Japan Interest Rate Strategy AXJ Trading Strategies - THB 2x10 IRS Curve Strategies Sept 30, 2008 Asia Interest Rate Strategy
The Primary Analyst(s) identified above certify that the views expressed in this report accurately reflect his/her/their personal views about the subject securities/instruments/issuers, and no part of his/her/their compensation was, is or will be directly or indirectly related to the specific views or recommendations contained herein. This report has been prepared in accordance with our conflict management policy. The policy describes our organizational and administrative arrangements for the avoidance, management and disclosure of conflicts of interest. The policy is available at www.morganstanley.com/institutional/research.
Please see additional important disclosures at the end of this report.
MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives
Global Trade Ideas

Market US
Mortgages Mortgages are likely to benefit from policy actions that reduce systemic risk as well as from specific measures that look to cap mortgage rates. The Treasury purchase of mortgages reduces extension risk and helps mortgage valuations appear more attractive. The particular trade benefits from the flatter curve and tighter swap spreads expected in a systemic-risk reduction. Buy TBA+IO, long 3y10y Mortgage volatility has been dropping relative to swap volatility but has more to drop, in our view, especially as policy measures take effect. The trade captures this expected reduction in mortgage volatility relative to swap volatility. The trade appears cheap swaption straddle in our models and is positive carry. Sell 10s on UST 2s10s30s We like this position as another way to play for bear steepening of the spot curve, and while 10s have cheapened on this fly significantly over the past month, we believe the 10Y has further to go. This remains a core view for us. 2y Forward 1s2s has the best risk-adjusted rolldown on our carry quotient metric. Compared to 2y 2s10s, the trade offers only Buy 2y 1s2s steepener slightly less rolldown over the course of one year, but has less than one-third of the historical realized volatility. Recent TIPS underperformance linked to oil and the anticipation of negative seasonals has created oversold conditions. We like Buy Jan 09 TIPS owning short-dated TIPS, as we expect inflation to remain sticky amidst the pullback of commodities. Jan09 TIPS offer value, in our view, as we are calling for a rise between the August/November CPI prints, while the market is pricing in a decline. We maintain our longer-term view that increased inflation expectations are going to be pushed further out the curve. As such, we Buy 10y10y TIPS like holding 10y10y inflation. Buy 100bp OTM 3y10y Despite rising inflation risks, USD forward rates are still historically low and have lagged in the sell-off due to the flattening of the payors curve. We recommend paying on forward swap rates either outright or through swaptions and CMS caps with expiries of 3y or greater to express an inflationary view. Buy 3m 2y1y 3m10s We favour selling 3m mid-curve payors on the 2y1y rate versus buying 3m10 payors as the greens look very cheap on the curve. bear steepener With short expiries, we also like fading short-tail volatility richness relative to longer-tail volatility. Sell 1m/3m 3m Libor basis We expected the 1m/3m Libor basis 3m forward to normalize after the Fed announced that it would introduce 84-day TAF loans to complement its existing 28-day TAF loans. This spread has begun to tighten over September and we expect it will tighten further in the coming weeks. 1 x 1.5 3.10% / 3.45% This trade was a way to position fade the richness of vol in the front end and position for an unwind of the flight-to-quality trade. USD 3m2y payor spreads While our risk scenario, a sell-off in Libor rates due to rising Libor sets has materialized, the rally in UST yields has kept the markto-market losses on this position to a minimum. We like holding this trade through quarter end and legislative proceedings to take place this week. However, we continue to monitor our stop of 0bp should the widening of swap spreads overtake the rally of 2y USTs and push 2y swap rates higher. Buy a 1x2x1 1y1y receiver The receivers on this trade are struck ATMS, ATMF and at a strike such that trade is symmetrical. This trade maximizes the fly payout if 1y rates remain unchanged and roll down to spot. Buy call protection pools Lower mortgage rates will increase value of call protection. Specified pools offering call protection, including loan balance pools, vs. TBA seasoned pools and 10/20 Interest First pools will see payups rise. Buy RPX Dec 09 The performance of real estate has been the guidepost of financial market movement since the start of the credit crisis a year composite vs. curve ago. The residential property derivative market is indicating that we are only halfway through home price declines, and we expect steepeners home prices to remain an important factor in rates/curve movements. We are recommending two trades a curve cap and a CMS rate floor hedged with a long RPX position to take advantage of this relationship. Sell 5y10y muni ratio We like the trade because we were taking advantage of the high level of ratios and the steepness of the ratio curve. Over the past two weeks, the spike in risk premia hurt the trade. We believe the trade should come back to more normal levels when the market normalizes. Buy 3m 10y10y midcurve We like shorting the back end of the curve, as it appears rich on a variety of our metrics. We put this trade on in the form of a payor spread midcurve payor spread as a way to limit our downside. Buy FN 5.0 vs. 5y UST
Trade Idea
Rationale
Mortgages
Treasuries Swaps Inflation
Inflation Swaptions
Swaptions Basis
Swaptions
Spread Mortgages RPX
Muni
Duration
EUROPE
Duration 5-year cash The front end is pricing about 40bp of cuts to end of 2009. There was significantly more risk premium priced in than earlier in the year. We believe that there is room for 1s2s to invert further. We recommend adding bull steepeners which should perform well should cuts materialize earlier than current market expectations. A basic regression of the 5s10s German benchmark curve as a function of the current ECB refi rate and the Ifo Business Climate shows that the yield curve is over 20bp too flat, given the current levels of these variables. It was definitely too steep earlier this year; it is too flat now. With 2s5s steepening beyond 5s10s, the 2s5s10s barbell has lately moved to positive territory. We see 2s5s10s falling back below zero on a 5-year led rally.
Curve
5s10s cash steepener
Barbell Spreads
2s5s10s cash barbell
Volatility
Volatility
Sell 10-year DBR swap The recent unprecedented wave of flight to quality in financial markets has led to a sharp widening in swap spreads across all spreads vs. buy protection currencies. Not only have swap spreads reach new wides, they also moved well beyond what we observed in credit markets. on the iTraxx Crossover Outright 6m10y We believe that the 10Y sector would be attractive to sell outright, given that the premium over realized vol is in contrast to other sectors where realized is at or above implied. Realized vol at the front end is likely to be higher in an uncertain rate cut environment, and also more susceptible to sudden corrections in the Euribor-EONIA spread. 3m1y/3m2y vol switch While we prefer 10Y tails on an outright basis, we believe that 1Y tails offer value against 2Y tails, both from a realized vol perspective and on the basis that a move up in ECB rate cut expectations would likely be more bullish for 1y tails.
See additional important disclosures at the end of this report.
UK
Duration Spread The front end of the Gilt curve still looks like it is worth owning, even after this weeks rally. Four reasons: 1) elevated Libor; 2) a deteriorating economy; 3) inflation has peaked; and 4) 2-year has previously traded further through Base rates. Buy 2-year Gilts vs. 2-year We are bullish both the front end of the UK and Europe, but we believe there is more upside to Gilts than Schatz. The 2-year Schatz spread is pricing either synchronized cuts by the ECB and BoE or unchanged rates by both. We believe that there is a higher chance that the BoE cuts first and cuts more times in this cycle. Buy 2-year Gilts
JAPAN
Swaps Front-end Fwd steepeners (pay 100%*2y fwd 1y vs. rec 115%*1y fwd 1y, or equal DV01) <CLOSE> Buy 10yx10y ATM receiver swaption <HOLD> Japan is likely to confront below-trend growth, and BOJ is widely perceived to be way behind the cycle. The key concern inflation should push the risk premium further out the curve. Leveraging on high carry in very short-dated swaps, we hold forward steepener (pay 100%*2y fwd 1y versus rec 115%*1y fwd 1y). Empirical directionality to rate decreases with an overweighted DV01 in 1y fwd 1y swaps. (Refer to Japan: A Case of Three Segmented Markets, June 11, 2008.)
Swaptions
JGB
Sell JGBU8/JGBZ8 calendar spread <CLOSE>
Recent improvement in GDP is short-lived and driven by surprisingly good capex. Corporates ability to sustain capex is weakening, as profits are rapidly slowing. Industrial production is likely to drop in the Jan-Mar quarter. This means that there is a risk that recessions in Japan and the US would coincide in the Jan-Mar and Apr-Jun quarters. To express this idea, we focus on 10y/10y swap as it tends to follow the Japans IP cycle. Leveraging on cheap and sluggish vega, scale into buying 10y/10y ATM receiver swaption at 3.10% without delta hedge, positive carry in one years time. In a recessionary environment, it is highly likely that CTAs and program traders will maintain their long bias in duration. As a result, we see a need for them to roll over current longs from JBU8 to JBZ8. On the other side of spectrum, we have seen repo on CTD trading very specials, which means that the dealer community is attempting to deliver. As a result, this reduced the odds that they will buy back front contract and hence allow the CTAs / macro to dominate the roll. In view of our stance on oil cycle reversal, we actually prefer to increase the short in JGBi_#10 to create the weighted real curve flattener (90% DV01 in #10 versus 100% DV01 in #15). While spot JGBi#15 real yield has lost roughly 70.2bp running since mid-July, the weighted real curve flattener has lost even less, at about 1.5bp negative MTM move since mid-July.
Inflation
Swaptions
Converting outright long in linkers into the weighted real curve flattener by holding JGBi_#15 and sell 90% DV01 in #10 <NEW> Buy 1yx20y ATM swaption against 1yx3y, vega weighted <CLOSE>
Fiscal outlook and uncertain supply in the 20y sector have created jump risk in the 20y tail. While this sector has cheapened on the back of risk aversion, 1yx20y volatility remains subdued. In the meantime, the 3y tail is likely to remain range bound since the BOJ is caught between stag and flation. We like to leverage on relative weakness in 1yx20y and own jump risk in 20y tail and selling 3y tail. With our new bias toward a lower yield environment, the delta risk relating to our shorts in 1yx3y straddle presents a critical problem in risk management. Consequently, weve decided to close the trade.
Swap Spreads
Bought 8y-9y outright We would like to stay long risk premium but the futures are still trading rich on asset swap spreads. Instead, we prefer to buy 8 JGB asset swap <NEW> to 9-year JGB ASW such as the JB285 area. This bond is roughly 8.5 years in maturity and rolls down very steeply into the rich futures CTD area. As of September 26, 2008, this ASW rolldown is roughly 16.9bp running per year. Scale into buying body of With more slowdown in the pipeline, we think owning 5y JGB against the wings in a 2y/5y/10y butterfly is the ideal way to 2y/5y/10y JGB butterfly position for the arrival of the new cycle. Most JGB index duration averages around 6.0-6.5 years and the 5-year sector has <NEW> become an important part of index tracking strategies. In addition, an unchanged BOJ policy rate effectively encourages domestic banks to use 5-year JGB as the pivot. Also, urgency among life insurers on the ALM gap which also argues well for 5y/10y part of our butterfly to flatten in our favor.
JGB
Asia ExJapan
Curve Duration Duration Duration Curve Curve Spread AUD 2y 2s10s steepener CNY 1Y NDF KRW long 3Y KTB futures Long KTBi KRW 2x5 IRS curve steepener KRW CCS 1x3 curve flattener Pay HKD 1x2 IRS curve spread vs. receive USD 1x2 curve spread THB 2x10 curve steepener We entered this trade as a way to play an overpriced housing market, the risk of a credit crunch spreading to Australia and in anticipation of falling metal prices. Global credit concerns filtered through to Australia, causing the curve to continue to steepen. Expect a reduction in the risk premium on 1Y CNY NDF. A tactical long position on bonds to hedge against risk on growth. Capitalize cheap valuation of KTBi. Curve is likely to dis-invert to price in the prospect of monetary easing. Expect an ease in short-term USD liquidity squeeze to bring the CCS curve shape to normal. We believe that the credibility of the HKD peg supports a re-normalization in the HKD-USD interest rate spread.
Curve
Supply risk at the long end and fading monetary tightening bias support the case of curve steepening.
Global Cross Rates Strategy Evaluating Risk Premiums: Systemic and Liquidity Risk Metrics
The metrics critical to gauging the current crisis are those that surround the valuation of money and cost of funding overnight, 1-day, 1-week and term. In this report we describe the metrics that we use on a global basis as a helpful guide to evaluate opportunities in the market. Furthermore, we continue to rely on our longheld thesis of ReNormalization to provide a framework for understanding the current conditions in the market (Exhibit 1). Our conclusion is that we are encouraged by all the market support schemes put forth by the Fed and US Treasury in addition to the coordinated efforts with other global central banks. But one must realize that these measures will simply take time to work and restore confidence. Let us explain: The Treasury and Fed Have Not Yet Begun to Fight Naysayers beware, the Treasury and the Fed have not yet begun to fight, as many of the market support schemes are yet to be fully enacted. Exhibit 1 illustrates the evolution of US government support facilities, the majority of which have only recently been introduced, as an overlay to our ReNormalization thesis (counterclockwise flow of arrows). Noteworthy in this evolution is the progression from funding schemes to actual purchases of assets. We believe that these support facilities, once fully enacted, will go a long way toward restoring proper order and confidence to the market. Since 4Q06, we described our thesis for the impending delevering of the market that we called ReNormalization a process by which assets are revalued lower due to the rising cost of funding. The primary risk we identified in this thesis was not solely the delevering, rather, it was the speed at which assets would delever. To slow this process, the government introduced various liquidity, funding and recently even asset purchase schemes, shown as the clockwise flowing arrows in Exhibit 1. The intention is to slow the speed of delevering to a more stable pace by keeping troubled assets fungible.
Exhibit 1
Before and After: The Market Maybe Underestimating the Full Scale of Market Support Schemes
Source: Morgan Stanley Research
Understanding this process is critical to anticipating future market developments. Let it not be lost on anyone that the majority of these government support facilities were created just in the last few weeks and are yet to be fully implemented. As we argue above, the key to stabilizing the delevering is to keep assets fungible throughout the process. Previously, this centered on funding schemes such as TAF, TSLF and PDCF. Now it is centering on purchases of assets, the ultimate of fungibility. We believe that the new and proposed measures by the government to support the markets will work. However, we need to be patient, as it will take time for these schemes to start and then begin to work. Evaluating Risk Premiums: Four Sign Posts to Monitor Beyond government assistance with funding and fungibility for troubled assets lies the art of assigning the proper risk premiums for these assets. Risk premiums are often difficult to define, but there are four sign posts that we use as guides to define both systemic and liquidity risk premiums:
Exhibit 2
1.
TED Spread Reaches New Peak to Reflect Market Uncertainty

350 bp 300 250 200 150 100 50 0 -50 1984 1988 1992 1996 2000 2004 2008 1987 Stock Mkt Crash 308bps
Yield curve (systemic): We use changes in the slope of the UST 2s10s curve to assess term premiums. Steepening curves imply increasing systemic risks and vice versa. Swap spreads (systemic): We focus on the level of US 2yr swap spreads, as it provides information on the demand to own UST collateral and repo specialness relative to Libor rates. Wider spreads imply increasing systemic risk and vice versa. Libor-OIS (liquidity): We use this measure to communicate information about the markets view on counterparty risk and secured versus unsecured lending. In many ways, the market has come to view Libor-OIS spreads as the definition of liquidity conditions. We use 3-month Libor-OIS because it smoothes short-term technicals in funding markets. Wider spreads imply increasing liquidity risk and vice versa. TED spread (liquidity): We use a crude measure of this spread and define it as the difference between the 3-month Libor set and the 3-month T-bill. This measure communicates to us the level of safe-haven demand to own T-bills relative to Eurodollars. Since both are short-term measures of cash demand, we view this as a liquidity metric. Wider spreads imply worsening liquidity risk and vice versa (Exhibit 2).
2.
331bps Sep 29 '08
3.
4.
Both systemic and liquidity risks are interrelated but tracking the performance of these metrics, and money market flows help us evaluate the relative level of risk premiums. Money markets need to further stem the outflows in credit-related products, a critical signal to indicate that funding stresses are declining (Exhibit 3).
Exhibit 3
Money Market Winners and Losers: Inflows versus Outflows ($bn)
Source: IMoney.net, Morgan Stanley Research
Global Cross Rates Strategy Liquidity and Funding Risks: What We Are Watching and Why
Exhibit 4
1 - Libor-OIS Spread Metric

BPS
250
EUR Spot 3m Libor-OIS

200 150 100 50 0 Nov-07 May-08 Feb-08 Mar-08 Aug-07 Sep-07 Dec-07 Apr-08 Aug-08 Sep-08 Jun-07 Jan-08 Jun-08 Oct-07 Jul-07 Jul-08
Money and financing markets are at the sharp end of systemic risk. Recent events have undermined confidence in the system, causing the money markets to exhibit extraordinary stress. However, the authorities are pushing hard to repair the damaged confidence in the system. If they can succeed, the money markets have the capacity to recover quickly, even if some idiosyncratic risks still persist. So its important for the authorities and investors alike to monitor closely the developments in the money markets.
GBP Spot 3m Libor-OIS USD Spot 3m Libor-OIS
Money Markets Funding Pressures Have Morphed into Systemic Risk

During normal times, short-term financing is a very low risk and very low reward business. It follows that access to the money markets is quite binary: if borrowers are considered to be good for the money for a week or a few months, they will borrow at a very similar rate to any other borrower in a similar position. The longerduration markets bonds and equities can take a view on each borrowers longterm creditworthiness (idiosyncratic risk): for money markets, such issuer-specific long-term concerns do not matter. So when money markets exhibit large volatility or money market liquidity dries up leading to funding pressures, the issue then is not about idiosyncratic risk: its about systemic risk. This is why we continue to emphasize the importance of watching the short-term financing markets.
Exhibit 5
2 - US CP Market Spread Metric

440 400 360 320 280 240 200 160 120 80 40 0 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 145 Leading to Jan01 Inter-Meeting Cut 409
Money and Financing Markets Are Exhibiting Great Stress

At present, the money markets exhibit great strain evidence that systemic and liquidity concerns remain extremely high, despite the many interventions of monetary and fiscal authorities around the globe. These record levels of funding stresses are coming about as a result of cash hoarding by financial institutions that remain concerned about whats hiding on the balance sheets of their counterparties. The following are key metrics that we use to gauge money market stresses: 1. 2. Libor-OIS spreads (Exhibit 4), which reflect the term premium between expected overnight lending rates and term bank lending rates. Spreads between differently-rated US CP (Exhibit 5). In particular, we focus on the spread between AA and A2/P2 non-financial CP the spread which Greenspan cited (among other things) as the reason for his Jan 01 intermeeting rate cut (the spread hit 145bp and is currently at a high of 409bp). The FX implied USD funding rates (Exhibit 6) offer insight into global funding pressures as banks outside the US turn to the FX markets to source dollars funding (term rates over 5% and overnight reached 35%).
Source: Federal Reserve, Morgan Stanley Research
Exhibit 6
3 - FX Implied USD Funding Rate Metric
3.
Source: Morgan Stanley Quotient Analytics
These data are transparent, timely and give a good idea of the levels of stress in the money markets. As Exhibits 4 through 6 clearly demonstrate, these indicators show that stresses in money and financing markets remain extremely high (if not at their highs) and continue to be a pervasive problem for all markets and the economy.
Signs of Confidence Returning to the Market

Exhibit 7a
Increased Deposits in Large Banks as Investors Allocate Away from Money Markets
$3,600Bn 3,550 3,500 3,450 3,400 3,350 3,300 3,250 3,200 3,150 3,100 3,050 Sep07 Dec07 Mar08 Jun08 Sep08 Large Bank Deposits Jump as Investors Shift Away From Money Market Funds 3,541
Official intervention can be effective in restoring confidence in the system, even after the failure of a specific financial institution. This can be seen in money markets, because they reflect systemic rather than borrower-specific idiosyncratic risk. Thus the failure of Bear Stearns in March jeopardized confidence in the financial system; but its swift resolution by the US authorities and forceful action to provide market liquidity managed to restore some confidence in the financial system. This led to systemic risks being addressed (for the time being at least) which resulted in Libor-OIS spreads tightening from 80bp to 57bp in the days after the BSC/JPM rescue financing plan by the Fed. During September, the flurry of news about the future of several large US financial institutions again jeopardized confidence in the system, especially as related to a large firm that was not rescued. Fears for the viability of the system rose further, despite rescues for other troubled financial institutions. Since then, the authorities in the US and elsewhere have worked tirelessly to rebuild confidence in the system. But evidence thus far from the money markets is that these initiatives have not (yet) succeeded. Specifically, the authorities in the US and elsewhere have now reacted in kind by supersizing liquidity programs directly targeting money market stresses (Exhibit 7b). Make no mistake, the authorities have flooded money markets with liquidity; they have broadened and extended the availability of central bank financing facilities; they have increased the availability of offshore USD; they are planning to introduce measures to buy troubled mortgage-related assets; they have facilitated the takeover of several vulnerable banks in Europe and the US. Still, the money markets continue to exhibit fear for the sustainability of the financial system, with deposits at large banks increasing as investors allocate away from riskier money markets (Exhibit 7a). But in our opinion, it is possible that the authorities efforts will, over time, reassure the markets that no more institutions of systemic importance will be allowed to go under without a partner or government help. If the authorities can, by their actions, convince investors of their commitment to maintaining viable institutions, fears of systemic risk will begin to retreat as liquidity channels through the system and this could happen surprisingly quickly (as the bandwidth pipes are now very wide Exhibit 7b). The first evidence that these schemes are working will be seen in the financing and money markets, specifically via the three money market metrics listed above (LiborOIS, CP spreads and FX implied USD rates). This is why we think these metrics are important gauges for all market participants.
Exhibit 7b
Supersized Fed Liquidity Programs Offer Plenty of Liquidity Bandwidth for the Authorities to Target High Money Market Spreads and Rates
Global: Swap Spreads: At the Mercy of Libors Next Direction

Key Trades
Exhibit 8
Decomposition of 2ySpread
2y UST/OIS Spread 2y OIS/Libor Spread 2y Swap Spreads
Source: Morgan Stanley
Europe: 10-year DBR swap spread tighteners versus buying protection on 5year iTraxx Crossover index Japan: 2-year JGB spreads not yet tight enough to enter wideners
10-Sep 31 64 95
1-Oct Change 50 19 106 42 156 61
Spread Movements to Remain Volatile as Concerns over Libor Supersede Government Supply Woes (for Now)
Since the start of the credit crunch, swaps spreads have been driven by two prevailing forces government bonds and Libor funding concerns (more specifically bank credit concerns, see Exhibits 9a and 9b).
Exhibit 9a
US
Treasury Specialness Factor The flight to quality into Treasuries has richened Treasury collateral, driving government rates down faster than swap rates, causing spreads to widen. Repo rates on USTs have fallen dramatically as a result, improving the carry on long UST positions. While earlier this year, increased supply from both the Treasury and the Fed (via SOMA sales) along with the TSLF program helped to reduce this component, the events of recent weeks have driven the specialness factor back to the wides. As a result, the spread between 2y UST yields and 2y OIS rates has widened by 19bp from 31bp to 50bp (see Exhibit 8). Credit (Libor) Factor Increased stress in the money markets caused 3m Libor to rise by more than 60bp in the past week, which has had a significant negative impact on receiving fixed swap positions. Furthermore, lack of liquidity in the term funding markets is creating a lot of uncertainty and volatility around the true level of Libor, raising risk premiums in the swap spread curve. As a result the spread between 2y OIS and 2y swap rates has widened by 42bp from 64 to 106bp (see Exhibit 8). These two effects can be analyzed independently by separating the swap spread into two components the spread between 2y UST yields and the 2y OIS swap rate (the specialness factor) and the spread between the 2y OIS swap rate and the 2y Libor swap rate (the credit factor) (see Exhibit 8). These correlate to the divergence of their respective short-term funding rates: UST repo, fed funds and 3m Libor. The UST/OIS spread currently trades at 50bp for 2y spreads and is driven by the demand for Treasuries. The OIS/Libor spread currently trades at 106bp and is driven by the embedded credit spread in Libor (see Exhibits 9a and 9b). The Supply Effect of the Troubled Assets Relief Program (TARP) Should it pass close to its current form, we expect that the initial effect of the proposed Troubled Assets Relief Program (TARP) to reduce the specialness of UST collateral, as temporary supply increases substantially. However, since this factor has not been the primary driver of swap spreads, we believe that its effects will be limited to a 20-30bp tightening on 2y and 5y spreads. In order to get a more meaningful tightening, confidence will need to be restored to the system, and unsecured term lending spreads will need to come in, which could take more time.
2-Year Swap Spread Breakdown: Credit Dominates Treasury Specialness

160 140 120 Basis Points 100 80 60 40 20 0 Mar04 Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 Mar08 Sep08 2yr Specialness : 50 bp 2yr Credit : 106 bp
Exhibit 9b
5-Year Swap Spread Breakdown: Credit Dominates Treasury Specialness

120 100 80 Basis Points 60 40 20 0 -20 Mar04 Sep04 Mar05 Sep05 Mar06 Sep06 Mar07 Sep07 Mar08 Sep08 5yr Specialness : 47 bp 5yr Credit : 66 bp
Europe
Cautiously Entering 10-year DBR Swap Spread Tighteners Not only have swap spreads reached new wides, but they had also moved well beyond what was observed in credit markets. With policymakers stepping in and trying to contain systemic risk, we see scope for meaningful swap spread tightening. Idiosyncratic risk, however, is still too high to fight, thus the idea of hedging the tightener by buying credit protection on the 5-year iTraxx Crossover index (see Exhibit 10).
Exhibit 11
Overnight Repo Rate in Japan (T+1 Settlement, %) into Fiscal Half-Year
Exhibit 10
Swap Spreads versus Credit Spreads

-20
-30
y = -0.0473x - 20.838 R 2 = 0.6413
-40 10Y DBR ASW Long Run Crisis Equilibrium -50
-60
Jul 1, 2007 to Aug 31, 2008 Sep 1, 2008 - Sep 17, 2008 y = -0.2587x + 86.752 R 2 = 0.7115 Short Run Distress Equilibrium 400 450 500 550 600 650 700
-70
Sep 18, 2008 - Sep 26, 2008 Last
-80 200 250 300

350
5Y iTRAXX Crossov er
Exhibit 12
6M JPY Libor 1M GC for JGB, bp

-15 -20 -25 2 J BA W B y G S , p -27.8 Bp -30 -35 -40 -45 -50 25 30 35 40 45 50 55 30.2 Bp
Dont Worry about Carry, but Mind the Policy Action The swap spread leg of the trade is fractionally carry-negative, while the credit leg implies around 50bp of negative carry per month, not a big number considering the 22bp standard deviation of the Crossover index daily changes over the last month. The main risk on this trade remains a slower-than-expected policy action to tackle the current credit crisis, failing to ease the extreme stress in money markets.
Japan
2-Year JGB Swap Spread Has Narrowed of Late, but We Caution Against Entering Spread Wideners As Japan approaches the fiscal half-year towards the end of September, recent money market risk-aversion has created an earlier and larger-than-expected rise in funding pressure. This is in contrast with the US, where funding rates of UST collateral have fallen dramatically. Along with TIBOR, the domestic yardstick for funding, general collateral rates in JGB have suffered a larger increase than LIBOR. As a result, the Libor-GC spread has compressed into the end of September. These carry mechanics have created a cheapening in the 2y JGB swap spread of late (see Exhibit 12). While the tightening is attractive, its absolute level still appears to be 7.3bp tighter than what our model is implying. We strongly caution against entering 2y JGB swap spread wideners at this level.
(6M Libor minus 1m GC), Bp
Policy Implications for Mortgages Are Positive

Key Trades
Long FN 5 versus 5y UST We recommend an overweight position in mortgages, specifically a long FN 5 versus 5y UST trade. Mortgages are expected to benefit from policy actions that reduce systemic risk as well as from specific measures that look to cap mortgage rates. The Treasury plan to purchase mortgages directly for example, as well as enabling the GSEs to do the same, is targeted at maintaining and improving housing affordability. Thus, we feel that the Treasury is likely to effectively cap mortgage rates (as opposed to spreads), which reduces extension risk (Exhibit 13). In other words, the Treasurys action removes one tail of the mortgage rate volatility distribution as the government is virtually guaranteeing that mortgage rates will not rise in any meaningful manner. Exhibit 14 displays the current OAS across the coupon stack as well as the OAS adjusted for the reduced extension risk. We calculate this adjusted OAS by capping the secondary mortgage rate at 6% in our prepayment model for the duration of the Treasurys MBS purchase authority till the end of 2009. Policy actions that reduce systemic risk as well as specific measures that look to cap mortgage rates are tantamount to buying mortgages at a wider OAS, which we represent by the upper line in Exhibit 14. The adjustment makes the recent compression in coupon swaps appear reasonable. The reduced extension risk benefits the lower coupons more so than higher coupons, not surprisingly given their higher durations and volatility exposures. The higher durations benefit from the rate scenarios more skewed to lower rates while the higher volatility exposure benefits from the reduced volatility of mortgage rates implied by the cap. Another way to think about this is that owning mortgages was equivalent to a long bond and short call option position. The Treasurys move has added a long mortgage put option to that equation. Mortgage investors could monetize the value of the put option by either explicitly selling mortgage put options or by selling swaption payers when hedging their mortgage volatility position. Our understanding is that the mortgage option market lacks the necessary depth and liquidity to effectively monetize the value of the Treasury put option. However, a more liquid and thus practical manner to monetize this put option would be to hedge only the lower rates tail when purchasing mortgages. In other words, buy receivers while hedging a long mortgage position but not payers (for more details, please see Policy Implications for Mortgages Are Positive by Janaki Rao, September 22, 2008).
Exhibit 13
If Mortgage Rates Were Capped

Distribution of FN30 Current Coupon 1998-to date
250
200 Observations
Treasury looks to cap mortgage rates.
150
100
50
0 4 4.5 5 5.5 6 6.5 7 7.5 8 8.5
FN30 Current Coupon
Note: The mortgage rate cap target displayed is for purpose of illustration only and does not imply any cap targetted by the Treasury. Source: Morgan Stanley Research
Exhibit 14
Capping Mortgage Rates Improves Mortgage Valuations as Extension Risk Is Reduced

OAS, (bps) 160 140 120 100 80 60 40 20 0 4.5 5 5.5 6 6.5 7 FN30 Coupon
Level of OAS calculated with mortgage current coupon yields capped at 6%
* Mortgages are cheap once the lower extension risk is factored in. * Impact larger on lower coupons.
OAS as currently calculated with no rate cap.
Recommended Trade
Long FN30 5 versus 5y UST. We reiterate our call for a long FN30 5 versus 5y UST trade in a 100 to 79 ratio. This trade captures the swap spread tightening and curve flattening expected as systemic risks are reduced besides mortgage outperformance. For investors wanting to hedge the volatility exposure, we recommend the following trade: long $100mm FN 5s, Short $50mm 5y UST, and Long $54mm 50bp OTM 3y10y swaption receiver. The trade is DV01 and vega-neutral, assuming that we only need to hedge half the vega exposure of mortgages ignoring the extension risk. The vega exposure is not exactly symmetrical, but for practical purposes the difference is minor enough to ignore.
10
Global Inflation Review

Exhibit 15
Key Trades
US and Europe: Long breakevens (bonds) entry point JGBI real curve flattener: long 100% JGBI_#15 versus 90% JGBI_#10 Need to Manage Linkers Risk as Oil Cycle Reversal Is Approaching In our view, oil and commodities have already met the criteria for classic bubble formation. It usually starts with prices displaying larger marginal rates of increases after a sustained period of ascent. While it is impossible to judge a bubble before it bursts, one can predict a cycle reversal when the rate of decline (after the peak) is as rapid as the rate of increase (prior to the peak). Recent examples of such postbubble episodes are the Hang Seng index (peaked in October 2007) and the Shenzhen equity index (peaked in September 2007). Is it dj vu all over again? When we overlay the path of the WTI oil price on the NASDAQ Nov91-Apr01 cycle, we are very surprised to see such tight similarity (see Exhibit 15). If this classic pattern repeats itself, the risk that the next leg of the oil cycle reversal is going to be delayed till early 2009. This is a relevant risk for inflation linked bonds and we caution against being too complacent. Linkers Realized Carry Overwhelmed by Mark-to-Market Pain We have been buying inflation-linked JGBs outright this year, as we think they are ideal for a stagflationary environment. While we have earned substantial carry on our core holdings in JGBi_#15, the reverse in correlation between real and nominal yields has been a pain. In summary, realized carry has been overwhelmed by markto-market pains. Using JGBi_#15 as a reference, we have entered into a long position on April 25 and May 23 at 1.3% and 1.4%, respectively. Since then, these positions have earned a carry of roughly 27bp and 24.6bp running. Unfortunately, real yield has sold off 48bp and 38bp. As a result, our linker portfolio is down 21bp and 13.5bp running, net basis (see Exhibit 16). Position Management in Linkers One can reduce real yield exposure by creating a synthetic forward real yield receiver. This can be achieved by selling an equal notional in a shorter-maturity real bond. Within what liquidity permits, we think it is plausible to hold longs in JGBI_#15 against selling JGBI_#10 (see Exhibit 17A). In view of the possibility of an oil cycle reversal, we actually prefer to increase the short in JGBi_#10 to create the weighted real curve flattener (90% DV01 in #10 versus 100% DV01 in #15, see Exhibit 17B). The risk-reduction can be observed in both Exhibits 17A and 17B. While spot JGBi#15 real yield has lost roughly 70.2bp running since mid-July, the synthetic forward real yield only loses 3.875bp. The weighted real curve flattener loses even less, at about a 1.5bp negative MTM move since mid-July.
Oil Is Confronting a Classic Post-Bubble Reaction

Nasdaq Peak = Feb-2000 WTI Oil Peak = Jun-2008
3 months of short term relief till Dec-2008?
Dj vu? Resume a sustained decline from Jan-2009?
Exhibit 16
Realized Carry in Holding Linker #15 Outright as of September 26

25th April 2008 Bought JGBi_#15 Outright At 1.3% Real Yield
23th May 2008 Bought JGBi_#15 Outright At 1.4% Real Yield

Exhibit 17a
Forward Real Yield Receiver, bp

Spot JGBi_#15 Real Yield, Bp [LHS] Synthetic Fwd Real Yield (100%*#15-86.9%*#10), Bp [RHS] 180 170 Spot Real Yield For JGBi_15, Bp 160 150 140 130 120 110 100 08M04 08M05 08M06 08M07 08M08 08M09 30 29 Synthetic Forward Real Yield, Bp (100%*#15 - 86.9%#10) 28 27 26 25 24 23
Exhibit 17b
Hold longs in JGBi_#15 and hedge with 86.9% DV01 shorts in JGBi_#10.
#10 / #13 Real Curve Flattener, bp

Spot JGBi_#15 Real Yield, Bp [LHS] Synthetic Fwd Real Yield (100%*#15-90%*#10), Bp [RHS] 180 170 160 150 140 130 26 25
Hold longs in JGBi_#15 and hedge with 90% DV01 shorts in JGBi_#10.
24 23 22 21 20 19 18
22
120 110 100 08M04 08M05 08M06 08M07 08M08 08M09
11
Exhibit 18
10Y JGB Yield and Business Cycle
We Expect 1.25% for 10y JGB Yield by End of 2008 or 1Q09 In all fairness, there have been a lot of swift policy actions in the US, but we do recognize that the economy is likely to be sluggish over the next 1-2 years, even if the rescue packages are working smoothly. So, even though we are in the positive camp, we still think that the 10y JGB yield can trend lower to 1.25% within 3-6 months. This scenario is arrived at by super-imposing the Oct 93-Jan 99 cycle, as in Exhibit 18. If there are more negative surprises, the Nov 86-Oct 89 cycle would lead us to conclude the following path: 1. 2. 3. 1.20% by December 2008 1.10% in one years time 0.92% in two years time US TIPS Breakevens Update: Cheap Entry Point but TARP-Dependent After having risen every month since the start of the year, the August non-seasonally adjusted CPI index (CPURNSA), which is used by the TIPS market, showed the first monthly decline. The 0.40% drop was double that predicted by our model as the decline in energy prices was finally passed through this measure. This precipitated a significant collapse in breakevens. In addition, the ensuing systemic risk-led volatility for all financial products in September drove breakevens lower as fears of debt deflation would lead to lower inflation prospects in the near future. This may be an attractive entry point to start scaling into TIPS breakeven trades, which are at multi-year lows (see Exhibit 19). However, the risk is that financial turmoil will simply jump over to Europe in full force, as we have seen in recent days, and global growth prospects remain low. Indeed, our economists now see a recession in their sights. This means that breakevens could just bounce along the bottom of the range. EUR Breakevens: Flight-to-Quality Suppression to Provide Cheap Entry Point Capital preservation and the preference for government bonds is a key factor for the suppression of breakevens in Europe, see the spread between inflation swap and the bond breakeven spread, Exhibit 20. We believe that this contribution has exaggerated the collapse in the nominal/real spread. The three valid reasons why breakeven have fallen so much are 1) oil prices: down 30% from their highs; 2) inflation has declined for two consecutive months to 3.6% from a peak of 4.1%, with further slowing expected; and 3) deleveraging: a reduction in outstanding long inflation trades. We think that a rebound in bond breakevens will occur when evidence that the stresses in money markets show signs of improvement. This is also likely to slow the deleveraging process and a focus on the true value of inflation expectation will return. Although inflation is likely to contract as the economy slows, we put strong emphasis on the reaction of the ECB and possibility of a series of rate cuts over the next couple of years, allowing the inflation debate to re-ignite.
Exhibit 19
10-Year US TIPS Breakevens: Market Dislocations Drive Inflation Breakeven Rates to Bottom of Long-Term Range
Exhibit 20
Europe 10-year Inflation Swap versus Bond Breakevens
12
Europe: Buy Government Bonds as Fundamentals Deteriorate

Key Trades
Buy 5-year OBL Enter a 5s10s German cash steepener Buy 5-year OBL on a 2s5s10s German cash barbell Buy 2-year Gilts Buy 2-year Gilts, sell 2-year BKO
Exhibit 21
5s10s Curve Too Flat, Given Refi & Ifo

100.0 bp 80.0 60.0 40.0 20.0 0.0 -20.0 -40.0 -60.0 1999 Actual 5s10s (lhs) Fitted 5s10s on Refi Rate and Ifo (lhs) Residual (rhs) bp 240.0 200.0 160.0 120.0 80.0 40.0 0.0 -40.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 280.0
Fundamentals Still Matter As the focus is all on liquidity and money market stress, the European be it euro area or UK economic outlook keeps worsening at a rapid pace. Crucially, our economists now anticipate a BoE rate cut, but they see the ECB leaving rates unchanged for the foreseeable future. As a result, we think that the 5-year point is cheap on the German government bond curve and it will likely rally as fundamentals deteriorate. We recommend buying 5-year Bobls outright or entering a 5s10s cash steepener or even buying 5-year on a 2s5s10s butterfly. In contrast, we expect 2-year Gilts to continue to perform, even after last weeks rally. We would caution against buying 5-year Gilts versus 2s and 10s, even if they look cheap, and we believe that 2-year Gilts will outperform 2-year Schtze. 5s10s German Curve Already Too Flat, Given Current Rates A basic regression of the 5s10s German benchmark curve as a function of the current ECB refi rate and the Ifo Business Climate shows that the yield curve is over 20bp too flat, given the current levels of these variables (see Exhibit 21). It was indeed too steep earlier this year; it is too flat now. And notice, this analysis does not depend on expectations of future lower ECB rates; it simply reflects the current level of rates as well as the level of the Ifo. It Could Steepen a Lot if Rate Cuts Are Priced More Aggressively If instead markets were to price rate cuts more aggressively, then the 5-year point would look even cheaper and the 5s10s curve even flatter. Exhibit 22 highlights that when the ECB entered its easing cycle in May 2001, the 5s10s, at nearly 45bp, was much steeper than today. When the bank resumed cutting rates in December 2002, after a long pause, the curve was as steep as 70bp. Crucially, in both cases 5s10s was steeper than 2s5s, as the 5-year point was leading the rally. The current situation is exactly the opposite, with 5s10s flatter than 2s5s. This is not sustainable, in our view. Regardless of the actual ECB moves, 5s10s would steepen if the market priced rate cuts again. 5-Year OBL to Rally on 2s5s10s German Cash Barbell A simple chart of a 2s5s10s barbell makes a related point. With 2s5s steepening beyond 5s10s, the 2s5s10s barbell has lately moved to positive territory (see Exhibit 23). This is similar to what we experienced in early June. Back then, amid heightened inflationary pressures, the ECB had just signaled the possibility of a surprise rate hike; now, with fundamentals deteriorating and inflation off its peak, things look different. We see 2s5s10s falling back below zero on a 5-year-led rally.
Exhibit 22
5s10s to Steepen if Rate Cuts Priced

120.0 100.0 2s5s (lhs) 5s10s (lhs) Refi Rate (rhs, inverted) 80.0 60.0 40.0 20.0 0.0 -20.0 1999 2.50 3.00 3.50 4.00 4.50 5.00 2000 2001 2002 2003 2004 2005 2006 2007 2008 1.50 2.00
Exhibit 23
2s5s10s to Dip Again Below Zero
13
Exhibit 24
2Y Gilts at the Top of the Recent Range
Buy 2-Year Gilts, Outright or versus 2-Year BKO Where to buy on the Gilt curve instead? The key point is that our economists think that the BoE has more scope to cut interest rates than the ECB. Implications are twofold: 1. The 5-year point looks cheap on the 2s5s10s Gilt curve too, but 5-year Gilts historically have underperformed when the BoE cut rates. Therefore, we would like to own 2-year rather than 5-year Gilts. We expect 2-year Gilts to outperform 2-year Schtze. 2-year Gilts are at the top of the recent range (see Exhibit 24) and, in our view, they would look cheap in a scenario where central banks decided to go ahead with concerted rate cuts, let alone our main case of an ECB on hold (see Exhibit 25).
2.
Risks of more aggressive policy action by the ECB than the BoE seem like an unlikely scenario.
Exhibit 25
2Y Gilts Cheap Given Current Rates
14
Europe Vol: Volatility Remains Directional

Key Trades
Sell 6m10y outright 3m1y/3m2y volatility switch Volatility triangle
Exhibit 26
Implied Vols Rise; 30Y Realized Vol at Highs

140 130 120 110 100 90 80 70 60 50 40 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08
90 85 80 75 70 65 60 55 50 45 40 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 6m30y EUR Vol (bp) Realized Vol (bp) 30-Sep-08
6m2y EUR Vol (bp) Realized Vol (bp) 30-Sep-08
Amid the recent events in the money markets, the vol market has been relatively orderly. Even though liquidity has fallen, the main activity after the turmoil of the past couple of weeks was position-squaring demand from orphan positions. Gamma has outperformed, with realized vol staying high at the front end, but making new all-time highs in the 30Y sector (see Exhibit 26). Nevertheless, changes in gamma have broadly been in line with changes in the swap curve slope (see Exhibit 27), implying that the potential for exotics hedging-driven flows around the inversion point have been enough to counterbalance the credit/liquidity fears dominating other sectors of the market. Indeed, while it had been changes in the front end driving the swap curve slope over the past few months, the vol market seems to have adapted seamlessly to the long-end rally, driving the forward curve flattening over the past few days. The continued directionality despite the market turmoil increases our conviction that the highs we saw in June are unlikely to be breached in a significant manner, even in a further inversion of the swap curve. However, vol could also remain elevated, given the continued proximity to zero on the swap curve slope, as well as uncertainty over economic direction. Rate cuts, if and when they materialize, would likely result in a steepening of the curve, and should put some downward pressure on vol. We believe that liquidation of any remaining long positions would also add pressure to any vol sell-off. As such, we consider the following positions attractive to enter once liquidity is firmer.
Exhibit 27
Change in Vol Consistent with Swap Curve Slope

5.50 2Y Swap 2Y2Y Vol (rhs, bp) 105 100 95 5.10 4.90 4.70 4.50 4.30 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 90 85
25 20 15 10 5

5.30
1y fwd 10s30s (lhs, bp)
2Y2Y Vol (rhs, bp, inverted)
65 70 75 80 85
0
80 75 70 65 Nov-08
-5 -10 -15 -20 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08
90 95 100 105
15
Exhibit 28
6m10y Implied Above Realized Vol

90 85 80 75 70 65 60 55 50 45 40 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 6m10y EUR Vol (bp) Realized Vol (bp) 30-Sep-08
Outright 6m10y For those looking to fade the rise in vol, we believe that the 10Y sector would be attractive to sell outright, given that the premium over realized vol (see Exhibit 28) is in contrast to other sectors where realized vol is at or above implied vol. Realized vol at the front end is likely to be higher in an uncertain rate cut environment, and also more susceptible to sudden corrections in the Euribor-EONIA spread. Also, we believe that a market refocus on economic fundamentals post additional Fed measures would lead to new positioning for rate cuts using contingent bull steepeners, usually expressed in 2s10s, which would add downward pressure on the 10Y Vol. 3m1y/3m2y Vol Switch While we prefer 10Y tails on an outright basis, we believe that 1Y tails offer value against 2Y tails, both from a realized vol perspective (see Exhibit 29), and on the basis that a move up in ECB rate cut expectations would likely be more bullish for 1y tails. We would recommend either buying 3m1y straddles versus selling 3m2y straddles, delta-hedged, or using the cheapness of the 1y tail to enter 1s2s contingent bull steepeners, struck 50bp out of the money. Vol Triangle While relative value structures are subject to price discovery on a renormalization in liquidity, we would keep this vol triangle on our radar as a way to express a short position in 2y2y vol. We recommend taking advantage of the rise in gamma by entering a vol triangle, which has very similar profile to the outright 2y2y position, but benefits from better carry in the scenario where vol does not fall off. Specifically, we would buy 25% 1y2y straddles, sell 100% 1y3y straddles, and buy 75% 3y1y straddles. Exhibit 30 shows that the position has tracked the level of 2y2y vol fairly well, but has a lower range, and higher carry around 5bp over three months, compared to 1.5bp for the outright 2y2y position. The main risk to these positions is that vol continues to rise, driven for example by lack of certainty on counterparty/credit risks or by further flattening of the curve, or that rate cuts do not materialize sooner than current market expectations.
Exhibit 30
Exhibit 29
3m1y Vol Looks Cheap Against 3m2y Vol

10 5 0 -5 -10 -15 -20 -25 -30 -35 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 3m1y-3m2y EUR Vol Spread (bp) Realized Vol Spread (bp) 30-Sep-08
1y2y/1y3y/3y1y Vol Triangle Directional

4 2 0 -2 -4 -6 -8 -10 -12 -14 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 1y2y/1y3y/3y1y EUR Vol Triangle (lhs, bp) 2y2y EUR Vol (rhs, bp, inverted) 50 55 60 65 70 75 80 85 90 95 100
16
Japan: Stay Long Risk Premium

Key Trades Stay long risk premium by 1) buying 8y-9y JGB ASW and 2) owning 1Yx10Y swaption volatility. Refrain from fading liquid sectors Recession trade buy body of 2y/5y/10y JGB butterfly
Exhibit 31
Term Structure of JGB Swap Spread

Renewed stress in the global financial markets has created a surge in counterparty risk-aversion which, in turn, has dramatically increased the risk premium attached to liquid sectors such as JGB futures. In Japan, the presence of a high risk premium has seen the CTD (7y sector) outperforming the rest of the yield curve. We would like to own this risk premium but seek cheaper alternatives in 8y-9y JGB ASW (e.g., JB285) and quasi-gamma (such as a 1Yx10Y ATM swaption straddle). Risk-aversion has become systematic and fear has its own momentum now. We last observed a similar (but smaller) episode of this kind during the BoJ shock in September 2002. At the time, market sentiment was already weakened by Moodys two-notch downgrade of Japans long-term rating from Aa3 to A2. Risk Premium Trade #1 Buy 8y-9y JGB ASW As reiterated earlier, we would like to stay long risk premium, but futures are still trading rich on asset swap spreads. Instead, we prefer to buy 8-9-year JGB ASW such as the JB285 area. This bond is roughly 8.5 years in maturity and rolls down very steeply into the rich futures CTD area. At the time of writing, this ASW rolldown is roughly 16.9bp running per year (see Exhibits 31 and 32). The potential risk to the trade could be if the GC-Libor spread tightens, thus reducing the carry advantage of the trade.
Scale into long in JB285 ASW
Exhibit 32
Exhibit 33
Roll-Down of JGB Asset Swap
Long Volatility but Cherry-Pick from the Vol Surface

We like to long quasi-gamma sector as their time decays are not rapid.
Pure gamma sector pricey and has a lot of time decay.

Unwind pressure is high and could push Vega sector cheaper.
17
Exhibit 34
1Yx10y Implied Swaption Vol

1Yx10Y Implied Swaption Vol, Bp Per Year
76 72 68 64 60 56 52 48 44 40 36 2004 2005 2006 2007 2008
Risk Premium Trade #2 Buy 1Yx10Y ATM Swaption Straddle It seems like the only certainty these days is uncertainty itself. We still like to stay long gamma but do recognize that time decay is quite undesirable for short-dated options. In our view, this can be alleviated by owning expiries further out than six months, but one has to be careful about taking on too much vega exposure, as the latter is confronting significant unwinding pressure. As expected, most options with expiry of less than a year are largely trading at levels richer than our multi-factor volatility model. We are tempted to buy cheaper volatilities in the 2Yx7Y to 2Yx10Y sector (see Exhibit 33), but we have decided to settle for 1Yx7Y to 1Yx10Y. This choice is based on our preference to maintain a balance between the amount of gamma and vega exposures we would like to hold. This sector trades fair, and we are content with not paying too much. Recession Trade Buy Body of 2y/5y/10y JGB Butterfly We think that a further slowdown is in the pipeline, and we would not be surprised if the economy contracts more over the next 8-12 months (see Exhibit 36). We think that owning 5y JGB against the wings in a 2y/5y/10y butterfly setting is the ideal way to position for the arrival of the new cycle. Most JGB index durations average around 6.0-6.5 years, and the 5-year sector has become an important part of index-tracking strategies. A shift by index-linked players toward a more aggressive stance on duration could see pension funds and asset managers more likely to start buying the 5-year. In addition, the 2-year JGB yield is trading lower and lower. An unchanged BoJ policy rate effectively encourages domestic banks to use 5-year JGB as the pivot point in their yield curve strategies. Lastly, there could be risks to the trade if the life insurers feel a greater sense of urgency to fill the ALM gap, which means the 5y/10y part of our butterfly flattens and that could potentially hurt the trade.
Exhibit 35
2y/5y/10y JGB Butterfly

40 Japan Industrial Production YoY (%) 30 20 10 0 -10 -20 -30 1994 1996 1998 2000 2002 2004 2006 2008 Japan Industrial Production % YoY 2y/5y/10y JGB Butterfly, Bp 2y/5y/10y JGB Butterfly (-50%/+100%/-50% DV01)
2002 Experience (IP Slowdown)
Exhibit 36
Further Slowdown in the Pipeline

US Employment
Thousands
400 300 200 100 0 -100 -200 -300 -400 -24 -21 -18 -15 -12 -9 -6 -3 0 3 6 9 12 15 18 21 24 (Month) Current Cycle Assuming Last Dec is Current Peak
Japan Industrial Production

% YoY
8
Past Business Cycle Average
Current Cycle LHS
Business Cycle Peak
Recession Period
6 4 2 0 -2 -4 -6 Past 3 Business Cycle (Average) RHS
Business Cycle Peak
Recession Period
-8
-24 -21 -18 -15 -12 -9
-6
-3 0 (Month)
12 15 18 21 24
18
AXJ Interest Rate: Defensive Trades under Extreme Anxiety

AXJ Core Theme
CNY: 1Y NDF pricing in excessive depreciation KRW: IRS 2x5 curve steepener; range-trade 3Y KTB futures; CCS 2x5 curve flattener; long KTBi HKD: Pay HKD 1x2 IRS curve spread versus receive USD 1x2 curve spread THB: 2x10 IRS curve steepener
Exhibit 37
AXJ Assets: YTD Change

180% 1300 1100 130% 900 700 80% 500 300 30% 100 -20% -100 -300 -70% TWD CNY VND INR KRW MYR IDR PHP SGD HKD -500
Should market confidence be restored and extraordinary stress in the global financial markets is reduced, we do not believe liquidity normalization is guaranteed and global interest rate markets should struggle to settle at a new equilibrium in the coming months. The global financial market turmoil poses three key risks to the AXJ markets: i) deteriorating liquidity conditions and tight credit conditions increase the risks of slower capital inflows; this, coupled with sluggish export demand from US, Europe and Japan, will put AXJ economic growth at risk of further slowdown; ii) risks of heightened currency weakness and FX volatility in countries such as Korea and India, where macro imbalances (current account deficits) are more exposed; and iii) balance sheet constraints will discourage risk-taking in the near term, especially for leveraged investors, despite already heavily discounted asset valuations (see Exhibit 37). Extreme anxiety requires more aggressive policy response from AXJ policymakers. We expect the short-term policy response to focus on liquidity management to mitigate pressure in the currency and money market China, Hong Kong, India, Indonesia, Korea and Taiwan have implemented measures to inject liquidity and reduce volatility in the currency market. With inflation pressure abating and rising risks of prolonged weak growth, it becomes increasingly likely that AXJ central banks will undertake monetary easing earlier than what is currently priced in by the market, and we believe that any delay in monetary easing will lead to more aggressive easing later. We view it as a developing macro theme over the next few months and believe that the following trades offer a defensive bias in a turbulent market. CNY: 1Y NDF pricing in excessive depreciation: We maintain our view that the PBoC will allow for slower CNY appreciation to cushion downside risk to export growth, but we remain constructive on the medium-term outlook of CNY and expect CNY to appreciate both against the USD and against its trade-weighted basket of currencies in NEER terms. The CNY NDF market has priced in a substantial risk premium in CNY exchange rate against the USD over the last month 1Y CNY NDF implied appreciation has dropped from a 1.5% appreciation in CNY against the USD at the beginning of September to the current 1.9% depreciation, which, in our view, is excessive. The severe repricing in the USDCNY forward exchange rate reflects, in part, unwinding of crowded USDCNY shorts on the NDF market (see Exhibit 38). More unwinds of such positions represent a near-term upside risk on USDCNY forwards, but we believe that the outright level of 1Y NDF starts to offer value from a fundamental perspective.
Equities (% Change) LHS Bonds Yield (Changes in bps) RHS
Fx 1yfw d implied yield (Changes in bps) RHS 5 Yr Sovereign CDS Spread (Changes in bps) RHS
Source: Morgan Stanley, Bloomberg
Exhibit 38
USDCNY1Y NDF: Dramatic Repricing of Forward-Looking CNY Appreciation

(1Y NDF Implied CNY Appreciation Against the USD, %)
Source: Morgan Stanley Quotient
19
MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives Exhibit 39
KRW 2x5 Curve Steepener (bp)

Korea: August economic data pointed to broad-based weakness in the macro trend and further moderation in CPI relative to the previous month. This reinforces our view that there is a good chance that the BoK is close to the end of its tightening cycle and could shift its focus toward easing and growth sometime in 1H09, if not sooner. However, a USD liquidity squeeze and volatilities in USDKRW are main risks to our modestly positive view on the bond/rates market, and we recommend taking a tactical approach in trading the KRW rates. Specifically, we favor three potential trading opportunities: (a) KRW IRS 2x5 curve steepener: The front-end inversion of the IRS curve (2x5) is at unprecedented levels, and 2x5s is about 35bp too flat relative to its normal shape (see Exhibit 39). We expect USDKRW to consolidate at around the current levels and the IRS market to build in the prospect of monetary easing in the coming months. (b) We expect 3Y KTB (Korea Treasury Bond) futures to trade in a 5.5-5.9% range in the near term; in other words, it is a buy when the yield rises close to 5.9%, and it is a sell when the yield falls towards 5.5%. (c) KRW CCS 1x3 curve flattener: The short end of the CCS curve steepened sharply, as the USD liquidity squeeze intensified over the last week (see Exhibit 40). A positive development recently is that the government is ready to supply up to US$10 billion through FX swaps to the interbank market. This should alleviate some pressure on the short-dated USDKRW forwards (less than six months) and bring the short end of the CCS curve to close to its normal shape. We believe that the KRW basis risk will remain elevated, given uncertainties with regard to onshore USD liquidity in the near term and tight credit market conditions, which reduce the USD inflow from the corporates (see Exhibit 41). In addition, we think foreign investors appetite for basis-paying positions is unlikely to recover, given balance sheet constraints.
Exhibit 40
KRW 1x3 Curve Flattener (bp)
Exhibit 41
KRW: Elevated Basis Risk (%)

-100 -150 -200 -250 -300 -350 -400 Sep-07
1Y KTB ASW 1Y CCS - IRS Basis
Jan-08
May-08
Sep-08
Source: Bloomberg, Morgan Stanley
20
Exhibit 42
KTBi: Rich/Cheapness(-) of BEI Relative to Fair Value (bp)

80 60 40 20 0 -20 -40 -60 -80 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08
KTB inflation linker: We maintain our view that the valuation of KTBi is attractive to long-term investors in terms of real yield and breakevens: i) the BEI is considerably low, compared with historical realized long-term inflation; ii) the BEI of the KTBi is pricing in much lower oil prices; iii) the BEI seems low after adjusting for the impact of the spot USDKRW exchange rate; iv) the KTBi is expected to benefit from an expanded local investor base; and v) low supply risk is supportive of the level of real yield. KTBi has outperformed the KTB nominal bonds in the last few sessions, but the BEI is still 35bp cheap relative to its fair value (see Exhibit 42). USDKRW weakness is likely to improve the carry outlook on KTBi beyond November (for more details and risks for the trade, see AXJ Trading Strategy: Korea: Time to Buy Inflation Linker (KTBi), September 9, 2008). HKD-USD 1x2 box spread: We believe that systemic risk in the Hong Kong banking system is fairly low and that the HKMA will take necessary measures to address the liquidity concern and defend the HKD peg; we expect the pressure that led to a sudden liquidity squeeze in the HKD money market to dissipate in the coming weeks. In the near term, USD liquidity strains in global money markets warrant a cautious stance; nonetheless, we believe that the credibility of the HKD peg supports a re-normalization in the HKD-USD interest rate spread. We recommended that investors position for a recovery in the HKD-USD box spread by paying HKD 1x2 IRS curve spread and receiving USD 1x2 IRS curve spread (HKD curve steepener and USD curve flattener), and we target a 25bp steepening in the HKD 1x2 curve spread relative to USD 1x2 curve spread with a stop loss of -15bp (see Exhibit 43). THB: 2x10 curve steepeners: As we discussed in the Global Perspectives, September 2, 2008, the flatness in the THB government bond curve and IRS curves offers a potential curve trade opportunity, but we were waiting for a better entry point. We believe that several recent developments support the case for a steepening over the next few months (see Exhibit 44): i) pressure for long-term yields to rise on the back of the governments funding needs next year; ii) fading monetary tightening bias in the coming months should support a stable or lower short rate; and iii) swap spreads are unusually low. Liquidity strain in the global money markets has so far had only little impact on the THB money market, with 6M fixing largely within a range of 3.75% to 3.99% last week, and on Wednesday it dropped to 3.63%, below the overnight policy rate of 3.75%. Money market rates could potentially break the recent range in the event of an escalation of liquidity squeeze; however, we expect the BoT to step up its liquidity provision to reduce excessive volatility on the money market rates. Nonetheless, we believe that the trade can be best executed when liquidity conditions start to ease. The trade can be put on with a modest positive carry, and we target a 45bp steepening over the next three months (for more details, see AXJ Trading Strategy: THB: 2x10 IRS Curve Steepeners, September 30, 2008).
Exhibit 43
HKD-USD: 1x2 Box Spread (%)
Exhibit 44
THB 2x10 Curve Steepener (%)

2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08
THB 2x10 IRS Curve THB 2x5 IRS Curve
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2008 Morgan Stanley

Global Perspectives Oct08

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Global Perspectives Oct08

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MORGAN STANLEY RESEARCH

Global Interest Rate Strategy

October 2, 2008 Interest Rate Strategy

Morgan Stanley & Co. International plc

US Interest Rate Strategy

Europe Interest Rate Strategy

Japan Interest Rate Strategy

Asia ex-Japan Strategy

Sept 26, 2008

Please see additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

Global Trade Ideas

Treasuries Swaps Inflation

Spread Mortgages RPX

5s10s cash steepener

2s5s10s cash barbell

See additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

Sell JGBU8/JGBZ8 calendar spread <CLOSE>

See additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

Source: Morgan Stanley Research

See additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

TED Spread Reaches New Peak to Reflect Market Uncertainty

Source: Morgan Stanley Research

Money Market Winners and Losers: Inflows versus Outflows ($bn)

Source: IMoney.net, Morgan Stanley Research

See additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

1 - Libor-OIS Spread Metric

EUR Spot 3m Libor-OIS

GBP Spot 3m Libor-OIS USD Spot 3m Libor-OIS

Money Markets Funding Pressures Have Morphed into Systemic Risk

Source: Morgan Stanley Research

2 - US CP Market Spread Metric

Money and Financing Markets Are Exhibiting Great Stress

Source: Federal Reserve, Morgan Stanley Research

3 - FX Implied USD Funding Rate Metric

Source: Morgan Stanley Quotient Analytics

See additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

Signs of Confidence Returning to the Market

Source: Federal Reserve, Morgan Stanley Research

Source: Federal Reserve, Morgan Stanley Research

See additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

Global: Swap Spreads: At the Mercy of Libors Next Direction

1-Oct Change 50 19 106 42 156 61

2-Year Swap Spread Breakdown: Credit Dominates Treasury Specialness

Source: Morgan Stanley

5-Year Swap Spread Breakdown: Credit Dominates Treasury Specialness

Source: Morgan Stanley

See additional important disclosures at the end of this report.

MORGAN STANLEY RESEARCH October 2, 2008 Global Perspectives

Overnight Repo Rate in Japan (T+1 Settlement, %) into Fiscal Half-Year

Swap Spreads versus Credit Spreads

y = -0.0473x - 20.838 R 2 = 0.6413

-40 10Y DBR ASW Long Run Crisis Equilibrium -50

Sep 18, 2008 - Sep 26, 2008 Last

-80 200 250 300

6M JPY Libor 1M GC for JGB, bp

(6M Libor minus 1m GC), Bp