2011-05-04 unicredit euro compass - how long before the next cyclical downturn

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May 2011 Economics & FI/FX Research

Euro Compass

UniCredit Research page 1 See last pages for disclaimer.

How long before the next cyclical downturn?

The eurozone recovery is strengthening and broadening. After solid 0.8%qoq growth in 1Q, we have revised up our full-year GDP forecast from1.7% to 2.1%. In this issue of the Euro Compass, we take a medium-

term approach to analyzing the eurozone business cycle. Our aim is to

identify the current stage of the recovery and provide an approximate

timing for the beginning of the next downturn. Based on past regularities,

we find that this cyclical upswing is unlikely to end soon. With the

exception of inflation, all the indicators we looked at suggest the turning

point of this cycle could be around mid-2013. We feel comfortable with

this result, also because it is very much consistent with the average

length of eurozone business cycles in the last twenty years.

In recent months, core inflation (ex food, energy, alcohol and tobacco)has exceeded our expectations. At 1.6% in April, it is twice as high as in

early 2010, when it bottomed out. However, the April reading was

distorted upwards by the late timing of Easter and the new seasonality of

clothing/shoes prices after a methodological change in the way the price

of seasonal items is determined. We expect core inflation to fall back in

May. Our headline CPI forecasts remain on track but, after the latest

developments, the composition of the balance of risk has somewhat

changed: less upside risks from commodities, more from core prices.

When the ECB meets on 9 June, we expect a switch to (strong)vigilance, signaling that in July the refi rate will be raised by another

25bp. The risk of a dovish surprise, with Trichet sticking to very close

monitoring and therefore further delaying the next rate move, is fairlylow, no more than 20%. With respect to the liquidity strategy, the ECB

should leave the full allotment at the 1W MRO and 1M LTRO in place,

while the decision on the 3M LTRO is a very close call. Pulling the plug

here risks creating an additional source of volatility in an already very

uncertain environment.

FI: Risk aversion should remain the key driver for Bunds in the near term,likely offsetting the effect of the upcoming ECB rate hike. In the US, QE2

will come to an end but, given the recent stream of worse-than-expected

data, we do not forecast significant upward pressure on yields. Over a

longer horizon, we still expect the German curve to bear flatten and

move higher, while the US curve is likely to remain steep until year -end.

FX: The delay of the next ECB rate hike to July and Greek debt fearsprompted a heavy EUR-USD sell-off, and a test even below 1.40 cannot

be ruled out before July. However, prospects of widening interest rate

differentials and the commitment of EU countries to adjust the terms of

Greece's aid program imply that potential for a pullback above 1.50 in

2H11 still exists.

EditorMarco ValliChief Eurozone Economist+39 02 [email protected]

Editorial deadlineWednesday 18 May 2011, 15:00Prices at: Wednesday 18 May 2011, 8:00

BloombergUCGR, UCFR

Internet

www.research.unicreditgroup.eu


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Euro Compass


Contents

1 How long before the next cyclical downturn?3 Key Eurozone Forecasts

4 Europe in a nutshell

5 The European Economist

5 How long before the next cyclical downturn?

10 Inflation Watch

10 Less upside risks from commodities, more from core prices

11 UniCredit Inflation Forecasts

12 The ECB Watcher

12 The need for vigilance

14 ECB Most Watched

15 The Eurozone Economists Toolbox

19 European Central Banks Watch

19 BoE On hold despite high inflation

20 SNB CHF up on EMU debt crisis woes, again

21 Nordics Norges Bank catching up with Riksbank

22 FI Strategizer

22 Bonds to remain bid for the time being

24 A quick glance at the US and UK

26 FX Strategizer

26 EUR-USD: shell-shocked but not definitively knocked down

29 FX Monitor: G-10 Monthly Change

30 FX Monitor: G-10 Implied Volatility Curves

31 Country Outlook

31 Germany Already back to pre-crisis high

32 France Recovery keeps strengthening

33 Italy Still lagging behind

34 Spain The recovery remains an export story

35 Austria Economic growth in 2011 expected to exceed 3%

36 UniCredit Forecasts


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Euro Compass


Key Eurozone Forecasts

2010 2011 2012 Annual average1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 1Q-12 2Q-12 3Q-12 4Q-12 2010 2011 2012

GDP 0.4 1.0 0.4 0.3 0.8 0.5 0.3 0.4 0.4 0.5 0.5 0.5 - - -

GDP (% yoy) 0.8 2.0 2.0 2.0 2.5 1.9 1.9 2.0 1.6 1.5 1.7 1.9 1.7 2.1 1.7

Private Consumption 0.3 0.2 0.2 0.4 0.4 0.3 0.2 0.3 0.3 0.3 0.4 0.4 0.8 1.2 1.2

Government Consumption -0.1 0.2 0.4 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.7 0.4 0.3

Gross Fixed Capital Formation -0.2 2.1 -0.2 -0.5 1.0 0.5 0.5 0.6 0.7 0.8 0.9 1.0 -1.0 1.8 2.9

Change in Inventories* 0.4 0.3 -0.1 -0.1 -0.1 0.0 0.0 0.0 0.0 0.0 0.1 0.1 0.5 -0.1 0.1

Domestic Total Expenditure 0.1 0.6 0.1 0.2 0.4 0.2 0.2 0.3 0.3 0.4 0.4 0.5 0.9 1.1 1.5

Exports 3.1 4.5 2.1 1.6 3.0 2.0 1.3 1.4 1.4 1.5 1.6 1.7 11.0 9.1 6.0

Imports 3.6 4.2 1.5 1.0 2.1 1.6 1.3 1.3 1.4 1.5 1.7 1.9 9.1 7.0 6.1

Net Exports* -0.2 0.1 0.3 0.3 0.5 0.2 0.0 0.0 0.0 0.0 0.0 -0.1 0.8 1.0 0.1

HICP Inflation (% yoy) 1.1 1.6 1.7 2.0 2.5 2.8 2.8 2.8 2.2 2.0 2.0 2.0 1.6 2.7 2.0

Core HICP Inflation (% yoy) 0.9 0.9 1.0 1.1 1.1 1.5 1.4 1.5 1.5 1.6 1.7 1.8 1.0 1.4 1.7

Unit Labour Costs (% yoy) -0.5 -0.6 -0.6 -0.2 -0.5 0.2 0.5 0.4 0.9 0.9 0.9 0.9 -0.5 0.1 0.9

Employment growth 0.0 0.1 0.0 0.2 0.3 0.3 0.2 0.2 0.3 0.3 0.3 0.3 -0.4 0.8 1.1

Unemployment rate (%) 10.0 10.1 10.1 10.0 9.9 9.8 9.7 9.7 9.6 9.5 9.4 9.3 10.1 9.8 9.5

Current Account (% GDP) - - - - - - - - - - - - -0.2 0.1 0.2

Budget Balance (% GDP) - - - - - - - - - - - - -6.0 -4.5 -3.8

ECB Refi rate 1.00 1.00 1.00 1.00 1.00 1.25 1.50 1.75 2.00 2.25 2.50 2.75 - - -

3M Euribor rate 0.63 0.77 0.89 1.02 1.09 1.50 1.75 2.10 2.30 - - - - - -

2yr 0.96 0.60 0.83 0.94 1.42 2.10 2.25 2.50 2.80 - - - - - -

5yr 2.14 1.46 1.48 1.71 2.35 2.83 2.95 3.10 3.25 - - - - - -

10yr 3.09 2.58 2.28 2.63 3.17 3.45 3.55 3.65 3.70 - - - - - -

30yr 3.83 3.29 2.87 3.13 3.61 3.85 3.90 3.95 3.90 - - - - - -

EUR/USD 1.35 1.22 1.36 1.34 1.40 1.50 1.53 1.55 1.52 - - - - - -

EUR effective exchange rate (EER-21) 106.8 100.3 104.9 102.7 103.0 106.0 108.0 109.0 107.0 - - - - - -All data are % qoq unless otherwise specified; GDP data are working-day adjusted; interest and exchange rates are end of period

*Contribution to growth Source: UniCredit Research


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Euro Compass


Europe in a nutshellGDP OUTLOOK INFLATION OUTLOOK CENTRAL BANK OUTLOOK TRADE IDEAS

EUROZONE The economy entered 2011 on a solid footing, growingby a stronger-than-expected 0.8% qoq in 1Q. Althoughremaining healthy, GDP momentum will probably softensomewhat in 2Q, mostly due to surging oil prices. Weraised our full-year GDP forecast for 2011 from 1.7% to2.1%. We see 1.7% growth in 2012.

Inflation accelerated further in April, to 2.8%. The pick-up was totally driven by core prices, which were firmerthan expected (1.6%) also due to the late Easter.Inflation will probably ease marginally in May, but willremain well above the ECBs comfort zone forsometime. We expect CPI at 2.7% in 2011 and 2.0%in 2012.

This months reference to very close monitoring, thesame as in April, should be read as a sign that thecentral bank will most likely hold its fire in June, andprobably pull the trigger again in July. We continue tosee the refi rate at 1.75% at year-end.

FI: recent return of risk aversion has supported safe havendemand, leading to bull flattening of the Bund curve. Weexpect yields to go up but not too soon and not too fastgiven we do not see a near term decision on Greece.

FX: New ECB rate hikes being frozen until July and Greekdebt fears may expose EUR-USD to volatile sessionsahead, but in the medium term we still point to a targetabove 1.50 in a less EUR-adverse scenario

GERMANY The strong export-driven recovery in industry remains oncourse, becoming increasingly broad-based. Aftera strong rebound of +3.5% in 2010, we expect a similargrowth dynamic this year.

Underlying inflation has already bottomed out earlylast year and higher selling price expectations indicatea continuing upward trend in 2011, driven by highercommodity prices.

FI: In the short term Bunds should continue to be the safe-haven FI asset. We continue to see ECB action as themain risk factor for the short end.

FRANCE 1Q GDP surprised on the upside coming in at 1.0% qoq,the highest reading since 2Q-06. We expect that GDPwill soften in 2Q to 0.5% qoq, which is yet a healthylevel. This would lift the 2011 annual average to 2.3%

Consumer inflation accelerated by 0.1pp to 2.1% inApril. Our baseline scenario now foresees inflationaccelerating very gradually until the autumn, beforefalling thereafter. We expect CPI at 2.1% this year.

FI: France deficit will be above the average in the coregroup but, as we see little rating risks, the yield pick-up vs.Bunds appears interesting. The 30Y is the area offeringmore value vs. Bunds. The 5Y area looks interesting.

ITALY GDP expanded by a meager 0.1% qoq in 1Q, with bothindustrial production and services activity remainingbroadly flat. Manufacturing surveys in April did not pointto acceleration in factory activity at the beginning of thesecond quarter.

Inflation accelerated to 2.6% in April. We expect CPIinflation to remain stable throughout the summer andaccelerate slightly towards year-end, before entering adownward trend at the turn of the year. We seeinflation at 2.6% and 2.0% in 2011n and 2012.

FI: Italy continues to be the safest of periphery. The recentwave of risk aversion sent the 10Y BTP/Bund spread backto the 150bp area, but the pressure on BTPs has beenmuch more limited than for the other peripherals. We likethe 10/15Y area on the BTP curve.

SPAIN GDP accelerated 0.3% qoq in 1Q, a tad higher thanexpected. This lifts mechanically the 2011 GDP forecastfrom 0.6% qoq to 0.8%. The recovery should gathermore steam only in 2012: we see GDP expanding 1.4%.

CPI inflation further accelerated in April, printing at3.5%. In yearly average terms, we see CPIaccelerating to 3.5% in 2011, before easing back to2.5% in 2012.

FI: We remain prudent on Spain as the banking systemoutlook remains uncertain. The focus is going to be on theregional debt over the next few weeks and on therestructuring of banks. We like SPGB Apr21 on theSpanish curve.

UK We expect GDP growth in 1Q to be confirmed at 0.5%.The main contribution should come from net exports. Weexpect the other positive contributions to be fromconsumption and investment while the main drag shouldcome from inventories. We expect GDP to grow 1.5% in2011 and 2.0 in 2012.

Headline inflation in April increased to 4.5% from4.0%. This was mostly due to a rise in transport tariffsrelated to the late Easter. The other main contributioncame from alcohol and tobacco, which added 0.13pp.We expect inflation to average 4.1% in 2011 and 2.5%in 2012.

According to the May Inflation Report, the BoEsmedium-term view remains pretty much the same as inFebruary: inflation will fall back to target (by 2013), asthe temporary effects pushing up prices are waning andas significant spare capacity remains. We continue toexpect the first Bank rate hike in Q3 and the repo rate at

1% by the end of this year.

FI: Weaker-than-expected growth should keep 2Y Giltsanchored at low levels. Despite the rise in spot inflation,inflation expectations have not increased significantly, sopressure on long-maturities Gilts should remain limited.

FX: The falling EUR-USD and the ongoing BoE policydilemma between inflation and growth deflated the recent

EUR-GBP rally above 0.90 and should keep it furtherwithin the 0.87-0.89 band for the time being

SWEDEN Economic activity in 2011 remains strong. Although GDPmay decelerate from 0.7% qoq in 1Q11 to 0.4% in 4Q,2011 growth should still come in at 4.0%.

Headline inflation has further accelerated above 3% inApril. Indeed, annual inflation in 2011 is now expectedto exceed the Riksbanks 2% inflation target by 0.5pp.

The Riksbank is expected to keep hiking rates duringthe remaining meetings this year, bringing the repo rateto 2.75% by year-end.

FX: Assaults & retreats should c ontinue to characterizeEUR-SEK: we confirm our final target at 8.65, but it maytake time to reach it

NORWAY Economic activity is seen picking up. 1Q Mainland GDPshould print at 0.8% and 2011 growth should accelerateto 2.6% from 2.2% in 2010.

Inflation in Norway although accelerating still remainsbelow 2%. The resumption in the Norges Bank ratehike cycle may keep the annual reading below 2% too.

The Norges Bank should remain on hold at the Junemeeting, but bring the rate to 2.75% at year-end.

FX: Higher inflation may offer the NOK some support, butthe path towards our medium-term target at 7.70 will bepaved with large swings.

SWITZERLAND Backed by robust domestic demand, the small, openeconomy is experiencing a V-shaped recovery. After+2.6% this year, we expect GDP growth to decelerateonly slightly to 2% in 2011.

The CHF strength has a strong dampening effect onconsumer prices. Hence, despite the strong economyand higher commodity prices, the short-term outlookfor inflation still remains comparatively relaxed.

Despite the V-shaped economic recovery and theturnaround of the ECB, the pressure on the CHFremains strong. With EMU debt crisis woes continuing,the SNB is likely to pause for somewhat longer.

FX: The franc should remain strong reflecting the weakUSD and EMU uncertainty. Resuming ECB rate hikes fromJuly onwards should help EUR-CHF but the 1.35 area willremain seriously capped


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Economics & FI/FX Research

Euro Compass


May 2011

The European Economist

How long before the next cyclical downturn?Chiara Corsa(UniCredit Bank Milan)+39 02 [email protected]

Marco Valli (UniCredit Bank Milan)+39 02 8862 [email protected]

Two years after exiting from recession, the eurozone recovery is in good shape, as confirmed

by the solid 0.8% qoq GDP reading for 1Q 2011. Moreover, the current high level of business

surveys suggests that the growth dynamics, although easing somewhat, should remain

healthy in the near term. What is less clear at this stage is how long this cyclical upswing

will last. In the following, we take a medium-term approach to analyzing the eurozone

business cycle: our aim is to identify the current stage of the recovery and, based on

regularities from the past, provide an approximate timing for the beginning of the next

downturn.

The average length of the cyclicalrecovery is about three years

The first step of this analysis consists of measuring the average length of cyclical recoveries

in the eurozone for the time span for which official data are available. There are different ways

to pinpoint the beginning and the end of a cyclical upswing: in our view, an output-gap

approach outperforms a standard GDP-based approach, as the former allows separating the

cyclical component of economic growth (the one we are interested in) from the trend.

Following this approach, we define a cyclical recovery as the phase of the business cycle that

sees a narrowing of the output gap (i.e. GDP grows above potential)1. Using OECD data, we

find that in the last twenty years the length of the business cycle has varied considerably.

Sometimes it is even hard to pinpoint the beginning and the end of a cyclical recovery (see

chart on the right). For example, the four quarters of recovery between 1Q 1997 and 1Q 1998

and the subsequent two/three quarters of modest slowdown can either be considered as a

stand-alone mini cycle, or (as we prefer) as part of the four-year-long expansion phase that

ended with the bursting of the dot-com bubble. The last cyclical recovery was somewhat

shorter and lasted three years: from 1Q 2005 to 1Q 2008. All in all, we assume that a

reliable estimate for the average length of a cyclical recovery in the eurozone is around

three years. Given that in this cycle the output gap started to narrow in 2Q 2010, if historywere to broadly repeat itself, this recovery would last until approximately mid-2013.

The next step is to look at a set of indicators which tend to display some regularities in their

cyclical fluctuations, therefore providing valuable information about the current stage of the

cyclical recovery. We identify four indicators:

1) The financing gap of non-financial corporations (NFCs). This gauge, constructed as the

difference between corporate savings and investment, measures the corporate sectors

reliance on external financing to fund investment plans.

BUSINESS SURYES REMAIN IN GOOD SHAPE DATING EUROZONE CYCLICAL RECOVERIES

EC Economic Confidence

70

75

80

85

90

95

100

105

110

115

120

Jan-90 Jul-93 Jan-97 Jul-00 Jan-04 Jul-07 Jan-11

Output gap (In % of potential GDP)

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

Q1 1991 Q4 1993 Q3 1996 Q2 1999 Q1 2002 Q4 2004 Q3 2007 Q2 2010

12 quarters15 quarters6 quarters

Source: Markit, OECD, UniCredit Research

1Admittedly, official output gap data are often revised significantly over time, but this is a major problem only in case of real-time analyses that focus mostly on the

absolute level of the output gap, like for example the estimation of a Taylor Rule. Given that here we have a backward-looking approach and we are interested in thechange rather than the level of the output gap, revisions do not pose a major problem.


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Euro Compass


May 2011

Corporate sectors balance sheetsare in good shape

For the eurozone as a whole, these data are available only from 1999 onwards. The left chart

shows that the financing gap is highly cyclical, with turning points in correspondence of the

main junctures of the business cycle. This is not surprising, as the investment cycle the key

driver of a sustainable recovery usually turns upwards after a significant improvement of the

financing gap position (which becomes positive/less negative). Afterwards, the strengthening

of the investment recovery tends to lead to higher borrowing needs, and the peak of the

investment cycle usually occurs when the reliance on external financing approaches elevated

levels, largely increasing firms vulnerability to shocks. Following an aggressive adjustment

during the credit crisis, corporate balance sheets in the euro area now appear to be in good

shape (the last available data refer to 4Q 2010), and the broadly-balanced financing gap

indicates that we are still far from a vulnerable end-of-cycle position, like the one

recorded in 2000 (-8% of gross value added) and 2008 (-6%). This implies that the non-

financial corporate sector can still count on a good buffer against shocks like a potential

demand slowdown, high commodity prices and tighter financial conditions. One note of

caution: while the financing gap (a flow variable) depicts a bullish outlook, corporate debt (a

stock variable) still significantly exceeds the level prevailing at the beginning of the2005-2007 recovery. This does not challenge our view that this investment upswing is bound

to last for several more quarters, but it does suggest that, in this cycle, the vulnerability

threshold for the financing gap will probably be lower (in absolute value) than in 2000 and

2008. For the sake of comparison, assuming a -4% vulnerability threshold for the financing

gap and the same pace of deepening of the gap recorded in the last recovery , alarm bells for

the investment (and business cycle) outlook would start ringing sometime in 2H 2013.

ULCs: far from a typical end-of-cycle development

2) Unit labor costs. The investment recovery is spilling over to the labor market, and this is

definitely good news. However, this may also raise some concerns that the economic upswing

is already entering an advanced stage, particularly because we showed that the current pace

of employment growth may be as good as it gets in this cycle (see Labor market moving in

the right direction, April Euro Compass). We think that this fear is overdone, as we are not

yet at the late stage of the cycle when wage growth starts accelerating meaningfully, puttingcorporate margins under pressure. As a matter of fact, productivity is still rising healthily and

the wage dynamics remains subdued, leaving unit labor costs (ULCs) in negative territory,

i.e. very close to this cycles lows and quite depressed by historical standards. The

chart on right shows that high ULCs are a typical end-of-cycle development, and we are

currently far away from this environment2.

3) The credit cycle. The idea of looking at regularities of past credit cycles may seem odd

after an unprecedented banking crisis, which is still negatively affecting lending standards and

forcing several eurozone countries to deleverage aggressively.

FINANCING GAP TR ACKS THE BUSINESS CYCLE ULCS REMAIN DEPRESSED

-9.0

-8.0

-7.0

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

1999Q4 2001Q3 2003Q2 2005Q1 2006Q4 2008Q3 2010Q2

-5.5

-4.5

-3.5

-2.5

-1.5

-0.5

0.5

1.5

2.5

Financing Gap (in % of GVA) - LS

Output Gap - RS

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

Q1 1996 Q3 1998 Q1 2001 Q3 2003 Q1 2006 Q3 2008 Q1 2011

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0Output Gap - LS

ULC (% chg, yoy) - RS

Source: Eurostat, OECD, UniCredit Research

2This should remain the case even when assuming that Eurostat data underestimate the actual pace of employment growth in this recovery (as we suspect), as

indicated by the unusually large gap between surveys of hiring intention and official employment data.


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Euro Compass


May 2011

The next credit downturn willprobably occur in mid-2013

However, both the crisis and the following developments showed clearly that demand remains

the key driver of the lending cycle, while supply-side effects tend to matter less. Therefore, it

can be useful to compare current lending dynamics with past credit cycles. What hard data tell

us is that lending has only just started to recover. The growth rate of lending to the private

sector is currently 2.5% yoy (cyclical low: -0.7% in 1Q 2010), which is well below the cyclical

highs recorded since the beginning of the time series in 1980. However, due to the peculiarity

of this cycle, this time around credit growth per se may be less informative than usual, and

here we focus on the average length of past credit cycles and the timing of turning points of

household and corporate lending. The last 30 years have seen four credit cycles (excluding

the one that has just started), with the recovery leg posting an average duration of 12

quarters. Household lending tends to turn earlier than corporate lending (the average lead is

one year). If all these regularities were to be replicated in the current cycle, the next credit

downturn would need to occur around mid-2013, with household lending starting to

lose momentum already at the end of 2012 and corporate lending following suit after

three/four quarters.

High inflation probably does notreflect a mature stage of the cycle

4) Inflation. As inflation tends to react to economic growth with a lag, and therefore is more

likely to pick-up at an advanced stage of the recovery, it may become natural to infer that the

current high inflation rate could prelude an economic downturn in the not-too-distant future. At

least this is the message that seems to emerge from the last twenty years of history (see the

right chart). However, it looks like this time around we are experiencing unusually high

inflation at an early stage of the cyclical recovery, when there is still a large amount of

spare capacity in the economy. We see two main reasons for this peculiar development:

- The unprecedented monetary policy easing by the major central banks, particularly by the

Fed. This contributed to an increase of speculative positions in the commodity market, leading

to large price increases in a short time frame;

- A V-shaped recovery in emerging markets, which pushed up strongly demand for

commodities, and hence their prices.

Accordingly, our take is that the current high inflation rate reflects cycle-specific factors,rather than indicating a mature stage of the business cycle.

Next turning point? Mid-2013

Bottom line: Our fundamental analysis based on past regularities shows that an end to this

cyclical recovery is unlikely to materialize in the near term. As a matter of fact, with the

exception of inflation, all the indicators we looked at suggest that mid-2013 is the most likely

timing for the next turning point. We feel comfortable with this result, also because it is

very much consistent with the average length of eurozone business cycles in the last twenty

years.

A LOOK AT PAST CREDIT CYCLES THIS INFLATION CYCLE MAY BE DIFFERENT

In %, yoy

-4.0

0.0

4.0

8.0

12.0

16.0

20.0

Q1 1981 Q1 1986 Q1 1991 Q1 1996 Q1 2001 Q1 2006 Q1 2011

Lending to the private sector

Lending to households

Lending to NFCs

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

Q1 1991 Q1 1995 Q1 1999 Q1 2003 Q1 2007 Q1 2011

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Output gap - LS

Inflation - RS

Source: ECB, OECD, Eurostat, UniCredit Research


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Euro Compass


May 2011

Refi rate not to affect the length

of the current upswing

Can monetary policy affect the length of this recovery?

Central bank action can affect the length of the recovery phase if policy rates are left ata level that is not justified by fundamentals. For example, monetary policy can shorten the

duration of the recovery if accommodation is removed too early, or can artificially prolong the

cyclical upswing if the rate stance is kept overly loose for a prolonged period of time (in the

latter case, increasing the probability of a more abrupt correction later on). In order to gauge

the appropriateness of the ECBs monetary policy stance, we resort to our Taylor Rule3, which

suggests that the level of the refi rate probably:

- Was a neutral factor for the length of the 2005-2007 recovery, as the central bank started its

tightening campaign exactly when prescribed by our reaction function;

- Was a dampening factor at the early stages of the 2008-2009 downturn, as the ECB hiked

rates in summer 2008 when our rule pointed to the need for refi rate cuts;

- Is a neutral factor for the length of the current upswing, given that the central bank seems to

be moving in a very timely fashion to counter the narrowing of the output gap and therecovery in lending aggregates, while the provision of unlimited liquidity to banks helps limiting

the systemic risk coming from the periphery.

Given these conclusions, the ECBs monetary policy stance should not be regarded as a

possible swing factor, and therefore can be neglected for the rest of our analysis.

Focus on downside risks

Another couple of years of healthy growth. What could go wrong?

We have shown that a physiological turning point could materialize sometime around

mid-2013, leaving another couple of years of reasonably healthy economic growth ahead. Its

clear, however, that there are a number of risks to this scenario. Here we focus on

downside risks, i.e. factors that could lead to an early turning point in the euro area business

cycle. History shows that major cyclical downturns (and recoveries) tend to be anticipated by

turning points in financial markets. In particular, equity prices, equity market volatility andcorporate spreads the tree variables that are included in our Financial Market Index

4shown

in the right chart display the strongest leading properties for eurozone GDP growth,

consistent with the idea that financial market developments are a key driver of the real cycle,

rather than being just its by-product. Therefore, it is natural to expect also the next cyclical

downturn to be heralded by a generalized tightening of financial conditions. Where

could this new financial market shock come from? We see two main possibilities:

TAYLOR RULE: THE ECB IS WELL ON TRACK IN THIS CYCLE FINANCIAL MARKETS HOLD THE KEY

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

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

Actual

Fitted

Financial Market Index

-2

-1

0

1

2

3

4

5

01-Jan-99 01-Jun-01 01-Nov-03 01-Apr-06 01-Sep-08 01-Feb-11

Source: Markit, ECB, Datastream, UniCredit Research

3 Our Taylor Rule is a monthly specification of the ECBs reaction function. It explains the level of the refi rate as a function of: 1) a PMI-based measure of output

gap; 2) the yearly growth rate of lending to the private sector.4

The Financial Market Index (FMI) aggregates in one single indicator the signal coming from the VDAX, DJ Euro Stoxx 50 and corporate spread (BBB, 5-7y).

Volatility and spread enter the algorithm with a positive sign, equity with a negative sign. The FMI is negatively correlated with economic growth and leads eurozoneGDP by one quarter and the Ifo expectations index by one month.


9/40


Euro Compass


May 2011

Risk #1: a sovereign credit eventin the periphery

1) A sovereign credit event in one or more of the peripheral countries. However, we

have been arguing for a long time that a unilateral (or unfriendly) debt restructuring would do

more harm than good if the following conditions are not met:

- eurozone banks are sufficiently re-capitalized;

- troubled countries are back to growth, start seeing the results of the implemented structural

reforms, and are able to generate a stable primary surplus.

As none of these conditions are currently being met and probably wont be for several more

quarters, we remain confident that European policymakers will eventually opt for the less

costly solution, which is buying more time by extending the lifeline to Greece. Talks of a

second rescue package worth EUR 60bn go in this direction, and would allow the country to

cover financing needs through 2013. Our baseline scenario remains that unilateral debt

restructuring will become an option only under the ESM umbrella, i.e. from mid-2013

onwards. If we are right on this, the probability that the eurozone recovery will be prematurely

derailed by a sovereign credit event should be reasonably low.

Risk #2: a sharp growthdeceleration in emerging markets

2) A sharp growth deceleration in emerging markets, particularly China. Tighter monetary

policy and government intervention aimed at taking some steam off the growth dynamics in

these countries does increase the risk of hard-landing down the road, but we remain

fundamentally optimistic. So far, the attempt to prevent an overheating of the economy and

the creation of asset bubbles seems to have been successful, while the vast majority of the

emerging economies can still enjoy healthy balance sheets both in the private and the public

sector, with only a relatively small number of countries showing a vulnerable current account

position. This should be sufficiently reassuring that downside risks for the eurozone

stemming from the emerging market channel could remain contained for some time.


10/40


Euro Compass


May 2011

Inflation Watch

Less upside risks from commodities, more from core pricesMarco Valli (UniCredit Bank Milan)+39 02 [email protected]

In April, eurozone inflation picked-up by 0.1pp to 2.8% yoy, the highest reading since October

2008. In contrast to recent developments, this time core prices drove the inflation

acceleration, while energy inflation had a dampening impact on the headline (-0.05pp) and

food inflation was neutral. The spike in core CPI (ex-food, energy, alcohol and tobacco) from

1.3% yoy to 1.6% deserves attention. The current pace of core prices growth exceeds our

expectations and is twice as high as in early 2010, when core inflation hit the cyclical low.

However, there are two factors that distorted upwards the April reading:

April core CPI distorted upwards 1) The late timing of Easter, which boosted the price of holiday-sensitive spending items

compared to last year. The effect was particularly visible in transport fares (air transport:

+10.3% mom, 6.6% yoy; water transport: +12.1% mom, 15% yoy), also because companies

did not miss the opportunity to pass onto consumers part of the recent strong increase of oil

prices. In May, we expect a price reversal in all these spending items.

2) A further 2.6% mom increase in the price of clothing/shoes , after a 15.1% jump in

March. This is stronger than we had projected, but we are still learning when it comes to

detecting the new seasonality of clothing/shoes prices following a methodological change in

the way the price of seasonal items is determined. The strong April reading increases the

probability that in May clothing/shoes prices will be softer than initially thought.

We expect core inflation todecelerate in May

These considerations suggest that the underlying trend in core inflation, while turning out

somewhat firmer than we had previously expected, is probably not as strong as

implied by the last official number. In May, we have pencilled in a technical deceleration to

1.4% yoy, which will help ease the pressure on headline inflation.

Energy and food prices: easingupside risks?

Besides a likely slowdown in core inflation, May will probably also see a monthly decline in

energy prices, the first such move since August 2010. This reflects the recent pull-back inBrent prices, although it is worth recalling that the 11% drop in oil prices over the last two

weeks looks more moderate when considering euro-denominated prices: -7%. Mechanically,

this subtracts just less than 0.1pp from our CPI projections, definitely not a game changer.

However, note that easing energy pressures come hand in hand with signs of a cooling

down of agricultural commodity prices. After having risen by 40% between mid-2010 and

February 2011, the FAO Food Price Index declined 2.7% mom in March and was up only

0.5% mom in April. This indicates increasing chances of a moderation in food CPI momentum

after the spring, consistent with the working assumptions of our baseline scenario.

Bottom line: Our headline CPI forecasts (2.7% in 2011 and 2.0% in 2012) remain on track

but, after the latest developments, the composition of the balance of risk has somewhat

changed: less upside risks from commodities, more from core prices.

CORE INFLATION SHARPLY UP FOOD COMMODITIY PRICES START COOLING DOWN

Core CPI (in %, yoy)

0.5

1.0

1.5

2.0

2.5

3.0

Jan-00 Apr-01 Jul-02 Oct-03 Jan-05 Apr-06 Jul-07 Oct-08 Jan-10 Apr-11

FAO Food Price Index (in %)

-14

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10

Sep-05 Aug-06 Jul-07 Jun-08 May-09 Apr-10 Mar-11

-40

-30

-20

-10

0

10

20

30

40

50

60

mom - LS

yoy - RS

Source: Eurostat, FAO, UniCredit Research


11/40


Euro Compass


May 2011

UniCredit Inflation Forecasts

EM U H ICP H ICP ex tob ac co ( unre vi se d)

Core

(Eurostat) France CPI ex t obacco I taly FOI ex t obacco

Index mom Yoy Index Mom Yoy yoy Index Mom yoy Index Mom Yoy

Jan-10 107.99 -0.8 0.9 107.75 -0.8 0.9 0.8 118.32 -0.2 1.0 99.1 0.1 1.3

Feb-10 108.33 0.3 0.8 108.02 0.3 0.7 0.8 118.99 0.6 1.2 99.2 0.1 1.3

Mar-10 109.53 1.1 1.6 109.09 1.0 1.3 1.2 119.58 0.5 1.5 99.4 0.2 1.5

Apr-10 109.98 0.4 1.6 109.58 0.4 1.4 0.9 119.90 0.3 1.6 99.8 0.4 1.6

May-10 110.10 0.1 1.7 109.71 0.1 1.5 0.9 120.04 0.1 1.6 99.9 0.1 1.5

Jun-10 110.10 0.0 1.5 109.70 0.0 1.3 1.0 120.02 0.0 1.4 99.9 0.0 1.3

Jul-10 109.63 -0.4 1.7 109.32 -0.3 1.7 1.0 119.68 -0.3 1.6 100.2 0.4 1.7

Aug-10 109.85 0.2 1.6 109.54 0.2 1.5 1.0 119.97 0.2 1.3 100.4 0.2 1.5

Sep-10 110.19 0.3 1.9 109.77 0.2 1.7 1.2 119.88 -0.1 1.5 100.1 -0.3 1.6

Oct-10 110.52 0.3 1.9 110.15 0.3 1.8 1.1 120.03 0.1 1.5 100.4 0.2 1.7

Nov-10 110.62 0.1 1.9 110.27 0.1 1.8 1.1 120.09 0.0 1.5 100.4 0.1 1.7

Dec-10 111.29 0.6 2.2 110.93 0.6 2.1 1.0 120.61 0.4 1.7 100.8 0.4 1.9

Jan-11 110.50 -0.7 2.3 110.11 -0.7 2.2 1.1 120.32 -0.2 1.7 101.2 0.4 2.2

Feb-11 110.96 0.4 2.4 110.57 0.4 2.4 1.0 120.90 0.5 1.6 101.5 0.3 2.3

Mar-11 112.47 1.4 2.7 112.11 1.4 2.8 1.3 121.90 0.8 1.9 101.9 0.4 2.5

Apr-11 113.10 0.6 2.8 112.75 0.6 2.9 1.6 122.32 0.3 2.0 102.4 0.5 2.6

May-11 113.07 0.0 2.7 112.71 0.0 2.7 1.4 122.50 0.1 2.0 102.4 0.0 2.5

Jun-11 113.11 0.0 2.7 112.74 0.0 2.8 1.4 122.58 0.1 2.1 102.4 0.0 2.6

Jul-11 112.65 -0.4 2.8 112.26 -0.4 2.7 1.4 122.37 -0.2 2.2 102.8 0.3 2.6

Aug-11 112.90 0.2 2.8 112.50 0.2 2.7 1.3 122.72 0.3 2.3 103.0 0.2 2.6

Sep-11 113.44 0.5 2.9 113.04 0.5 3.0 1.5 122.58 -0.1 2.3 102.9 -0.1 2.7

Oct-11 113.71 0.2 2.9 113.31 0.2 2.9 1.5 122.80 0.2 2.3 103.2 0.3 2.8

Nov-11 113.72 0.0 2.8 113.31 0.0 2.8 1.5 122.77 0.0 2.2 103.1 -0.1 2.7 Dec-11 114.15 0.4 2.6 113.74 0.4 2.5 1.5 123.13 0.3 2.1 103.4 0.3 2.6

Jan-12 113.08 -0.9 2.3 112.63 -1.0 2.3 1.4 122.84 -0.2 2.1 103.5 0.1 2.3

Feb-12 113.40 0.3 2.2 112.94 0.3 2.1 1.4 123.29 0.4 2.0 103.7 0.2 2.1

Mar-12 114.78 1.2 2.1 114.34 1.2 2.0 1.6 123.93 0.5 1.7 103.9 0.2 2.0

Apr-12 115.23 0.4 1.9 114.79 0.4 1.8 1.6 124.20 0.2 1.5 104.3 0.3 1.8

May-12 115.32 0.1 2.0 114.87 0.1 1.9 1.6 124.40 0.2 1.6 104.3 0.0 1.9

Jun-12 115.37 0.0 2.0 114.92 0.0 1.9 1.7 124.49 0.1 1.6 104.5 0.1 2.0

Jul-12 114.89 -0.4 2.0 114.41 -0.4 1.9 1.7 124.25 -0.2 1.5 104.8 0.3 1.9

Aug-12 115.16 0.2 2.0 114.68 0.2 1.9 1.7 124.73 0.4 1.6 105.0 0.2 2.0

Sep-12 115.72 0.5 2.0 115.24 0.5 1.9 1.8 124.68 0.0 1.7 104.9 -0.1 2.0

Oct-12 115.99 0.2 2.0 115.51 0.2 1.9 1.8 124.89 0.2 1.7 105.2 0.3 2.0

Nov-12 116.01 0.0 2.0 115.52 0.0 2.0 1.8 124.87 0.0 1.7 105.2 0.0 2.0

Dec-12 116.45 0.4 2.0 115.96 0.4 2.0 1.9 125.29 0.3 1.8 105.5 0.3 2.0

2010 1.6 1.5 1.0 1.5 1.6

2011 2.7 2.7 1.4 2.1 2.6

2012 2.0 2.0 1.7 1.7 2.0

Source: Eurostat, INSEE, ISTAT, UniCredit Research

Marco Valli (UniCredit Bank Milan) Tullia Bucco (UniCredit Bank Milan)+39 02 8862.8688 +39 02 [email protected] [email protected]


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Euro Compass


May 2011

The ECB Watcher

The need for vigilanceMarco Valli (UniCredit Bank Milan)+39 02 [email protected]

When the ECB meets on 9 June, we expect a switch to a (strong) vigilance posture, a clear

signal that in July the refi rate will be raised by another 25bp . In our view, the risk of a

dovish surprise, with Trichet sticking to very close monitoring and therefore further delaying

the next rate move, is fairly low, no more than 20%. We see three main reasons for this.

ECB seems happy with the refirate at 1.75% at year-end

New macroeconomicprojections: another hawkishrevision

ECB wants to remainpredictable

1) First, the ECB was not particularly enthusiastic about the dovish market reaction to

the May press conference. Right after 5 May, with the German 2Y yield and the EUR trading

well below pre-meeting levels, some GC members were quick to point out that the central

banks stance had not changed and the market had overreacted to Trichets words. We tend

to agree on both points: the ECBs decision to remain on hold in June is simply an indication

that the central bank is happy with another 50bp of tightening by year-end, and certainly not a

sign of deep strategy rethinking. In fact, it would probably take a significant degree of

stress in financial markets for the ECB to materially change its mind about the need forfurther rate hikes down the road. With the market squarely positioned for a 25bp increase

in July and another move sometime in 4Q, a dovish surprise on 9 June would lead to an

aggressive re-pricing of ECB rate expectations. We seriously doubt that the ECB would like

that: as the early start to the tightening cycle was intended to send a strong credibility

message to the market and firmly anchor inflation expectations, any sign of back-pedalling in

the absence of financial market disruption would create unwelcome volatility in rate and CPI

expectations.

2) At the next meeting, the ECB will publish a new set of macroeconomic projections,

which once again will be revised in a hawkish direction . After the stronger-than-expected

growth performance in 1Q, the central bank will probably raise its 2011 GDP forecast from

1.7% to 2%, most likely confirming the 1.8% call for next year. This implies three years of

above-potential growth after the exit from recession. Upward revisions will occur also on theinflation front: the 2011 forecast will probably be lifted significantly, from 2.3% to 2.7%, while

the number for 2012 should look slightly firmer at 1.8% vs. 1.7%. While the bulk of the

revision for this year will stem from higher commodity prices, it is fair to state that the trend of

core CPI is also proving somewhat stronger than the ECB (and we) was previously expecting

see the Inflation Watch section for more details. Given this macroeconomic landscape, it

would be a major surprise if Trichet were to miss the opportunity of the June meeting to pre-

announce a further removal of monetary accommodation.

3) Although not pre-committing, the ECB wants to remain predictable. Therefore, the

decision to start this tightening campaign using the same code words of the past hiking cycle

suggests that the central bank intends to stick as closely as possible to the semantic pattern

followed in 2005-2007.

DOVISH REACTION TO THE MAY PRESS CONFERENCE ECB TO PROJECT STRONGER GROWTH, HIGHER INFLATION

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

2.60

5-May-11 1st (Jun11 ) 2nd (Sep11 ) 3rd (Dec11 ) 4th (Mar12 )

Strip @ 05-May-11 Strip @ 04-May-11 keyrate (e)

2011 2012 2011 2012

1.7 1.8 2.3 1.7

2011 2012 2011 2012

2.0 1.8 2.7 1.8

CPI

March ECB Projections

UniCredit assessment of the June ECB Projections

GDP CPI

GDP

Source: Bloomberg, ECB, UniCredit Research


13/40


Euro Compass


May 2011

In the early stages of that tightening cycle, the reference to very close monitoring was never

used for three consecutive months, hinting that in June a step-up in rhetoric is very likely.

Focus on liquidity strategy

Full-allotment at 3M LTRO is aclose call

Apart from the near-term policy message, the June meeting will bring important decisionson the liquidity strategy because, as usual, the ECB will announce the calendar of

refinancing operations for the upcoming quarter. We consider it likely that the ECB will

leave the full allotment at the 1W MRO and 1M LTRO: this is required to leave a safety

valve in case of market tensions. Furthermore, with the level of the refi rate rising, the full

allotment at the 1W MRO would allow keeping the EONIA subdued. This would ease banks

funding costs. During the second quarter, the net rollover at the 1W MRO has been positive

(+EUR 7bn on average), suggesting that banks are actually using this facility.

The decision with respect to the 3M LTRO is a much closer call . During the second

quarter, banks have tended to bid at this facility less than the expiring amount (-EUR 14bn on

average in April and May), a sign that demand is dropping. However, this facility still accounts

for the bulk of ECB liquidity provision (EUR 232bn, almost 55% of the total). Pulling the plug

here risks creating an additional source of volatility. All in all, a further extension of the fullallotment also at the 3M LTRO seems a more prudent choice.

A long road to neutrality One final remark. In the European Economist section, we show that a plausible timing for a

turning point in the eurozone business cycle could be around mid-2013. If this reading is

correct, the ECB would have approximately two years to bring the refi rate toward a

more neutral level. Where is neutral? A rule of thumb sets the neutral level of the policy rate

in line with the growth rate of nominal GDP. Assuming that the areas growth potential after

the crisis (and for at least the next couple of years) does not exceed 1.5%, a neutral refi rate

could be in the 3-3.25% area. We expect the ECB to get there in 1H 2013 .


14/40


Euro Compass


May 2011

ECB Most Watched

Marco Valli(UniCredit Bank Milan)[email protected]

In 1Q, GDP growth accelerated strongly to 0.8% qoq (2.5% yoy). We suspect that

domestic demand was a key driver of the positive performance. Business surveys suggestthat momentum remains healthy so far in 2Q.

The trade-weighted euro declined 1.5% since mid-April, while euro-denominated Brentprices dropped by 10.4%.

Inflation accelerated to 2.8% yoy in April, driven by core prices (see the Inflation Watchsection). The inflation rate will probably ease marginally in May, and should approach the

3% area in the late summer.

In March, M3 yearly growth picked-up to 2.3% from 2.1%. Loans to the private sectorexpanded 2.5% yoy vs. 2.6%, with lending to NFCs accelerating to 0.8% vs. 0.6%, and

household credit improving to 3.4% yoy vs. 3.0%.

ECB Forecasts ECB Key exogenous variables

March ECB Projections

Growth Inflation

2011 2012 2011 2012

1.7 1.8 2.3 1.7

UniCredit Forecasts

Growth Inflation

2011 2012 2011 2012

2.1 1.7 2.7 2.020

30

40

50

60

70

80

90

100

15-Sep-08 23-Mar-09 28-Sep-09 5-Apr-10 11-Oct-10 18-Apr-11

99

101

103

105

107

109

111

113

115

117Euro-denominated Brent - LSEUR TW - RS

UniCredit Composite PMI & GDP Growth Inflation

-2.6

-2.2

-1.8

-1.4

-1.0

-0.6

-0.2

0.2

0.6

1.0

1.4

1.8

Sep-98 Jun-00 Mar-02 Dec-03 Sep-05 Jun-07 Mar-09 Dec-10

38

43

48

53

58

63

GDP qoq (in %) - LS

UniCredit Composite PMI (qtr avg) - RS

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Feb-99 Jul-01 Dec-03 May-06 Oct-08 Mar-11

HICP (in %, yoy)

Core (in %, yoy)

M3 Dynamics Credit Dynamics

M3 (in %, yoy)

-2

0

2

4

6

8

10

12

14

Jan-99 Jun-01 Nov-03 Apr-06 Sep-08 Feb-11-4

-2

0

2

4

6

8

10

12

14

16

18

Feb-00 Apr-02 Jun-04 Aug-06 Oct-08 Dec-10

Loans to households: total (in %, yoy)

Loans to households: mortgage (in %, yoy)

Loans to non-fin. corp. (in %, yoy)

Source: Datastream, ECB, Eurostat, Markit, UniCredit Research


15/40


Euro Compass


May 2011

The Eurozone Economists Toolbox

Chiara Corsa(UniCredit Bank Milan)+39 02 [email protected]

Marco Valli(UniCredit Bank Milan)+39 02 8862 [email protected]

1. GDPUniCredit Composite PMI

The manufacturing PMI in April rose to 57.7 from 57.5, while the services index declinedslightly to 56.9 vs. 57.2. As a result, our Composite PMI eased only marginally to 57.1 from

57.2, a level still consistent with a healthy pace of growth at the beginning of 2Q.

GROWTH MOMENTUM REMAINS HEALTHY

-2.6

-2.2

-1.8

-1.4

-1.0

-0.6

-0.2

0.2

0.6

1.0

1.4

1.8

Sep-98 Jun-00 Mar-02 Dec-03 Sep-05 Jun-07 Mar-09 Dec-10

38

43

48

53

58

63

GDP qoq (in %) - LS

UniCredit Composite PMI (qtr avg) - RS

Source: Markit, Eurostat, UniCredit Research

UniCredit GDP Tracker

Our GDP Tracker did a good job in predicting 0.8% qoq growth in 1Q. Industrial productionremained on a solid footing, while construction rebounded after the weather-related drop in

4Q. The consumption leg of our indicator points to an acceleration in private consumption.

SOLID GROWTH IN 1Q

-2.6

-2.2

-1.8

-1.4

-1.0

-0.6

-0.2

0.2

0.6

1.0

1.4

Q2 1995 Q4 1997 Q2 2000 Q4 2002 Q2 2005 Q4 2007 Q2 2010

Actual GDP

GDP Tracker

Source: European Commission, Eurostat, ECB, National Sources, UniCredit Research

The UniCredit Composite PMI is a weighted average of manufacturing and services PMI (headline), with weights based of the sectors share of total GVA.Weights are updated quarterly. The composite PMI is available starting from 3Q-98 and explains about 70% of the volatility in qoq GDP.

The UniCredit GDP Tracker estimates qoq GDP growth using IP, construction, retail sales and car registrations, plus one index of services confidence toovercome the lack of hard data in the tertiary sector (ex retail).
mailto:[email protected]:[email protected]


16/40


Euro Compass


May 2011

2. Employment

UniCredit Employment Indicator

In April, our employment indicator was stable at 0.5 st. dev. above its long term-average,indicating an ongoing moderate pace of job creation at the beginning of 2Q.

EMPLOYMENT GROWTH CONTINUES AT AN UNEXCITNG PACE

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

Mar-97 Feb-99 Jan-01 Dec-02 Nov-04 Oct-06 Sep-08 Aug-10

UniCredit Employment Indicator

3M-ma

Source: European Commission, Eurostat, UniCredit Research

3. Money

M3 growth accelerated in March, to 2.3% yoy vs. the previous 2.1%. The growth rate ofloans to the private sector remained broadly stable, at 2.5% yoy vs. 2.6%%, confirming that

the recovery in the credit cycle continues, albeit at a moderate pace.

M3 GROWTH KEEPS ACCELERATING

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

Jan-99 Sep-00 May-02 Jan-04 Sep-05 May-07 Jan-09 Sep-10

official M3

M3 corrected for portfolio shifts

loans to private sector

Source: ECB, UniCredit Research

The UniCredit Employment Indicator is a weighted average of standardized 12-month-ahead employment expectations in the industrial, construction, andservices sectors, as computed by the European Commission for its monthly survey. Weights are based on the share of total GVA of the three sectors, andare updated quarterly. The Indicator tracks both qoq and yoy employment growth (national accounts definition), but the latter fit is better.

The ECB estimates the size of portfolio shifts through a univariate time-series model of M3 that includes also a number of dummies and trends (see ECBMonthly Bulletin, October 2004). The estimate is carried out quarterly. However, given that this adjustment was particular to the nature of the portfolioshifts that occurred during 2001-2003, the growth rate of M3 corrected has coincided with that of official M3 for some time now, and continues to do so.


17/40


Euro Compass


May 2011

4. Inflation

UniCredit Underlying Inflation Index

Underlying inflation accelerated further in April, to 1.15% yoy from 0.91% yoy. The lateEaster and a new seasonality for clothing/shoes prices explain most of the rise.

UNDERLYING INFLATION UP FURTHER

-1.0

0.0

1.0

2.0

3.0

4.0

Jan-02 Sep-03 May-05 Jan-07 Sep-08 May-10

Headline

Core

UniCredit Underlying

Source: Eurostat, UniCredit Research

UniCredit Persistence-Weighted (PW) Inflation Index

In April, our PW Inflation measure stabilized at 2.4%. Headline CPI accelerated to 2.8% vs.

2.7%, while core inflation (ex food, energy, alcohol and tobacco) rose to 1.6% from 1.3%.

PW INFLATION STABILIZED IN APRIL

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Jan-99 Jun-00 Nov-01 Apr-03 Sep-04 Feb-06 Jul-07 Dec-08 May-10

PW Index

HICP

Source: Eurostat, UniCredit Research

Our UniCredit Underlying Inflation Index strips out erratic components (food, energy, alcohol) and administrative prices (among the most important:tobacco, social protection, education, medical, dental and hospital services). It covers 68% of the total HICP basket.

Our UniCredit Persistence-Weighted (PW) Inflation Index is an alternative measure of core inflation that gives more weight to the items of the HICPbasket displaying a higher degree of persistence. At any given point in time, the degree of persistence of each of the twelve HICP sub-components issimply given by the sum of its autoregressive coefficients, a proxy for the speed with which prices converge toward the mean after a shock. The sum of

autoregressive coefficients (if negative, it is put equal to zero) is then re-scaled to deliver the new, persistence-based and time-varying weight of the item.


18/40


Euro Compass


May 2011

5. Financial Markets

UniCredit FMI

The ongoing periphery woes are not affecting broad financial market conditions in anymeaningful way. Our FMI remains supportive for growth.

FINANCIAL MARKET CONDITIONS REMAIN FAVORABLE, DESPITE PERIPHERY WOES

FMI

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

1-Feb-99 1-Jul-01 1-Dec-03 1-May-06 1-Oct-08 1-Mar-11

Source: Bloomberg, UniCredit Research

6. Monetary Policy

UniCredit Coincident Taylor Rule

Amid the ongoing narrowing of the output gap and the recovery in the credit cycle, ourcoincident Taylor rule points to a fair level of the refi rate of 1.55.

OUR TAYLOR RULE POINTS TO ANOTHER RATE HIKE

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0


Actual

Fitted

Source: ECB, Markit, UniCredit Research

The FMI aggregates in one single indicator the signal coming from the VDAX, DJ Euro Stoxx 50 and corporate spread (BBB, 5-7y). Volatility and spreadenter the algorithm with a positive sign, equity with a negative sign. The FMI is negatively correlated with economic growth and leads eurozone GDP byone quarter and the Ifo expectations index by one month.

The UniCredit Coincident Taylor Rule is a monthly specification of he ECBs reaction function. It explains the level of the refi rate as a function of: 1) aPMI-based measure of output gap; 2) the yearly growth rate of lending to the private sector.


19/40


Euro Compass


May 2011

European Central Banks Watch

BoE On hold despite high inflation

Chiara Corsa(UniCredit Bank Milan)+39 02 8862 [email protected]

Mauro Giorgio Marrano(UniCredit Bank Milan)+39 02 8862 [email protected]

This months data confirmed our doubts about the strength of the recovery after the

contraction at the end of last year (-0.5%qoq). GDP in 1Q (preliminary figures) posted only

a modest rebound (0.5% qoq). The biggest decline was in the construction sector (-4%),

while services rebounded (0.9% vs. the previous -0.6%) and IP growth accelerated (to 1.1%

vs. 0.2%). We expect GDP growth in 1Q to be confirmed at 0.5%. Regarding the expenditure

breakdown, which will be published with the second GDP release, the main contribution to

growth should come from net trade, in line with the strong export growth and the sharp

decline in imports shown by trade balance data for 1Q. We expect the other positive

contributions to come from consumption and investment, which we see rebounding

moderately from the contraction in the previous quarter. Within investment, strong capex

growth should be partially offset by a further decline in construction investment. We expect

the main drag on growth to come from inventories. Moving into 2Q, survey data this monthsignaled a weaker-than-expected start. The manufacturing PMI fell to 54.6 in April from a

downwardly revised 56.9, the lowest level in seven months. The services PMI plunged to

54.3 in April from 57.1 in March. While both indexes remain at healthy levels, these data

certainly signal a loss of momentum. On a positive note, CBI and BRC retail sales performed

quite well in April, but this seems to be driven by the late Easter-effect.

Headline inflation in April increased to 4.5% from 4.0%. Core inflation accelerated to

3.7% from 3.2%. The ONS estimates that most of this increase was due to a strong rise in

transport tariffs - predominantly air fares (up by 29% mom) - related to the late Easter. This

accounts for all the acceleration in the core and added 0.36 pp to headline inflation. The rest

of the increase came mainly from alcohol and tobacco, which added 0.13pp.

In the May Inflation Report, the inflation profile was revised up in 2011 and 2012 compared to

the February Report, reflecting the recent increases in energy prices, which are expected to

push up domestic prices for gas and electricity. April inflation, thus, should not have come as

a surprise to the BoE, which expects inflation to peak at 5% this year. The outlook for real

GDP growth was revised down in the near term. The big picture for the medium term, the

time horizon relevant for monetary policy, remained pretty much the same as in the

previous report: inflation is expected to fall back to target (by 2013), as the temporary

effects pushing up prices wane and a significant margin of spare capacity remains.

Interestingly, the Bank Rate path assumed in the forecasts envisages only one hike by the

end of 2011 instead of two as in the February Report. This poses downside risks to our

expectations of two rate hikes (the first one in 3Q and another one in 4Q) by the end of this

year. The minutes of the May MPC meeting showed that MPC members did not change their

positions in light of this months data and the revised BoE forecasts (the split on the interest

decision remained the same as in April: six in favor and three against the proposal to

maintain Bank rate unchanged).UK FORECASTS

2010 2011 2012 Annual average

1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 1Q-12 2Q-12 3Q-12 4Q-12 2010 2011 2012

GDP 0.2 1.1 0.7 -0.5 0.5 0.4 0.4 0.5 0.5 0.5 0.6 0.6 -- -- --

GDP (% yoy) -0.4 1.5 2.5 1.5 1.9 1.2 0.9 1.9 1.8 1.9 2.1 2.1 1.3 1.5 2.0

CPI Inflation (% yoy) 3.3 3.4 3.1 3.4 4.1 4.4 4.3 3.8 2.8 2.4 0.0 0.0 3.3 4.1 2.5

Core CPI Inflation (% yoy) 3.0 3.0 2.7 2.8 3.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 2.9 2.9 2.1

Unemployment rate (%) - - - - - - - - - - - - 7.8 8.0 7.7Current Account (% GDP) - - - - - - - - - - - - -2.5 -2.0 -2.0

Pub. Sect. Net Borrowing (% GDP) - - - - - - - - - - - - 10.1 7.8 5.7Repo rate 0.50 0.50 0.50 0.50 0.50 0.50 0.75 1.00 1.25 1.50 2.00 2.50 - - -

3M GBP Libor (end quarter) 0.65 0.73 0.73 0.74 0.79 0.90 1.05 1.30 1.55 - - - - - -

10 yr (end quarter) 3.94 3.36 2.95 3.22 3.65 3.85 4.00 4.25 4.50 - - - - - -

EUR-GBP 0.89 0.82 0.87 0.86 0.88 0.89 0.88 0.87 0.85 - - - - - -GBP-USD 1.52 1.49 1.57 1.56 1.60 1.69 1.74 1.78 1.79 - - - - - -

All data are % qoq unless otherwise specified; GDP data are wda. *Contribution to growth Source: ONS, UniCredit Research


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Euro Compass


May 2011

SNB CHF up on EMU debt crisis woes, againAlexander Koch (UniCredit Bank)+49 89 378-13013

[email protected]

The continuing strength of the Swiss currency remains a strong liability for the Swiss export

sector. Manufacturers and the tourism sector have to cope with an appreciation of 17%versus the EUR since the end of 2009. The latest exchange rate survey conducted by the

SNB confirmed that an increasing number of business contacts is reporting negative effects,

particularly on profit margins, but also on sales volumes. However, vibrant global demand

has so far more than compensated for the dampening currency impact . Real exports

delivered a strong performance at the beginning of the year. And business expectations in the

export sector remain clearly expansionary overall, also in respect to investment and

employment.

Accordingly, the upcoming growth figures for the first quarter can be expected to show the

continuation of the solid V-shaped recovery of the Swiss economy. In addition to robust

industrial demand, imported deflation for consumer goods and robust housing demand

backed by substantial net immigration are supporting overall domestic demand.

Although leading indicators signal softer growth dynamics throughout 2011 following the

initially very strong recovery pace, we expect annual real GDP growth in 2011 to remain

broadly unchanged compared to 2.6% last year.

Actually, the resilient economy would already require a departure from the zero-interest rate

policy of the SNB. And the recent start of interest rate normalization by the ECB should have

increased the room for maneuver for the Swiss central bank. Should have. But renewed EMU

debt crisis woes have once again pushed the Swiss currency up, leaving EUR/CHF

close to its record high. The unchanged safe-haven status of the Swiss currency together with

a still relatively relaxed inflation situation have reinforced our view that the SNB will likely

maintain its 0.25% target rate at its quarterly monetary policy meeting in June especially as

a quick resolution of the eurozone debt crisis in the coming weeks appears rather unlikely.

In its baseline scenario, the SNB doesn't project the headline inflation rate to rise abovethe 2% mark before the middle of 2013 even under the assumption of a constantly low

target rate. Hence, this means that the SNB can take its time before raising rates. But if EMU

officials can eventually stabilize the situation in the crisis countries, a window of opportunity

for a first SNB rate hike may open up by September.

SWITZERLAND FORECASTS


1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 1Q-12 2Q-12 3Q-12 4Q-12 2010 2011 2012

GDP (% qoq) 0.8 0.7 0.8 0.9 0.6 0.5 0.3 0.3 0.4 0.5 0.5 0.5 - - -

GDP (% yoy) 1.5 2.7 2.8 3.2 3.0 2.8 2.3 1.7 1.5 1.5 1.7 1.9 2.6 2.4 1.7

Private Consumption (% qoq) 0.8 0.0 0.4 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 0.3 1.7 1.2 1.2


Unemployment rate (%) 4.1 4.0 3.8 3.6 3.4 3.1 2.9 2.8 2.8 2.7 2.6 2.5 3.8 3.0 2.7

Budget Balance (% GDP) - - - - - - - - - - - - 0.0 0.3 0.2

Public Debt (% GDP) - - - - - - - - - - - - 38 37 35

3M CHF Libor mid target rate 0.25 0.25 0.25 0.25 0.25 0.25 0.5 0.75 1.0 1.25 1.25 1.5 - - -

3 Months (end quarter) 0.25 0.11 0.18 0.17 0.17 0.50 0.80 1.05 1.30 - - - - - -

10 yr (end quarter) 1.88 1.48 1.40 1.58 1.86 2.10 2.30 2.50 2.60 - - - - - -

EUR-CHF 1.42 1.32 1.34 1.25 1.30 1.29 1.30 1.32 1.34 - - - - - -

USD-CHF 1.05 1.07 0.98 0.94 0.92 0.86 0.85 0.85 0.88 - - - - - -

GDP data are wda. Source: National Sources, UniCredit Research


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Euro Compass


May 2011

Nordics Norges Bank catching up with Riksbank

Stephan Maier(UniCredit Bank Milan)+39 02 8862 [email protected]

The Riksbank is expected to continue raising rates in its remaining meetings this year,

bringing the repo rate to 2.75% by year-end. Norges Bank has now resumed its rate-hikecycle and should hike rates twice more to reach 2.75% in 2H11.

Sweden: Riksbank should raisethe key rate again by 25bp inJuly

Economic activity in Sweden continues to be very strong and inflation is picking up too.

Industrial production even accelerated to 4.6% qoq in 1Q11 from 1.5% growth in 4Q10, but

the manufacturing PMI is pointing to some deceleration during 2Q11. This deceleration is

already occurring in the consumer sector, where retail sales have contracted 1% qoq in 1Q11,

following a modest 0.3% expansion in 4Q10. Inflation in April accelerated to 3.3%, way above

the Riksbanks 2% target, and underlying inflation reached 1.8%. This means that core

inflation is still in line with the Riksbank's forecasts. The spike in the headline figure has

clearly come as a surprise to the Riksbank, and implies that the 2011 figure will be at least

2.5%, clearly too high for the Riksbank, even if heavily influenced by energy prices. Therefore,

the Riksbank is expected to hike the key rate in each and every remaining meeting this

year, bringing the key rate to 2.75% at year-end.

Norway: Norges Bank shouldremain on hold in June

Norges Bank resumed hiking the deposit rate at the May meeting after having left it on

hold since May last year. While the pace of economic expansion continues to be moderate,

an acceleration in inflation albeit starting from still low levels has been one of the reasons

for the rate hike. Regarding the real economy, both retail sales and manufacturing displayed

signs of weakness during 1Q. Retail sales declined by 0.4% qoq in 1Q and manufacturing

advanced just by a meager 0.5%. Furthermore, following the easing in the PMI,

manufacturing is likely to further decelerate in 2Q. However, inflation has accelerated to 1.3%

yoy in April, from 1% in March, and underlying inflation picked up from 0.8% to 1.3%. While

inflation is still only at roughly half its target of 2.5%, Norges Bank is now worried about wage

growth and the dynamics of the housing market; wage negotiations suggest wage growth of

around 4% in 2011, as unemployment continues to fall and house prices have gained pace.

Quarterly house price readings are quite volatile, but the 5.1% qoq price rise in 1Q11 has

been the strongest increase since 2Q09 and indeed household credit growth has accelerated

to 6.3% yoy in March, from readings of around 5% in 2010. Overall, economic data still points

to quite a good pace of recovery and a further rebound in inflation should keep Norges Bank

in tightening mode. Although Norges Bank may leave the key rate unchanged at 2.25% at

the June meeting, we think that it will hike rates twice again this year to 2.75%

SWEDEN FORECASTS


1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 1Q-12 2Q-12 3Q-12 4Q-12 2010 2011 2012

GDP (% qoq) 1.6 2.1 2.1 1.2 0.7 0.6 0.5 0.4 0.6 0.7 0.8 0.8 - - -

GDP (% yoy) 2.6 4.4 6.8 7.2 6.3 4.7 3.1 2.2 2.1 2.2 2.5 2.9 5.3 4.0 2.4


Repo rate 0.25 0.25 0.75 1.25 1.50 1.75 2.25 2.75 3.00 3.25 3.50 3.75 - - -

3 Months 0.51 0.79 1.28 1.62 2.20 2.50 2.80 3.25 3.30 - - - - - -

EUR-SEK 9.74 9.52 9.19 8.99 8.91 8.90 8.80 8.70 8.65 - - - - - -

NORWAY FORECASTS


1Q-10 2Q-10 3Q-10 4Q-10 1Q-11 2Q-11 3Q-11 4Q-11 1Q-12 2Q-12 3Q-12 4Q-12 2010 2011 2012

GDP (mainland, % qoq) 0.6 0.4 1.1 0.3 0.8 0.6 0.6 0.6 0.7 0.8 0.9 0.9 - - -

GDP (mainland, % yoy) 1.4 1.8 3.0 2.5 2.7 2.8 2.4 2.6 2.5 2.7 3.0 3.3 2.2 2.6 2.9


Depo rate 1.75 2.00 2.00 2.00 2.00 2.25 2.50 2.75 3.00 3.25 3.50 3.75 - - -

3 Months 2.34 2.79 2.60 2.55 2.61 2.75 3.00 3.25 3.35 - - - - - -

EUR-NOK 8.03 8.06 8.04 7.79 7.84 7.85 7.80 7.75 7.70 - - - - - -

NOK-SEK 1.21 1.19 1.15 1.15 1.14 1.13 1.13 1.12 1.12 - - - - - -



22/40


Euro Compass


May 2011

FI Strategizer

Bonds to remain bid for the time beingLuca Cazzulani(UniCredit Bank Milan)+39 02 8862 [email protected]

Chiara Cremonesi(UniCredit Bank London)+44 207 [email protected]

US: The end of QE2 should not have a major impact on US yields given the current

environment of slowing US growth. The Fed is likely to maintain its ultra-accommodative

stance, which will keep short-end yields low, and in the near term we see litt le pressure on the

long end from the increase in inflation or deteriorating fiscal outlook. The 2/10Y spread should

remain relatively steep in the near term.

EU: Uncertainty on periphery is likely to keep top-rated debt well-bid, slowing down the rise in

yields related to ECB rate hikes, positive growth in core countries and high inflation. The 2Y

Schatz is likely to remain at the currently expensive levels for some time yet. The 2/10Y bull

flattening may unwind in the near term before bear flattening kicks in.

UK: A weaker-than-expected recovery should keep short-maturity Gilts anchored at low

levels. We do not expect much pressure on the long end: the recent rise in inflation should be

perceived as temporary due to the sluggish growth outlook. We do not expect a significantchange in the curve shape in the near term.

Yields of AAA rated governmentbonds have fallen in the lastmonth:

In the last four weeks or so, yields of top-rated government bonds have declined by

about 20bp due to renewed uncertainty surrounding the debt crisis and the weakened

growth outlooks for the US and the UK.

in the EMU due to renewedworries about the debt crisis

In the EMU, discussion on Greek debt restructuring has been center stage, pushing the

Greek curve sharply up and offering support to Bunds.

in the US due to a weakeninggrowth outlook

In the US and UK, 10Y yields have also declined in the last month due to a combination of

weaker-than-expected macroeconomic data. EMU debt woes have offered tail wind.

The three weakest periphery wereunder great pressure, while Spainand Italy suffered slightly less

Troubles in the EMU periphery have remained center stage. GGBs have widened

massively, followed by PGBs and Irish bonds. Spain and Italy have widened more modestly,

although clearly investors regard Spain as relatively less safe. The potential risk coming from

the banking sector is well-known; the other issue that is going to capture investors attention in

the next few months is debt dynamics at regional level.

Stocks are mildly up vs. lastmonth

After a boost at the end of April, stocks corrected a bit, but overall are mildly up from

last month. The DAX is up by 1.74%, while the S&P is up by 1.36% compared to mid-April.

Commodities prices havecorrected by ca. 10%

Commodities prices have corrected by about 10%. This has mainly been the result of profit

taking as well as of worries that the recovery may not be sustainable.

YTD, USTs have delivered apositive return, while Bunds arein the red; ILBs haveoutperformed fixed coupons onboth sides of the Atlantic

Long-maturity USTs have delivered a 2.6% return (YTD, in USD) and short-dated ones

are also in positive territory (although by a much smaller 0.7%). Inflation-linked bonds are

the best performers, given the increase in inflation (and inflation expectations) since the

beginning of the year. YTD, Bunds are in the red by 0.7%. ILBs have outperformed fixed

coupons also in the EMU. US linkers have performed better than EU ones.

10Y UST CLOSE TO SUPPORT WEAKEST PERIPHERY COUNTRIES' BOND YIELDS ON THE RISE

-0.5

-4.0

3.0

0.8

2.6

0.8 1

.1

0.1

-5.1

-1.3

-3.3

-4.3

-5.2

0.1

-3.0

0.4

-10

-8

-6

-4

-2

0

2

4

6

Core

7-10

Core

1-3

Perip

7-10

Perip

1-3

7-10 1-3 7-10 1-3 7-10 1-3

EMU US UK JP

Totalreturn(%)

Asset return Eur return

0

200

400

600

800

1000

1200

1400

May-10 Aug-10 Nov-10 Feb-11 May-11

Yieldspreadvs.

Germany(bp)

PT IE GR



23/40


Euro Compass


May 2011

EMU debt crisis to remain centerstage in the near term

especially discussions onGreece

Investor focus is likely to remain on the EMU periphery in the next month. Greek debt

restructuring should remain the key issue. Investors agree that debt is not sustainable in the

long run and some form of intervention will be needed. Several options are possible:

imposing a haircut, extending debt maturity, setting up a (permanent) transfer union.

Greek bonds maturing beyond 2014 trade at a cash price lower than 60, and this

suggests that investors are placing a high probability on the haircut hypothesis.

According to our calculations, a haircut in the range of 50% is fully priced into 10Y GGBs.

More recently, the hypothesis of a re-profiling (an extension of maturity) has gained appeal

because it would be the easiest from a political perspective. We are skeptical about such an

option: it would imply a fall in GGB prices and, if not designed carefully, it risks creating a

redemption wall and it would not bring any relief in terms of debt/GDP ratio.

Scheduled events important towatch for periphery

Scheduled events that will be important to watch are:

The approval of the 5th tranche of the Greek package (by the end of May). Given the

funding shortfall of EUR 27bn and EUR 38bn respectively in the next two years, intervention

is needed. It could be a EUR 60bn extension of the bail-out package (more likely) or thedecision to re-profile the debt (which we regard as less likely). Should the first outcome

materialize, the decision to impose a haircut should come not earlier than 2013.

The elections in Portugal on 5 June are another important event. We think that whoever

the winner is, he will not be able to show less than a strong commitment to fiscal

consolidation.

The Eurogroup meeting scheduled for 24 June might discuss the case of Greece.

Indeed, the IMF and the EU will have concluded their fourth review of the program and this

would be a good window of opportunity for EU policymakers to present and discuss a plan

addressing the sustainability of the Greek debt

The results of the EBA stress test will be another important factor. At the moment the

market is putting a lot of emphasis on the restructuring of the banking sector, so we expect

the outcome of this exercise to be closely monitored. However, we doubt that this exercise

will provide a comprehensive solution for the EU banking system.

Investors are likely to continue monitoring the banking restructuring process in Spain.

All in all, uncertainty on periphery should keep safe-haven demand strong, slowing

down the rise in yields that we expect in relation to ECB rate hikes, positive EMU growth and

high inflation.

Do not expect near-termcheapening of the Schatz

As a result, the 2Y Schatz is likely to remain at the currently expensive levels for some

time yet. The chart below shows that the 2Y Schatz yield is about 30bp lower than the

average level of the first eight Euribor future contracts. This difference is related to demand

for safe assets. Note that, given that we expect the ECB refi to reach 1.75% at the end of the

year, the 2Y Schatz should trade in the 2.30/2.50% range by the end of the year.

EXPENSIVE 2Y SCHATZ THE 5Y RECOVERS VS. THE WINGS (SWAP CURVE)

0

20

40

60

80

100

120

140


Avg. 3MEuribor (first 8 contracts)-2YSchatz- bp 2Ys wap spread

-60

-40

-20

0

20

40

60

Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09 Jan-11

Actual FIT std error



24/40


Euro Compass


May 2011

The belly: still some room forrichening

The 5Y has richened up in the last month vs. the 2Y and the 10Y (this goes both for the

Bunds and the swap curve). Our model that relates the belly with the fundamental variables

(ZEW) indicates that, even after its recent richening, the 5Y still has some room to go. In

absolute yield terms, the 5Y swap at 2.90% does not look very attractive, especially relative

to the 2Y. The 2/5Y spread has bull flattened about 15bp to 60bp since early April. We

expect the curve to bear flatten in response to ECB rate hikes but before this happens, we

would expect to see unwinding of the recent bull flattening.

The 10Y Bund has richened about 30bp since April 10 due to renewed risk aversion. While

the near-term outlook will remain determined by the risk on/risk off picture, in a medium-term

perspective we expect 10Y yields to rise.

10/30Y flattening: more attractivewith Bunds than with swaps

Both on the swap and the Bund curve, the 10/30-year spread has shown little volatility

in the last seven months and we do not expect large changes in the near term . That

said, it would be more attractive to play flattening with Bunds than with swaps:

historical comparison with the Dec05-Jun07 tightening cycle shows that the 10/30-swap

flattened to 10bp (vs. the current 25bp) while the Bund curve flattened to 10bp (vs. the

current 50bp).

A quick glance at the US and UK

The main topic in the US: end ofQE2, debt ceiling and fiscalconsolidation

In the US, weaker-than-expected macroeconomic data have been the main reasons behind

the rally in Treasuries over the last few weeks. The escalation of the EMU debt crisis has

offered extra tail wind.

Over the next month the main topic for the US market should be the end of the Feds QE2

and the debate on fiscal consolidation.

Weak growth data and ultra-loosemonetary policy should keep 2Yyields low

At present, 2Y Treasuries yields are trading in the 0.50/0.55%area, around the level

observed before Bernanke announced that the Fed would embark in QE2 last August.

The end of QE2 should not come as a surprise and in our view should not have a majorimpact on US yields given the current environment of slowing US growth. Even if the Fed

does not embark on QE3, it is rather clear that it will remain in ultra-loose monetary policy

mode for some time. In this environment, a series of better-than-expected growth data are

needed to push yields up, particularly at the short end. Should growth data continue to

disappoint, 2Y yields should remain at their current ultra-low levels.

Inflation expectations and thedebt debate should be the majordrivers at the long end

At the long end, aside from the end of QE2, the dynamics of inflation expectations and

the debate on the fiscal outlook should be the major drivers. 10Y UST currently trade at

3.15%, the lowest level in the last five months although inflation is trending higher and the

fiscal outlook is less than brilliant.

Growth worries should keepinflation expectations subdued inthe near-term

Inflation continued to edge up in April, but this did not put much pressure on the long end.

Indeed, inflation expectations as proxied by BE rates have decreased significantly following

the slide in oil prices at the beginning of Ma

2011-05-04 unicredit euro compass - how long before the next cyclical downturn

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