Investment Research General Market Conditions

21 December 2012

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Euro area: What to watch in the coming months
The markets continue to be event driven. This is in particular the case for government bond markets, but also global stock markets seem to be more sensitive to the development in the European debt crisis than signals from forward looking growth indicators. Focus continues to centre on the development in the euro area debt crisis. There are an array of critical events in the coming months, such as ECBs 36 months LTRO, PSI negotiations in Greece, European bank recapitalisation, details/implementation in the wake of the EU Summit and large government bond auctions in Italy and Spain. In the short term the primary tools to fight the crisis will be the ECB and the EFSF possibly combined with further help from the IMF. In the long run can Eurobonds or redemption bonds be part of the solution.
Key events the coming months
Euro area Result of 36 months LTROs. Negotiations on Greek PSI deal. Bank recapitalisation in Europe. Rating move on EU17 and EFSF. EU summit details. Auctions in Italy and Spain. EFSF role in secondary markets. IMF role in debt crisis should be clarified. General election in France.
Source: Danske Markets

Key events
The markets continue to be event driven. Below we go through the key events that are likely to influence market sentiment in the coming months. Result of 36-month LTROs The first of the two 36-month longer-term refinancing operations (LTROs), with the option of early repayment after one year, will receive allotment today. Note, that there will also be allotment on a three month tender. These tenders are full-allotment at the average refi rate over the period. Note that banks that took from October one-year ECB tender are offered the right to shift into the three-year tender. Furthermore the right to end the three-year tender after one year is valid at any time after one year and for partial redemption as well. So basically the tender is flexible maturity from one year to three year, see ECB statement. The allotment at todays three-year LTRO is expected to be high due to the attractiveness of securing three-year liquidity at a low cost and due to the expiry profile of the ECBs open market operations. Yesterdays one-day fine-tuning operation (FTO), which was aimed at bridging the weekly main refinancing operation (MRO) with the three-year LTRO saw big demand (EUR142bn) indicating that many banks sought to switch funding to the three-year LTRO. Furthermore, it is reasonable to assume that a decent part of the three-month LTRO (EUR141bn), which expires today is rolled into the three-year LTRO. Finally, it seems obvious that banks would prefer to switch from the one-year LTRO (EUR57bn allotted on 27 October) to the three-year LTRO, due to the early repayment option of the three-year tender. For these reasons we would estimate a lower bound for todays allotment to be around EUR250-300bn. Given the very large demand for Spanish T-bills at yesterdays auction and given the strong performance of sub three-year PIIGS bonds in recent days we would judge the demand could easily be significantly larger and possibly even above EUR400bn.

2- and 10-year yields decoupled after 36 months LTRO was announced

5,5 % Euro 10-year gov yield 5,0 GDP weighted 4,5 4,0 3,5 3,0 2,5 2,0 Euro 2-year gov yield 1,5 GDP weighted 1,0 ECB refi rate 0,5 05 06 07 08 09 10 11 % 5,5 5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 1,0 0,5

12

Source: Reuters EcoWin and Danske Markets

Senior Economist Frank land Hansen +4545128526

franh@danskebank.dk
Analyst Anders Mller Lumholtz +4545128498

andjrg@danskebank.dk

Important disclosures and certifications are contained from page 6 of this report.
Important disclosures and certifications are contained from page 5 of this report.

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These very long LTROs could potentially improve the liquidity situation for the banking sector and thus alleviate refinancing risks and thereby the speed of balance sheet deleveraging. However, for the banks that are challenged on their capital position, this will not help them in this respect. The introduction of LTROs could also have an impact on yields in sovereign debt markets in particular at the short-end as the proceeds from refi operations can be invested in for instance Italian and Spanish bonds yielding a high carry. However to what degree this effect will materialise is very uncertain. So far we have seen some decoupling between two-year and 10-year yields. Draghi induced euro area banks to use this facility by saying: we want to make it absolutely clear that in the present conditions where systemic risk is seriously hampering the functioning of the economy, we see no stigma attached to the use of central banking credit provisions: our facilities are there to be used. This is a sharp change in the tone from the ECB that previously has used the term addicted bank, which actually stigmatised these facilities. This change in the tone implies that a large allotment will actually be seen as being positive for market sentiment. Negotiations on Greek PSI deal At the European Council meeting on 26 October it was announced that the haircut in the private sector involvement (PSI) would likely be 50%. The negotiations between representatives from the Greek government and the private sector are ongoing. The main disputes are: i) What should the new interest rates be; ii) Should the new bonds be issued under Greek or UK law; and iii) Whether there also should be a haircut on some of the official money for instance the ECBs holdings. Recall that the debt exchange is optional. The Greek commercial banks will have to endure big losses which (according to EBA) implies that these banks will need a recapitalisation amounting to EUR30bn, which would likely be financed through the EFSF. Bank recapitalisation in Europe The capital shortfall estimated by the EBA is set to EUR115bn, see EBA statement from 8 December. Recall that banks will be required to establish an exceptional and temporary buffer such that the Core Tier 1 capital ratio reaches a level of 9% by the end of June 2012. The amount of any capital shortfall identified is based on September 2011 figures and the amount of the sovereign capital buffer will not be revised. Sales of sovereign bonds will not alleviate the buffer requirement to be achieved by June 2012. The shortfall is biggest in Greece (EUR30bn) followed by Spain (EUR26bn), Italy (EUR15bn) and Germany (EUR13bn). A detailed plan on what banks intend to do to reach targets will have to be submitted by 20 January. This has been postponed from the previous deadline which was 25 December. In order to reach the targets banks should first aim at using private sources of funding, including retained earnings, reduced bonuses and new issuances of equity. For banks where this is not an option they should rely on official support from their national governments and only as a last option can the EFSF be used. Rating move on EU17 and EFSF S&P placed 15 euro area countries on negative watch prior to the December summit including the six AAA countries. A downgrade of France and the EFSF would be clearly negative, but it is likely partly priced in the market. A downgrade of Germany would be much more negative as this would be a big surprise. While the market still waits for the final verdict from S&P, both Moodys and Fitch have been very active. Moodys downgraded Belgium two notches to Aa3 on Friday, while Fitch cut its outlook on France and placed Spain, Italy and Belgium on Rating Watch Negative. The Fitch review is set to be finished by the end of January. EU-Summit details
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There are a number of details following the last summit that first needed to be spelled out and since implemented. Van Rompuy has announced that the legal details in the agreement from the summit should be finalised by the end of January. So far it is not clear what role the EU institutions should play and what will be required from the European Court of Justice to approve national the golden rules (structural deficit should not exceed 0.5%), see Statement from the euro area leaders. Finally the implementation risk remains very high and historically these processes have had a tendency to be longer than planned. Auctions in Italy and Spain The bond issuance in Italy and Spain is due to be stepped up in 2012. The total issuance in these two countries amounts to around EUR450bn in 2012, and in Q1 alone it is set to be just below EUR150bn. Since week five of SMP2 (where Italy and Spain was included) has the SMP purchases on average been around the total issuance of Italy and Spain. If this pattern is set to continue the ECB will have to step of its purchases considerably in Q1. EFSF role in secondary markets The firepower of the EFSF has been boosted via two models. The first model is introducing sovereign bond partial risk protection and the second option is a coinvestment approach. The protection will be between 20-30% and this option was set to be implemented in December. The second option was set to be implemented in January. It was not clear from the EFSF statement of 30 October how the EFSF funds will be split between the two models, but the combined firepower will be below EUR1000bn, as was suggested in October. Since the announcement in November there has been very little news on when the EFSF will initiate both the partial risk protection model and its operations in the secondary market. IMF role in debt crisis should be clarified At the December summit it was announced that Europe will contribute with up to EUR200bn additional funding to the IMF via bilateral loans from the member states central banks, see statement. EUR50bn should come from non euro members. The contribution from the euro area has already been approved, see statement. However, it is not clear what these funds should be used for. At the December ECB meeting Mario Draghi said More generally the mechanism by which money is being channelled to the European countries should not obscure the fact that we have a Treaty which says there should be no monetary financing of governments. The issue of whether the IMF could be used as a channel is legally very complex. But the need to respect the spirit of the Treaty should always be present in our minds. General election in France France will hold presidential elections on April 22 and May 6 2012. The main candidates are incumbent President Nicolas Sarkozy and most likely Francois Hollande though candidates can be declared until mid-March. Domenique De villepin has also announced his likely candidature, but he is an outsider. If Hollande wins we could see renewed uncertainty about EU crisis fighting tools. Hollande said on 12 December: If I am elected president, I will renegotiate the (fiscal compact) agreement to put what it lacks today, mentioning that he would push to include intervention from the European Central Bank, the creation of eurobonds and a financial relief fund. Germany is unwilling to accept these steps so a push for this could prove unsuccessful. More alarmingly, Hollande also said that he would not vote for the balanced budget rule, which is to be implemented in national legislation. This could cause a serious setback for the political process in Europe and after years with Merkozys intensifying leadership it could become rather uncomfortable for the
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ECB will be forced to continue to play a central role

275 EUR bn 250 225 200 175 150 125 100 75 50 25 EUR bn << Asset purchases (covered+government bonds) ECB purchases, per week >> 22,5 20,0 17,5 15,0 12,5 10,0 7,5 5,0 2,5 0,0 -2,5

Securities Market programme

w1 w8 w16 w25 w34 w43 w52 w8 w16 w25 w34 w43 10 11

Source: Danske Markets and Reuters

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financial markets to watch a Hollande publicly showing that he is very much in disagreement with German Chancellor Angela Merkel on several accounts. The presidential elections are followed by general elections on June 10 and 17 2012.

ECB, EFSF and IMF are short-term fire-fighting tools

Although it was not the original intention, we expect the ECBs SMP programme and the EFSF will work side by side as long as the market turmoil remains at the current elevated levels. This would likely be combined with additional help from the IMF. In the long run can Eurobonds or redemption bonds be part of the solution.

Key elements from ECB-meeting, 8 December

ECB introduced 36 months longer-term refinancing operations (LTROs) with the option of early repayment after one year combined with an easing of the collateral requirements. It is still full-allotment at average refi rate over the period. This could significantly improve the liquidity situation for the banking sector and thus alleviate refinancing risks and thereby the speed of balance sheet deleveraging. Shortly after the announcement from the ECB, the Danish central bank announced its own three-year liquidity programme for Danish banks. However, for the banks that are challenged on their capital position, nothing has changed. The introduction of LTROs could also have an impact on yields in sovereign debt markets in particular in the short end as the proceeds from refi operations can be invested in for instance Italian and Spanish bonds yielding a high carry. Whether this effect will materialise is uncertain. ECB President Draghi reduced expectations to an increase of the purchases through the securities market programme SMP. This comment changed market sentiment and is the main reason for the downbeat sentiment that began on Thursday. Interest rates cut 25bp (refi rate now at 1.00%). The reserve ratio was reduced from 2% to 1%. Despite the strong response on non-standard measures the net impact on the market was negative due to the signal of no increases in the ECBs buying of Italian and Spanish bonds.

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Key elements from EU summit, 9 December

Annual structural deficit must not exceed 0.5% of GDP. Rules need to be written into national law. It should also include automatic correction mechanism in the event of deviation. European Court of Justice will have jurisdiction to verify that the new national legislation is in line with the intergovernmental treaty. Automatic sanctions above 3% budget deficit unless qualified majority opposes details on sanctions still to be worked out. The changes will be implemented via inter-governmental treaty of 17 (not EU treaty change). There will be no need for referendums. It will be open to others to join in. UK and Hungary have made it clear that they will not join. 200bn bilateral loans from EU to IMF. 150bn is set to come from euro area central banks, 50bn from non-euro members. The private sector involvement (PSI) should be applied to Greece only. Dont put too much emphasis on this one. ESM (which will replace the EFSF) will be brought forward to July 2012. The leaders will re-assess the EUR500bn EFSF/ESM ceiling at March summit. In our view, the outcome was broadly as expected, and maybe even more accurate on the details than expected (feared). However, this was overshadowed by the fear of a downgrade from the S&P and the missing ECB response. The ECB has not stepped up its purchases significantly following the summit.

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Disclosure
This research report has been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank"). The authors of the research report are Frank land Hansen, Senior Economist and Anders Mller Lumholtz, Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analysts personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorized and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of the regulation by the Financial Services Authority are available from Danske Bank upon request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high quality research based on research objectivity and independence. These procedures are documented in the research policies of Danske Bank. Employees within the Danske Bank Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to the Research Management and the Compliance Department. Danske Bank Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the over-all profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors upon request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. First date of publication Please see the front page of this research report for the first date of publication. Price-related data is calculated using the closing price from the day before publication.

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