barclays capital - the _w_ides of march

7/31/2019 Barclays Capital - The _w_ides of March

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INTEREST RATES RESEARCH Global Rates Strategy | 30 March 2012

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 56

GLOBAL RATES WEEKLY

The (w)ides of March?As data has been inconclusive, peripheral Europe has again come under pressure as

post LTROs, some profit taking has coincided with supply. Going forward, the dynamics

of flow tilt towards continued supply concessions.

United States

Treasuries: A grinding rally 3

The Treasury market has partially reversed the sharp post-March FOMC selloff amid dovish

Fedspeak, slight weakness in economic data, and a rise in risk aversion. We maintain our

long 2y Treasuries view, as the OIS rate and the Tsy-OIS basis have room to decline.

Agencies: Continuing resolutions 7

Swaps: Tightening risks remain 10

Money Markets: Too much cash 12

TIPS: Relative value in relative ASWs 16

Volatility: A time to sell 18

Europe

Futures: New 10yr OAT future analysis 21

Having introduced the new BTP future contracts over the past few years, Eurex is now

launching a new 10y French (OAT) future on 16 April. We estimate FRTR 3.75% Apr

2021 as the CTD to the June 12 contract.

Money Markets: ECB: To exit or not? 24Sovereign Spreads: Eurozone supply expectations for Q2 2012 28

UK: Institutional flows and long yields 31

The latest data on domestic institutional flows in the gilt market suggest that demand

for linkers remains healthy despite real yield levels.

Covered Bonds: Depfa ACS covered bonds downgradedby six notches 35

SSA: The National Loan Guarantee Scheme 37

Euro Inflation-Linked: Positioning for the carry upswing 41

Volatility: Buy EUR mid-curve, sell US mid-curve 42

Australia

A 40bp gain in three days. Can we expect more? 45

After a 40bp rally, we believe investors who entered a receive AU 1y1y earlier in the

week should lock in their gains.

Japan

Seasonality and fundamentals 47

The markets may try to move based on the pattern of the past two years, in which

yields hit their peak for the fiscal year in April. However, JGBs, which would normally

cheapen relative to USTs during this period, are, in fact, rich currently and could enter a

bear steepening trend in the coming weeks.

Global Views on a Page

Global Traders Guide

Global Economics Calendar

Global Supply Calendar

Global Bond Yield Forecasts United States

Ajay Rajadhyaksha+1 212 412 7669

[email protected]

Michael Pond

+1 (212) 412 5051

[email protected]

Rajiv Setia

+1 212 412 5507

[email protected]

Europe

Laurent Fransolet+44 (0) 20 7773 8385

[email protected]

Alan James

+44 (0) 20 7773 2238

[email protected]

Japan

Chotaro Morita

+81 (3) 4530 1717

[email protected]

www.barcap.com


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Barclays | Global Rates Weekly

30 March 2012 3

UNITED STATES: TREASURIES

A grinding rally

The Treasury market has partially reversed the sharp post-March FOMC selloff amid

dovish Fedspeak, slight weakness in economic data, and a rise in risk aversion. Wemaintain our long 2y Treasuries view, as the OIS rate and the Tsy-OIS basis have room to

decline. We also recommend initiating 10s30s curve steepeners to benefit from the

auction concessions shift to the long end of the curve.

The Treasury market rallied over the past week, with 10y yields declining to 2.16%, partially

reversing the roughly 40bp selloff since the March FOMC meeting. While economic data

have been somewhat on the weaker side since then, especially on housing and initial claims,

and risk aversion has increased, with Italian and Spanish government bonds

underperforming their German counterpart (Figure 1), statements from Chairman Bernanke

suggesting caution have played a significant role as well.

In his latest speech, Bernanke focused not just on the unemployment rate but also on the

high level of long-term unemployed and the weakness in overall activity, suggesting thatthe Fed is not tied to one specific measure, which may have been the perception coming

out of the March FOMC meeting. While the Chairman could very well be wrong in his

explanation of the faster decline in the unemployment rate than should have been expected,

given the pace of GDP growth, his focus on overall activity suggests that a continuation of

the downward trend in the unemployment rate alone would not be enough to change his

cautious view of the recovery.

Price action since the peak of the selloff suggests expectations of a dovish Fed have been

rebuilding. Figure 2 shows that 10y real yields have partially reversed the selloff and 10y

breakevens, which had widened despite a hawkish perception of the Fed, simply reflecting, in our

view, bad positioning in the nominal market, have also tightened. As we have argued recently

(Will the bond market selloff be sustained, March 22, 2012), modest medium-term growthexpectations amid the threat from fiscal tightening, tight credit conditions, and weakness in

wage appreciation should keep a lid on rates.

Anshul Pradhan

+1 212 412 [email protected]

Figure 1: Italian and Spanish government bondsunderperformed over the past week

Figure 2: 10y real yields fell and breakevens tightened,partially correcting the dislocation in the selloff

250

300

350

400

450

500

550

600

Oct-11 Nov-11 Dec-11 Jan-12 F eb-12 Mar-12

Spain Italy

Spread vs 10y German bonds, bp

-50

-40

-30

-20

-10

0

Jan-23 Feb-07 Feb-22 Mar-08 Mar-23

200

210

220

230

240

250

10y breakevens, bp, rhs 10y real yields, bp, lhs

Dovish Fed

Hawkish Fed

Source: Bloomberg Source: Barclays Research
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30 March 2012 4

Maintain the long 2y Treasuries recommendation

In the near term, we maintain our long view on 2y Treasuries, which should benefit from afurther decline in Fed hike expectations and from the tightening of the Treasury-OIS basis.

Figure 3 shows that the 2y OIS rate, well within the late 2014 guidance, is still trading above

post-March payroll levels and well above post-January FOMC levels, when the Fed introduced

the late 2014 guidance. While better economic data since January do argue for a higher funds

rate at the end of 2014, near-term pricing looks aggressive; Figure 4 shows that expectations

for the next 1 year are 5bp higher. With the effective funds rate now beginning to decline, 2y

OIS rates should trade at 15-20bp, compared with the current 24bp.

The Treasury-OIS basis should also richen as primary dealer inventories decline in the near

term, led by negative bill supply, and over the longer term, as the effect of Operation Twist

fades. Figure 5 shows that the overnight GC-FF spread has been driven largely by the level of

primary dealer inventory of US Treasuries; a rise in the latter leads to additional financingneeds on behalf of dealers, which pushes the GC rate higher relative to the effective fed funds

rate. In recent months, dealer inventories have risen not just in the


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30 March 2012 5

We expect bill supply to turn negative over the next few months as the Treasurys

borrowing requirements fall below net coupon issuance. In Figure 7, we plot net bill supply

over a one-month period against the 1m moving average of the GC-FF spread. As can be

seen, net monthly bill supply peaked at $120bn on March 8 and should be -$75bn over April

and -$30bn over May. This should not only ease the burden of primary dealers, but also

lower the available supply for final investors, such as money market funds, who should in

turn find repos attractive forcing repo rates lower at the same time.

Over a longer horizon, as the effect of Operation Twist fades, dealer inventories in the


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30 March 2012 6

We believe the curve can steepen another 5-6bp following month-end. Figure 10 showsthat the curve typically steepens ahead of the bond auction; interestingly, the bulk of the

steepening in a non-refunding auction happens well before the auction date. In a

refunding auction, the market typically underestimates the concession needed to absorb

the extra $3bn, which usually leads to those auctions tailing (over the past year,

refunding auctions have tailed by 4.0bp on average, whereas non-refunding auctions

have come through by 0.6bp).

Figure 9: The recent steepening simply a payback for theexcessive flattening in the selloff; curve close to fair

Figure 10: Expect the 10s30s curve to continue to steepenahead of the bond auction

111

50

70

90

110

130

150

170

Sep-09 Mar-10 Sep-10 Mar-11 Aug-11 Feb-12

10s30s Treasury Curve Estimate

bp

Reaction to QE2

Reaction to Operation Twist

Reaction to language change

(6.0)

(4.0)

(2.0)

-

2.0

4.0

(10) (8) (6) (4) (2) - 2 4 6 8 10

Non Refunding since Jan 2011 Ex Sep

Refunding since Jan 2011

Average since Jan2011

Change in 10s30s curve ahead of the bond auction, bp

Days from the bond auction

Note: Estimate reflects 20bp of flattening related to Operation Twist.Source: New York Fed, Barclays Research

Source: Barclays Research


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30 March 2012 7

UNITED STATES: AGENCIES

Continuing resolutions

With the spike in rates having reversed halfway, we maintain our view on selling vol in

parts of the surface that have not fully retraced by owning agency callables. USD coveredbond outperformance amid record supply has been impressive and should continue.

Own callables to position for a continued reversal in rates/vol

Over the past 1-2 weeks, the sharp selloff in rates and spike in vols that gripped the market

for much of the prior months has reversed roughly halfway. As we highlighted earlier, 1 we

believe the impetus for the moves were imbalances in positioning, rather than a

fundamental shift in the economic backdrop; we expect the reversal to continue.

In our view, the rates market is still overestimating the probability of a Fed hike by YE13,

which should keep a lid on front-end Treasury yields. Also, we expect vol to continue to

subside as a rangebound rate environment is re-established. In particular, we favor selling

gamma on 5y tails, which had reached as low as the mid-50s earlier in the year, before

spiking to the mid-80s and now retracing about half that amount. Keep in mind that

gamma on 5s has declined the least on the vol surface, as other parts have almost fully

retraced to pre-selloff levels (Figure 1); thus, we believe it has the most room to decline.

Against this backdrop, we maintain our view that investors should position for a further

reversal in rates and vol by owning agency callables. Given the above discussion, we favor

5nc6m and 5nc1 structures. For example, an FHLMC 5nc6m European (2% 2/17s, trading

above par), offers almost 90bp of protection against a selloff in 4.5y agency bullet rates over

the next 6m. In our view, this amount of belly underperformance/agency-Treasury spread

widening seems unrealistic.

Agency bellwether outperformance hits turbulence

Agencies have cheapened 1-2bp to Treasuries over the last 1.5 weeks of March, despite no

threat of supply (Figure 2). While spread levels in the high single digits are unpalatable, we

reiterate our view that the combination of rangebound rates and declining overall supply of

1 Time to buy callables, Market Strategy Americas, 9 March 2012

James Ma


Rajiv Setia

+1 212 412 5507

[email protected]

Figure 1: 5y tails have not retraced on the vol surface Figure 2: Agency-Treasury spreads leak wider

Change

(3/9 - 3/28) 1y 2y 5y 7y 10y 30y

3m -5 0 8 6 4 -1

6m -3 1 6 4 3 -2

1y 0 4 3 1 0 -2

2y 7 6 4 1 0 -2

3y 5 4 2 0 -2 -4

5y -1 -1 -2 -2 -3 -4

10y -3 -3 -3 -3 -3 -3

0

10

20

30

40

50

60

01-Jan-12 22-Jan-12 12-Feb-12 04-Mar-12 25-Mar-12

bp

2y Agy-T 3y Agy-T 5y Agy-T 10y Agy-T

Source: Barclays Research Source: Barclays Research


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30 March 2012 8

spread product (as evidenced by just $4bn of agency bellwether issuance in March) should

keep spreads well supported. In addition, investors should be more willing to extend out the

curve to pick up spread over time, and we continue to recommend owning agency

bellwethers, particularly the 5y sector at ca. +21bp to matched-date Treasuries.

For investors seeking further spread pickup in the front end, we suggest opportunities in

MTN space (Figure 3); with bellwether supply dwindling, the liquidity premium for MTNsand other non-bellwethers should continue to decrease.

Studying abroad

While agency supply has been moribund of late, there has been record issuance of $16bn in

USD covered bond issuance this month, versus a $4bn average in January-February (Figure

4). Of this amount, $7.5bn originated from Australian, Nordic, and Swiss issuers, which is

surprising because they lack the benefit of government-guaranteed collateral in the cover

pool common to most Canadian names.

Importantly, valuations have not suffered despite the supply, highlighting the degree of

demand; non-Canadian names have outperformed, likely reflecting improved investor

attitudes towards riskier assets (Figure 5). We expect valuations to remain supported by

relatively attractive spread levels and a dearth of competing product. However, worries

about a global slowdown and/or a flare in European risk remain obvious risks.

This last point has made us of two minds on the potential for further outperformance in

SSA names. Note that we have been cautiously constructive on SSA names since last

December,2 but are becoming less so given their recent outperformance. At these levels, we

are becoming more wary of sovereign risk-related concerns resurfacing.

However, we are mindful that the calendar is entering a seasonal lull in supply for SSA paper

after many issuers prefunded in January-February (Figure 4), which could keep spreads

grinding tighter. For now, we remain constructive on the sector and believe investors should

continue to harvest new issue concession in SSA paper, such as the recently issued 5y EIB USD

benchmark (1.125% 6/17s), trading at L+25bp, or about 30bp behind agencies (Figure 6).

22012 Outlook: US Agencies, 14 December 2011

Figure 3: MTN pickup in the front end Figure 4: USD covered bond issuance accelerates

-40

-20

0

20

40

60

80

100

0 5 10 15 20

L Spd, bp

Bel lwether MTN

0

5

10

15

20

25

30

35

Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12

$ bn

SSA Covered



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30 March 2012 9

Legislative developments underwhelm

Although the new Canadian government budget provided sparse details beyond heavier

regulation of CMHC while allowing it to regulate a post-framework covered bond market,

the eventual release of the legislative framework is expected to have implications for that

countrys covered bond market, in two main aspects:

Consistent with remarks by Finance Minister Flaherty, we believe the government couldseek to reduce the availability of mortgage credit by limiting the amount of CMHC-

insured collateral eligible for cover pools. It is not known if existing programs would be

grandfathered.

More broadly, the CMHC is nearing its CAD600bn limit on the notional amount ofinsurance written. While in the past Parliament has generally raised the limit without

question whenever it was neared, the aforementioned stances within the government

could lead to more resistance as legislators seek to reduce the leverage and overall risk

posed to the system by what is perceived as excessive mortgage lending.

We await further details before assessing specific implications for existing bonds.

Here in the US, there has been very slow progress on GSE reform, despite TreasurySecretary Geithners comments that an update is forthcoming from his department soon. It

remains unclear if this is a follow-up to the existing white paper or a substantially new

proposal. In any case, there has been little progress from Congress, from where any real

plan for housing finance/GSE reform would have to originate.

Congress has already dragged its feet on the covered bond legislation; S 1435 is in limbo

awaiting a SBC hearing, and HR 940 has yet to be picked up by Ways and Means, despite

having received at least one extension which runs out on March 30. We reiterate our view

that consensus on true GSE reform will take several years, if not decades, to accomplish.

Figure 5: But valuations do not necessarily suffer Figure 6: Supras outperform, remain behind agencies

0

20

40

6080

100

120

140

160

26-May-11 26-Aug-11 26-Nov-11 26-Feb-12

L Spd, bp

CS 2.6 5/16 BNS 2.15 8/16

SPNTAB 2.125 8/16 ANZ 2.4 11/16

-10

0

10

20

30

40

50

60

70

80

Jul-11 Sep-11 Nov-11 Jan-12 Mar-12

L Spd, bp

FNM 5y FRE 5y KFW 5y EIB 5y



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30 March 2012 10

UNITED STATES: SWAPS

Tightening risks remain

We believe that there are significant tightening risks to 10y spreads and would

recommend going into wideners only if they go negative because of a spike in financialissuance. We continue to favor FVM2 invoice spread wideners relative to 10y spreads.

The rate sell-off that began after payrolls in early March seems firmly in the rear-view

mirror, as the market is coming to terms with the Feds view that the unemployment rate

should stop falling; as a result, the probability of another round of asset purchases is higher

than the market had thought. Rates have rallied all week, and spreads are marginally tighter.

In More price action = more trade opportunities, published in Market Strategy Americas,

March 15, we made the case that 10y spread wideners were appropriate for investors who

believe that QE3 willnot occur. In our view, this was because QE3 would likely take the form

of mortgages purchases, which would put tightening pressure on spreads. This effect is in

contrast with asset purchases of Treasuries in the belly and the long end of the curve, which

would put widening pressure on spreads. In our view, it was too early for the market tobegin pricing in Fed hikes in 2013; as a result, we believed that any sell-off in 10y rates

would be an opportunity to go long and any consequent widening of spreads would be an

opportunity to put on tighteners.

However, during the most recent sell-off in rates, convexity flows do not appear to have had

a significant effect on swaps, even though mortgage durations extended. This would lead

some to question whether QE3 could lead to spread tightening because of mortgage

hedgers. Traditionally, increases/decreases in durations of mortgage portfolios led to

paying/receiving flows in swaps in the 10y sector, as a result of which there was a strong

relationship between 10y swaps and overall mortgage index durations in the period before

2008. However, as Figure 1 shows, this relationship has been weak over the past two years.

There are a number of reasons for this, including slow prepayment speeds, flat S-curves,GSE portfolios rolling off, and nearly 20% of outstanding MBS at the Fed. To a large extent,

this explains why hedging flows from holders of mortgages have diminished.

Amrut Nashikkar


Figure 1: The correlation between 10y spreads and theduration of the overall mortgage index has been poor overthe past two years

Figure 2: 10y swap spreads are much more stronglycorrelated with mortgages than 5y spreads

-20

-10

0

10

20

30

40

50

Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11

bp

0

1

2

3

4

5

6

y

10y swap spd, LHS MBS Index duration, RHS

0

5

10

15

20

25

Mar-11 Jun-11 Sep-11 Dec-11

bp

0

10

20

3040

50

60

70

80

bp

10y spd, LHS FNCL 4.0 OAS, RHS

5y spds, RHS

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However, empirically, there still appears to be a link between mortgage spreads (whether

nominal or option adjusted) and 10y swap spreads, which does not appear to exist for other

parts of the spread curve 5y spreads, for instance. This can be seen from Figure 2, which

plots the OAS of 4% 30y fixed rate mortgages against matched-maturity 10y and 5y swap

spreads. This link may exist because of dealer and servicer hedging practices. For this

reason, we believe that 10y swap spreads could still face tightening risk from increased

expectations of QE3.

Without QE3, we estimate that the fair value of 10y swap spreads should be around 5-6bp

wider than they are trading currently. To gauge the extent of the tightening risk due to QE3,

recall that after the March 2009 QE1 announcement, mortgage spreads compressed by

more than 50bp. If QE3 is half the size of QE1, the sensitivity implied by Figure 2 suggests

that the corresponding effect on 10y swap spreads could be 6-8bp of tightening from

current levels, pushing them into negative territory on a matched-maturity basis. However,

5y swap spreads would be affected to a much smaller extent.

Strong corporate issuance in late April/May (high seasonal issuance periods for the past

few years) is another risk. Swapped issuance has been higher than expected over the past

few weeks. Normalization of credit spreads in Europe could pose additional risks to swap

spreads given that many institutions would have the incentive to term out their debt as

much as possible. As Figure 3 shows, net issuance in dollar-denominated high-quality

foreign debt picks up when financial credit risk declines. Given these risks, we recommend

wideners only if 10y spreads go significantly negative because of a combination of QE3

expectations and a spike in swapped issuance.

To express a spread widening view, we favor the 4-5y sector. As mentioned earlier, it is less

affected by mortgage/insurance hedging flows. Second, unlike the very front end, the

sector would be less affected if QE3 is sterilized through reverse repos by the Fed, which

would put tightening pressure on spreads at lower maturities. Third, the spread curve

generally rolls up in this sector. Finally, putting on a widener in this sector continues to offer

exposure to any return of European financial concerns.

Even in this sector, we specifically favor FVM2 invoice spreads wideners. As Figure 4 shows,

a fly consisting of the FVM2 CTD spread against 3y and 5y spreads cheapened as thefutures roll ended and has been unwinding since. Even though FVM2, on an outright basis,

no longer appears too cheap, the FVM2 invoice spread has not yet recovered fully, as Figure

4 shows. In our view, this means that FVM2 wideners are still attractive.

Figure 3: Dollar-denominated issuance by high quality

foreign issuers increases when credit spreads are low

Figure 4: FV invoice spreads still have room to widen relativeto the rest of the spread curve

-30

-20

-10

0

10

20

30

40

50

Ma r-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11

$bn

0

50

100

150

200

250

300

350

400

bp

mom chg in $SSA idx (LHS) Itraxx-Financials (RHS)

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

29-Dec-11 19-Jan-12 09-Feb-12 01-Mar-12 22-Mar-12

3s-FV-5s spread fly (bp)

Source: New York Fed, Barclays Research Source: Barclays Research


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30 March 2012 12

UNITED STATES: MONEY MARKETS

Too much cash

Non-financial corporate cash holdings continue to surge. Their balances held in savings

deposits, savings accounts, and money funds are close to $2trn and increasinglyconcentrated at US banks. But where will these firms put their cash when unlimited

deposit insurance expires and money funds are reformed?

Cash-like instruments with immediate liquidity account for a record 12.1% of non-financialassets. Most of it belongs to technology, energy, and pharmaceutical companies.

Data from the IRS on the 2004 foreign earnings dividend deduction (though dated)suggest that overseas cash buffers are overwhelmingly concentrated in European banks.

The presence of unlimited FDIC deposit insurance has pushed cash balances toward USbanks. Non-financials checking account balances have surged 51% in the past year,

displacing cash in money fund balances.

Pending money fund reforms could lock these balances at banks. But unlimited bankdeposit insurance is set to expire at year-end, leaving non-financials in a bit of a bind as

to where to leave their liquidity.

Non-financial companies have few alternatives for same-day liquidity outside of money

funds and bank deposits. But bank deposits and money funds could become significantly

less attractive to non-financial corporations later this year.

Rising balances

We define cash as any asset with immediate liquidity and no (market) risk to the par value.

For non-financial corporations, this covers their investments in bank deposits (savings and

checking), money fund balances, and repo. In the past year, non-financial corporations have

been on an aggressive shopping spree for these assets. At the end of December, they held

nearly $1.85trn in these instruments, up 21.4% from 2010 and considerably faster than the

growth in their other financial assets, which rose 4.8% over the period (Figure 1). Not

surprisingly, cash has climbed to 12.1% of overall financial assets the highest share since

the Fed began collecting this data in 1959.

The non-financial companies with the largest cash balances are in technology, energy,

and pharmaceuticals. Last week, one large technology company announced plans to

spend close to $80bn of its cash hoard through dividends and stock buybacks. For those

with a longer memory, another large tech company made a $32bn special dividend

payout in early December 2004. This one-time payment temporarily reversed an

established trend of rising non-financial corporate checking account balances and now

shows up as a kink in the Feds data.

Tax motive

While the payment of special dividends and share buybacks represents one use, companies

also maintain cash stockpiles for other purposes, including facilitating transactions and

maintaining precautionary liquidity buffers. Some is locked overseas on account of tax

differences between countries. Since foreign earnings are not taxed until they return to the

US, they may stay overseas in cash deposits and securities indefinitely. A survey conducted

by the Association for Financial Professionals found that 53% of respondents held cash

Joseph Abate


Non-financial corporate cash

totalled $1.85trn at year-end

Foreign bank deposits account

for 5% of aggregate holdings


13/59


30 March 2012 13

outside the US.3 Despite the reported prevalence, the balances on deposit at foreign banks

may not amount to much, at least compared with domestic allocations. Roughly $100bn

belonging to non-financials is held in overseas bank accounts approximately 5% of their

overall corporate cash holdings. Following a re-allocation away from these banks during the

2008-09 financial crisis, these balances have grown in line with the total accumulation of

non-financial corporate cash so that over the past several quarters, their share has been

pretty steady (Figure 2). A substantially larger amount is probably invested in higher yieldinglocal securities. Indeed, a recent Internal Revenue Service study revealed that over $360bn in

foreign earnings returned to the US following the 2004 special dividend deduction.4 Since

non-financial corporations held about $40bn in foreign bank deposits before the October

2004 announcement, a substantially larger amount must have been held in local (liquid)

securities. Of course, these figures measure only direct non-US bank exposure. To the extent

that non-financial corporations invest in prime money funds, they may have indirectnon-US

bank deposit exposure. Foreign bank deposits account for 15% of prime money fund assets,

or roughly $216bn.5

The IRS study also revealed that funds coming from Europe accounted for 62% of the total,

primarily from the Netherlands, Switzerland, Ireland and Luxembourg. And consistent with

the current distribution of cash, pharmaceutical and tech companies were significant

repatriaters. While there is undoubtedly a strong tax rationale for the location of deposits,

we strongly suspect that the 21% y/y surge in the non-financial corporate cash hoard has

more to do with precautionary liquidity hoarding than tax considerations.

Precautionary liquidity motive

There is further evidence of the precautionary liquidity motive in the relative allocations of

non-financials domestic cash holdings. Before the financial crisis, these corporations typically

kept most of their cash in money funds, as yields were higher than bank deposits. But since

2009, there has been a dramatic shift out of money funds toward checkable deposits, which

have risen from less than 5% of non-financial corporate cash to almost 37% at the end of

last year. At the same time, money fund holdings have shrunk to just 25%, reversing a multi-

decade trend (Figure 3). By the end of December 2011, non-financial corporations were

3 Where is All That Corporate Cash, Anyway?, J. Doherty, Barrons, December 12, 20114 See, The One-Time Received Dividend Deduction, M. Redmiles, Statistics of Income Bulletin, Internal RevenueService, Spring 20085 Non-financial corporations, like other institutional investors, however, concentrate their money fund holdings ingovernment-only funds which do not hold foreign bank deposits.

The recent surge in cash

balances is likely driven by

precautionary liquidity

Figure 1: Non-financial corporate cash and non-cash assets(2007=100)

Figure 2: Foreign deposits (% non-financial corp cash assets)

70

80

90

100

110

120

130

140

150

160

170

Mar-05 Jun-06 Sep-07 Dec-08 Mar-10 Jun-11

Cash

Non-cash

0

1

2

3

4

5

6

7

Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10

Source: Federal Reserve, Barclays Research Source: Federal Reserve

Corporate cash has

moved to bank deposits

from money funds


14/59


30 March 2012 14

holding almost $700bn (up 51% from a year earlier) in checking account balances,

considerably more than the $470bn (down 10%) held in money fund shares.

The shift toward bank deposits likely reflects two additional factors. First, money funds no

longer yield much over bank deposits, due to the Feds long-running easy policy of keeping

the fed funds target pegged between 0 and 25bp. The average government-only money

fund has yielded just 1bp since October 2010, and prime funds are barely yielding 3bp more

(Figure 4). Second, and perhaps more significantly, the FDIC has provided unlimited deposit

insurance on non-interest bearing checking account balances since the start of 2011 (there

was an earlier program begun during the 2008 crisis that expired in 2010). With little yield

difference between bank deposits and money fund balances, the only distinguishing feature

between these two same-day liquidity accounts is the provision of unlimited government

guaranteed insurance. The value of this government guarantee rose during the pickup in

risk aversion last year amid concerns about European banks and sovereign risk. As we wrote

several weeks ago, we estimate that the FDICs unlimited deposit insurance program

appears to have shifted $500-600bn out of money funds into non-interest bearing checking

deposits.6 Interestingly, despite their concentration in European bank deposits and the

heightened anxiety among institutional investors in money funds about European bank

exposures, non-financials did notwithdraw money from their non-US deposit holdings last

year. This suggests that tax concerns about repatriating these balances to US banks may

have overcome their other concerns. Of course, it is impossible to tell from the aggregate

data if there was a shift in deposits between non-US banks.

Rock and a hard place?

Non-financial corporations face a tough decision this year on where to allocate their

burgeoning cash hoard. At the end of the year, unlimited deposit insurance on non-interest

bearing checking accounts will expire. Although we believe the program will be extended on

a voluntary basis for an explicit cost, we expect most of the money center banks to opt out.

This spring, the SEC is preparing to revamp money fund regulation. However, the intense

debate between the industry and regulators suggests that reform implementation could

occur well after unlimited deposit insurance expires at the end of 2012.

6 See, Unlimited Deposit Insurance: Here to Stay? Market Strategy Americas, March 1, 2012.

Money fund yields

have compressed

Figure 3: Money fund and checking accounts (% non-financial corporate cash assets)

Figure 4: Money fund 7d net yields (%)

0

10

20

30

40

50

60

70

Mar-80 Mar-85 Mar-90 Mar-95 Mar-00 Mar-05 Mar-10

MMFs

Checking accounts

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Gov-only

Prime

Source: Federal Reserve Source: imoney.net

Unlimited deposit insurance

expires at year end


15/59


30 March 2012 15

Although other reforms are still possible, the SEC has focused on three main themes meant

to reduce systemic risk in money funds caused by sudden investor runs. Funds could be

forced to move from stable NAV-amortized cost accounting to a floating NAV structure by

which the portfolios mark-to-market value is calculated daily to determine the money funds

share price. Alternatively, the SEC has discussed moving to capital buffers and redemption

gates for stable NAV funds. Money fund sponsors would be required to hold a buffer of, say,

1-3% of assets under management. At the same time, investors would face a redemptiongate of perhaps 3%; they would be able to withdraw only 97% of, for example, their average

30-day balance with the remaining 3% retained by the money fund for 30d. If the money

fund breaks the buck over that 30d holding period, the investors remaining 3% would be

subordinated to other redemptions and therefore vulnerable to principal loss.

While we will write more on the merits of these proposals, we believe that these three do little

to address run risk directly. A floating NAV will not make non-financial investors any less

likely to run in periods of financial stress indeed, some short-duration bond funds

(enhanced cash funds) experienced substantial redemptions in fall 2008. And while we

believe that a capital buffer more closely aligns shareholder and fund sponsor interests with

respect to asset quality and risk, it would do nothing to prevent a run. Instead, in a higher rate

environment, we would expect the cost of the buffer to be passed onto non-financial (andother) shareholders in the form of lower returns. The only proposal (so far) to address run

risk directly is the redemption gate, but this mechanism will be difficult to implement

operationally and effectively requires money fund investors to maintain a minimum deposit,

which, judging from the tone of comment letters submitted to the SEC, is deeply unpopular.

While the popularity of the SECs reforms is not a primary concern of the agency, it cannot

be ignored entirely. In the coming year, non-financial corporations will need to decide what

to do with their almost $2trn cash hoard: keep it at banks in uninsured deposits or shift it

back to money funds and face either floating NAVs or a stable NAV with a redemption gate.

We do not have a firm conviction of what will matter to non-financial corporations more:

unlimited government guaranteed insurance or 100% same-day liquidity. That said,

potential reallocation of their $2trn could be severely disruptive and suggests regulators willmove carefully.

Proposed money fund reforms

include three themes

And may not adequately

address run risk


16/59


30 March 2012 16

UNITED STATES: INFLATION-LINKED MARKETS

Relative value in relative ASWs

10y TIPS ASWs have richened relative nominals this month. Further richening is justified

by fundamentals, though, and the TIIJan22s stand out as cheap on the curve. Therefore,we recommend positioning for continued compression.

10y relative ASW fair value around 23bp

Relative ASWs (TIPS ASWs relative to nominal Treasury ASWs) beyond the very front end out

to the 10y sector have richened by 4-12bp since the beginning of the month (Figure 1). Some

investors have begun to ask whether we think it is time to fade this move and position for TIPS

to cheapen back out. Our relative ASW model indicates that the richening is not only justified,

but that the decline in the relative spread should compress further at the 10y point.

We find that risk uncertainty and liquidity variables have historically done well at explaining

relative ASWs. Specifically, our model uses the 3m Libor-OIS spread, the VIX, and 3m rolling

average daily trading volume of TIPS (Figure 2). The first two are more tactical factors while

the latter is more structural. Because investors tend to flock to nominal Treasuries during

times of market stress, as indicated by an increase in L-OIS and VIX, TIPS tend to cheapen

relative to nominals. Over time, as the market grows and trading volume increases, the

liquidity differential between TIPS and nominals should compress and the relative ASW

should decline.

Over the past several months, as European sovereign risk has become less of a concern and

US economic data have been improving, investors risk appetites have risen and L-OIS and

VIX have come down. Additionally, the 3m average of TIPS trading volume is at an all-time

high and has been on the rise since the beginning of the year. These factors justify a decline

in 10y relative ASWs to levels close to all-time lows and about 9bp below current valuations.

The lag in 10y relative ASWs relative to improving fundamentals appears, in part, to be anissue of relative value. While all TIPS beyond the very short end have richened on relative

ASWs since the beginning of the month, the spread on the TIIJan22s has compressed the

least in the 5-10y sector. While the TIIJan22s have richened by about 5bp, the TIIJul19s, for

Michael Pond


Chirag Mirani

+1 212 412 6819

[email protected]

Figure 1: Relative ASWs (bp) Figure 2: Actual and model 10y relative ASWs (bp)

0

5

10

15

20

25

30

35

40

45

0 5 10 15 20 25 30

Relative Z spreads as of March 1st

Relative Z-spreads as of March 28

0

20

40

60

80

100

120

140

160

Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

10yr Relative TIPS ASWs

10yr Model Rel ASWs (Factors: L-OIS, VIX, tradingvolume)

Note: Barclays Research Source: Bloomberg, Barclays Research


17/59


30 March 2012 17

example, has tightened by 11bp (Figure 3). We could understand this relative cheapening of

the 10y sector if it was related to an auction concession or overhang. However, there

appeared to be strong demand for the 10y sector going into and coming out of the recent

auction, so we do not believe that redistribution of supply is the issue and instead think the

relative cheapening is due to derivative, rather than cash, flows that are unlikely to have a

sustained effect. If not for trading cost concerns, we would recommend a relative ASW

switch between the TIIJul19s and TIIJan22s to focus on an apparent relative valueopportunity. However, because full round trip bid-offers could equal expected gains in the

mid spread, we instead recommend buying TIIJan22s on a relative ASWs trade to position

for this issue to catch up to fundamentals and other TIPS ASWs. Using an entry level of

32bp, we use a stop of 38bp and a target of 25bp.

Figure 3: TIIJul19 and TIIJan22 relative ASWs

20

22

24

26

28

3032

34

36

38

40

Dec-11 Dec-11 Jan-12 Feb-12 Mar-12

TIIJan22 relative ASWs TIIJul19 relative ASWs



18/59


30 March 2012 18

UNITED STATES: VOLATILITY

A time to sell

We turn bearish on mid-tail gamma as a vigorous rate sell-off does not seem to be in the

offing. We recommend selling TY straddles systematically.

Overall, the recent rate activity seems to have made investors a little more cautious in

expecting a Fed-on-hold period or another round of asset purchases. Figure 1 shows the

net change in implied vol between March 9 and March 29, the period subject to the

gyrations in rates.

As seen, gamma on 5y tails and intermediate expiry on short-tails, such as 2y*1y gained the

most. This suggests some investors who were positioned for a dovish Fed (long front-end,

curve steepener, etc) rushed to the exit when the Fed did not commit to another round of

asset purchases at the March 13 FOMC meeting. This reshaped the vol surface appropriately.

Lower rates = lower vol

Although the jury is still out on the data, and payroll next month will be keenly watched,there are many reasons vol on mid-tails could come off over the next few months.

We think the recent rate-vol price action clearly establishes a rise in rates is a prerequisite for a

rise in vol (Figure 2). As highlighted in a recent publication7, we believe a sell-off in Treasury

yields may be capped. So while there may be positioning driven rate sell-offs, similar to the

recent one, a powerful move such as in May-June 2009 or in Nov-Dec 2010 is unlikely.

Consequently, any rise in mid-tail gamma would be limited too. Eventually, gamma would leak

cheaper to reflect the low-rate-for-long environment, maybe to levels closer to JPY vol.

More importantly, dealers continue to be long options, for two reasons.

One, there is more than usual supply of short-expiry swaptions from real moneymanagers (Figure 3). Most portfolio managers are deploying yield enhancement

strategies, some via selling options.

7 Will the bond market selloff be sustained, published on 22nd March 2012

Piyush Goyal


Figure 1: Fed expectations were re-priced in the rate sell-off. Figure 2: Rise in rate is a pre-condition for rise in vol

Change

(3/9 - 3/28)1y 2y 5y 7y 10y 30y

3m -5 0 8 6 4 -1

6m -3 1 6 4 3 -2

1y 0 4 3 1 0 -2

2y 7 6 4 1 0 -2

3y 5 4 2 0 -2 -4

5y -1 -1 -2 -2 -3 -4

10y -3 -3 -3 -3 -3 -3

1.80

1.90

2.00

2.10

2.20

2.30

2.40

2.50

2.60

29-Dec-11 19-Jan-12 09-Feb-12 01-Mar-12 22-Mar-12

80

85

90

95

100

105

110

3m10y (%, L) 3m*10y (bp/y, R)

Note: The above grid shows the change implied vol between March 9 andMarch 28. Source: Barclays Research

Note: Last data point as of March 28, 2012. Source: Barclays Research


19/59


30 March 2012 19

Two, there remains a large issuance of callable notes, leading to dealers swamped withhigh-strike Bermudan options in the top-left as well as the bottom-right of the vol

surface. The callable notes are popular as they are another way of boosting yield in fixed

income asset portfolios.

Unable to find a home for these options, dealers are likely delta-hedging the options,

cushioning rate volatility.

Finally, mortgage hedgers did not show up in the recent rate sell-off. Generally, in a rate

sell-off like the recent one, mortgage hedgers shed duration and worsen the rate move.

Their activity was the main reason 3m*10y revisited the record high levels in May-June

2009. And while it is well established that GSEs are running down their agency MBS

portfolio and therefore not buying options (Figure 4) and mortgage servicers are factoring

the weak relationship between prepay speeds and Treasury/ swap rates, we believe the

actual absence of mortgage hedgers empirically indicates the lack of support from the

hedging community. Their absence was also felt as little widening in 5y and 10y swap

spreads despite the rise in rates. As the realization sets in, mid-tail gamma would be subject

to an additional downward bias.

We expect 3m*10y to cheapen beyond 80bp/y. Essentially, gamma has bounced off 85-

90bp/y many times since the Lehman crisis in 2008. In the last down-trade, 3m*10y came

off from 120bpy+ to ~ 90bp/y between November last year and February this year. But

given that the recent rate sell-offs likely did not satiate investors positioned for a repeat of

prior episodes and the realization of lack of mortgage hedging sets in, 3m*10y would likely

make a new low for since the 2008 crisis. We target 80bp/y for 3m*10y.

Sell TY options systematically

We see the best way to position as selling Treasury future options systematically.

TY options are pricing a slightly higher vol than comparable swaptions. For example, as of

March 29, 2012, TYM2 straddles are priced for 86bp/y while the comparable swaptions is

pricing 83bp/y. So one can take in more premium and gain more in a range-bound rateenvironment.

Furthermore, it is important to build a systematic portfolio. This allows the strategy to

distribute the strike and expiry risk. At current levels, a short TYM2 straddle is priced for a

Figure 3: Asset managers are short more options than usual Figure 4: GSEs own lesser amount of options

Q12010

Q22010

Q32010

Q12011

Q22011

Q32011

Q42011

Notional ($bn)

$105$138$147

$429

5090

130170210

250

290330

370410

450

Q12009

Q22009

Q32009

Q42009

Q12010

Q22010

Q32010

Q42010

Q12011

Q22011

Q32011

Q42011

FRE, FNM swaptions (notional, $bn)

Source: Barclays Research Source: Fannie Mae, Freddie Mac SEC filings


20/59


30 March 2012 20

50bp+ range for the 7y yield for the next two months, which is within the range in which the

rate has traded for the past six months. By selling a straddle at regular intervals, say weekly,

the portfolio would gain if the 7y rate remains within a wider range.

Figure 5 shows how the performance of selling 1m*7y straddles systematically (un-delta-

hedged, held to expiry) for the past three years. H2 2009 and H2 2011 were the longest

periods of consistent good returns. Both of them had one thing in common rates wererang bound. After the spurt in rates in May-June 2009, 7y swaps stayed within 2.8 and 3.8

for nine months, ie, a 100bp range. The strategy did well in that period. Then again, after

the rally in July-August 2011, 7y swaps stayed within 1.4-2.1 for six months, ie, a 70bp

range. Clearly a range-bound rate environment, even if the range is relatively large helps the

strategy deliver good p&l.

Figure 5: Selling gamma systematically did well in H2 2009 and 2011

-80

-60

-40

-20

0

20

40

60

Mar-09

May-09

Jul-09

Sep-09

Oct-09

Dec-09

Feb-10

Apr-10

Jun-10

Jul-10

Sep-10

Nov-10

Jan-11

Feb-11

Apr-11

Jun-11

Aug-11

Sep-11

Nov-11

Jan-12

Mar-12

-1,000

-500

0

5001,000

1,500

2,000

p&l (bp of swap01) cum p&l (bp of swap01)

QE1Greec QE2

Eurozon


Conclusion

Sell mid-tail gamma systematically for the next few months (target 3m*10y = 80bp/y) as

rate sell-off seems to have run out of steam, dealers are swamped with options and the

absence of support from mortgage hedgers is empirically established.


21/59


30 March 2012 21

EURO FUTURES

New 10yr OAT future analysis

This articles wasprevious publishedon 30 March 2012.

Having introduced the new BTP future contracts over the past few years, Eurex is now

launching a new 10y French (OAT) future on 16 April. We estimate FRTR 3.75% Apr

2021 as the CTD to the June 12 contract. Assuming a successful launch, we believe the

10y OAT future is likely to be used as a hedging/risk-taking instrument for core EGBs

outside of Germany, as well as a vehicle for positioning between core and peripheral

bonds. Furthermore, the repo trading volumes for 10y OATs will l ikely be boosted as on-

the-run benchmarks might trade less special going forward and basis trading strategies

would support repo activity as well.

On 21 March Eurex announced that it will introduce a new 10y OAT future with effect from

16 April. This comes on top of the introduction of long, short and medium-term BTP futures

contracts in Sep 2009, Oct 2010 and Sep 2011, respectively. During the eurozone crisis,

alongside the remarkable widening in peripheral country spreads, France has been the main

underperformer within core country space, with the 10y FranceGermany spread widening

from 30bp in early 2011 to about 200bp in autumn 2011. While this has tightened back

since then, it is still at around 100bp currently. The main reason for creating the new BTP

future contracts was to introduce a new hedging instrument for non AAA euro area

government bonds (EGBs) as an addition to the Bund futures contract. However, given that

since then there has been a notable widening of core country spreads versus Germany, and

a substantial widening of BTP and Spanish government bond spreads versus all core paper,

a need for another future representing the core countries ex Germany has arisen. With the

introduction of the OAT future, investors will now have access to a various set of futures

representing the broad EGB categories.

Figure 1: 10y BTP Bund spread evolution vs 10y BTP future daily volume since inception

0

5000

10000

15000

20000

25000

30000

35000

Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12

0

100

200

300

400

500

60010yr BTP future volume

10yr BTP - Bund (RHS)

Source: Bloomberg

The average daily volume on the 10y BTP future since its inception in Sep 2009 until the end

of H1 2011 has been c.5k contracts, rising to an average of c.10k contracts from July 2011

until now a period during which BTP Germany spread has been substantially volatile.

While more volatile peripheral spreads have supported volumes on the BTP futures,

Cagdas Aksu

+44 (0)20 7773 [email protected]
https://live.barcap.com/go/publications/content?contentPubID=FC1806542https://live.barcap.com/go/publications/content?contentPubID=FC1806542


22/59


30 March 2012 22

volumes are still much lower than for the Schatz, Bobl and Bund future average daily

volumes, each of which are in the order of multiples of 100k contracts. We think the

volumes on the OAT future are likely to be between BTP and Bund contract volumes, as

long as EGB spread volatility remains a theme.

Contract specifications

The contract specifications for the new 10y OAT future are very similar to those of the 10ryBund future contract. The most important to highlight are: underlying maturity range for

the deliverable bonds is 8.5-10.5 years with an original maturity of no longer than 17 years;

notional coupon on the contract will be 6%; minimum outstanding size for the deliverable

bonds will be 5bn and the three nearest quarterly months of the March, June, September

and December cycle will be traded.

CTD analysis for the June 12 contract

The bonds in the June 12 contract delivery basket will have maturities ranging from 11 Dec

2020 and 12 Dec 2022 (and a minimum outstanding size of 5bn). Therefore, FRTR 3.75%

Apr 21, FRTR 3.25% Oct 21 and FRTR 3% Apr 22 will be in the delivery basket for June. And

the September delivery basket will include these and potentially the new 10y Oct 2022

benchmark, which is likely to be issued in the summer months. Figure 2 illustrates thebonds that are likely to be in the delivery basket for the next three cycles.

Looking at the delivery basket, there are typically a few ways to determine the CTD: the

bond with smallest net basis, or the bond with the highest implied repo rate (more

accurately the bond with the highest implied repo versus the actual repo rate), is the most

likely candidate for the CTD. Apart from these, there is also a rule of thumb that the bond in

the basket with the lowest DVO1 tends to be the CTD in a low yield environment and the

bond in the basket with the highest DVO1 tends to be the CTD in a high yield environment.

As there is no price information on the new futures yet, we need to experiment with a few

of these various methods to determine the CTD bond.

Figure 2: Likely delivery baskets for Jun 12, Sep 12, Dec 12Contract settlement date 11-Jun-12 10-Sep-12 10-Dec-12

Deliverable maturity range lower bound(8.5y) 11-Dec-20 10-Mar-21 10-Jun-21

Deliverable maturity range upper bound(10.5y) 12-Dec-22 10-Mar-23 12-Jun-23

Bonds within deliverable range FRTR 3.750% Apr 21 FRTR 3.750% Apr 21 FRTR 3.250% Oct 21

FRTR 3.250% Oct 21 FRTR 3.250% Oct 21 FRTR 3.000% Apr 22

FRTR 3.000% Apr 22 FRTR 3.000% Apr 22 NEW FRTR Oct 2022

NEW FRTR Oct 2022*

Note: * Assuming the new 10y OAT Oct 22 is issued some t ime during summer with a size bigger than 5bn. Source: Barclays Research

First, we focus on the rule of thumb mentioned above. The basic idea is that at 6% market

yield level (in this case for the 10y OATs), all the bonds in the delivery basket are equallycheap to deliver against the futures contract on the delivery date. This is because all of the

bonds will be trading at their conversion factors (CF), and the invoice amount for the

futures (futures price * CF + accrued interest on the bond) will be equal to the dirty price of

the bond on the delivery day for all of the bonds in the delivery basket. Assuming all of the

bonds in the delivery basket rally in parallelfrom 6%, the bond with the lowest DVO1 will

richen the least and be the CTD in a low yield environment. However, the key word here is

parallel, meaning the bonds in the delivery basket should be flat to each other in yield

terms. There is actually some steepness between the shortest maturity/DVO1 bond (FRTR

Apr 21) and long maturity/high DVO1 bond (FRTR Apr 22) in the June delivery basket.


23/59


30 March 2012 23

However, this is similar to the steepness that the Bund delivery basket has between the

shortest and longest maturity bonds (DBR Jan 21 and DBR Jan 22). Furthermore, while 10y

OAT yields are c.100bp over Bund yields, absolute levels, ie 2.80-2.90%, are still far from the

6% notional coupon. This will most likely mean the steepness of the delivery basket will not

be big enough to make the longest maturity bond in the basket become CTD. As such, FRTR

3.75% Apr 2021 should be the CTD.

To health check the rule of thumb, we have derived a future price by setting one of the

bonds in the delivery basket at zero and driving the net basis of the remaining bonds from

the implied future price. The most sensible net basis table emerges when we derive the

future price by setting the net basis of FRTR Apr 21 at zero (Figure 3). Moreover, even when

we set the net basis of FRTR Oct 21 and FRTR Apr 22 separately at zero, the net basis on

FRTR Apr 21 turns out the most negative, which implies it will be the CTD.

Figure 3: Delivery basket with futures price derived from setting the net basis of FRTR Apr 21 at zero

Future price 125.71

Maturity Spot yield Repo to contract date

Conversion

factor Gross Basis Net Basis

FRTR 3.750% Apr 21 25-Apr-21 2.81% -0.05% 0.848510 72 0

FRTR 3.250% Oct 21 25-Oct-21 2.86% -0.10% 0.806920 174 111

FRTR 3.000% Apr 22 25-Apr-22 2.96% -0.10% 0.781200 211 152


Market implications

Assuming a successful launch, the new 10y OAT future is likely to be used as a

hedging/risk-taking instrument for core EGB paper outside of Germany, as well as an

instrument to position for spread moves between core and peripheral EGBs. The impact of

the contract launch for the 10y part of the French curve versus other parts or the CTD bond

versus other bonds in the basket is not necessarily clear at this stage. If we move in an

environment in which there is further cross market spread consolidation, it would probablybe beneficial to the 10y part of the curve, via boosting liquidity, as well as to the relative

value of the CTD bond versus surrounding bonds. However, if we are still in a volatile,

spread widening environment over the coming quarters and should the future be used for

the purposes of shorting France versus other papers, then the CTD and the future could

cheapen/trade would cheap versus the surrounding on the-run benchmarks.

The repo activity for 10y French bonds is likely to improve as well. At the moment most

investors looking to short France express this in the on-the-run benchmarks such as FRTR

Apr 22 and FRTR Oct 21, keeping them special in repo. If the OAT future takes off

successfully, these bonds are likely to be more available in the repo market as some shorts

are more likely to be expressed via the future market, and this should help the repo activity.

Furthermore, basis trade strategies (cash versus futures) are likely to be implemented,which should help the repo trading volumes for 10y OATs in general as well.


24/59


30 March 2012 24

EUROPE MONEY MARKETS

ECB: To exit or not?

We expect the ECB to keep policy rates and liquidity measures on hold at the upcoming

meeting. Extension of the full allotment is still a pending issue on which the ECB has beenenigmatically silent over the last months.

Over the last few days forward money markets rates have stabilized, having been quite volatile

in the latter half of March. As we have stressed in the past, the initial sell-off (triggered by the

upbeat comments by the Fed and the ECBs focus on inflation and an exit strategy) was

overdone. Indeed, in the subsequent days, it was followed by a correction (owing to the

disappointing economic data and rising concerns about the Spanish fiscal outlook).

At present the forwards curve is pricing in the EONIA fixing at around 35/37bp until the end

of the year, with some increase towards the 50bp area after January/February 2013 (when

banks can start to exercise the option of exit from the 3y LTROs). The next two 3m Euribor

futures have stabilized at around 67bp (June and September), close to the lowest level ever

reached by the 3m Euribor fixing.

At this weeks ECB refinancing operations (MRO and 3m LTRO) the demand for euro

liquidity was broadly in line with the amount maturing (a 1.5bn increase at the MRO and a

4.5bn drop at the 3m LTRO). Due to the abundant and long liquidity in the system, we

believe the refinancing operations will be used to fine tune the short-term liquidity of some

banks, but not necessarily to meet funding needs. Interestingly, USD borrowing declined

sharply at the 3m tenor (-USD19bn compared with the allotment at the January auction),

probably reflecting deleveraging from USD assets and the improved market conditions for

European banks USD funding.

ECB meeting: no new measures, probably some hints on its strategy

The most important event next week will be the ECB meeting (Wednesday). Following therecent shift in its rhetoric on inflation and the potential risks from abundant liquidity in the

system, we expect the ECB to keep both policy rates and liquidity measures on hold. On the

latter, the ECB could announce the extension of the full allotment beyond the current deadline

of the end of the sixth reserve period (mid-July 2012), and probably to the end of the year.

There is some risk on that side, though: the ECB has been enigmatically silent on the issue of

full allotment over the last few months, and did not include the extension of the full allotment

in the set of liquidity measures to support banks that it has announced since December last

year (longer LTROs, wider collateral, drop in reserve requirements). The last time it prolonged

the full allotment policy was in October 2011; at the same time it announced the introduction

of two special 1y LTROs (one at the end of October and the other in December, which were

replaced later by the first 3y LTRO) and the launch of the CBPP2. The fact that nothing has

been said yet on full allotment, which expires in 2 to 3 months, raises the suspect that the ECB

might consider dropping the unlimited funding at OMOs (or at some of them) as one of the

key first steps of the exit strategy it has discussed recently.

Indeed, as shown in the Figure 1, in 2010 and first part of 2011 the extension of the full

allotment was decided on the month before its expiration and spanned only one quarter. This

might be interpreted as a sign that there was an internal debate in the Governing Council (GC)

on whether or not to extend the full allotment. In the second part of 2011 the tough

conditions of the banking sector (in the context of a worsening of the sovereign crisis)

eliminated any doubt on the necessity to extend the unlimited borrowing and the ECB

Giuseppe Maraffino

+44 (0) 20 3134 [email protected]


25/59


30 March 2012 25

extended it for a longer period than one quarter and announced that well before the

expiration. Therefore, in our view the fact that the ECB has not included the extension of the

full allotment in the recent set of measures could be related to the fact that, similar to 2010,

some GC members are likely contemplating the possibility of dropping it after its expiration

date (mid-July 2012). Due to its importance, we believe the GC will take some time before

announcing the final decision (probably, in May or June meeting).

Clearly, full allotment still provides a very good backstop to banks funding, and therefore

might be seen as discouraging the adjustment process necessary for business models. Due to

high level of surplus liquidity and the increase in the average maturity of ECB borrowing, theliquidity is not an issue for banks (at least for the near term); this is also confirmed by the low

demand at the current operations. Therefore, the ECB might expect that the drop of the full

allotment at all or some of the operations (as it did in March 2010 on the 3m LTRO before

moving back in May due to the beginning of the Greek crisis) in practice would have a limited

impact on the liquidity conditions and on the EONIA fixing. However, there would likely be a

strong signalling impact; it could cause sentiment on banks to deteriorate, and limit any

further declines in euribors and money market rates in general (if anything, forwards should

sell off on this), as well as reintroducing some volatility in term rates.

In this respect, it is worth noting that even if the two successful 3y LTROs have eliminated the

refinancing risks for banks, the interbank market is not working properly. The EONIA vs

Euronia spread is still wide (at around 20bp) meaning that some credit risks is still priced in themarket and the unsecured term interbank market is still very illiquid, in contrast to the ECP and

CD markets (which involve transactions between Money Market Funds and banks) that have

started working again following the general improvement in sentiment.

Overall, we believe it would be quite a risk for the ECB to drop the full allotment so soon after

doing the two 3y LTROs, and given the situation is still quite fragile. Our base case is thus that

the full allotment procedure will be extended, by at least one quarter (as was the case in 2010

first part of 2011, before the worsening of the sovereign debt crisis).

Figure 1: ECBs announcement of the full allotment in the past

Date MeetingMaintenance period

extensionRefi rate Additional Measures taken on the day

Oct-08 Launch Press release mid-January 2009 3.75% Reduce in the refi rate (by 50bp) and tightening of the corridor t o 100 bp from 200bp

Dec-08 Extension Press release mid-April 2009 2.50% Widening of the corridor to 200 bp from 100bp

Mar-09 Extension March meeting Beyond end 2009 1.50% 50bp refi rate cut; extension of supplementary LTROs

Dec-09 Extension December meeting mid-April 2010 1.00% Refi rate unchanged

Mar-10Drop only at the

3m LTRO March meetingmid-October 2010 (MRO and

STRO) 1.00% Refi rate unchanged

May-10

Restore of full

allotment at the

3m LTRO

Press releaseonly for the May and June 3m

LTRO1.00%

introduction of special 6m LTRO in May; reactivation of USD operations; activation of SMP

purchases

Jun-10Full allotment at

the 3m LTROJune meeting extension to the end of Q3 1.00% Refi rate unchanged

Sep-10Extension for all

operationsSeptember meeting mid-January 2011 1.00%

Extension of the full allotment also for the 3m LTRO till end the year; rate at the 3m LTRO

fixed at the average rate of the MROs over the life of the respective LTRO.

Dec-10Extension for all

operationsDecember meeting mid-April 2011 1.00%

Mar-11Extension for all

operationsMarch meeting mid-July 2011 1.00%

Jun-11Extension for all

operationsJune meeting mid-October 2011 1.25%

Aug-11Extension for all

operationsAugust meeting mid-January 2012 1.50% Supplementary 6m LTRO

Oct-11Extension for all

operations October meeting mid-July 2012 1.50% Two supplementary 12m LTROs; launch of CBPP2

Source: ECB, Barclays Research


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30 March 2012 26

Withdrawal of liquidity: possible tools

In a recent speech, the President Draghi stressed the difference between different concepts

of liquidity, pointing out that the impact on inflation and asset prices comes from a

sustained and strong increase in money and credit and not from the central bank liquidity

per se (i.e. liquidity borrowed at the refinancing operations). At the moment there is no

strong evidence of the transfer of central banks liquidity in money and credit, as was also

evidenced by the February M3 data on bank lending to the economy, which remained weak

with only a moderate recovery in the monetary aggregate (although this did not capture the

second 3y LTRO).

Interestingly, he mentioned that, in the case of increase in inflation risks, the Eurosystem

has several tools to withdraw the liquidity in excess, and in particular indicated: 1) the

increase in the reserve requirement; and 2) term deposits with maturities longer than the

current one (1-week) used to sterilize the SMP purchases.

On the reserves requirement, it is worth remembering that at the December meeting, the ECB

decided to reduce the reserve ratio from 2% to 1%, starting from the beginning of January

reserve period. As noted in the press conference, the decision was aimed at increasing the

available collateral for banks (as they need to borrow less to meet their reserve requirement)and not to boost the liquidity available for banks. It was also taken in the context of full

allotment with a very large liquidity surplus and a reserve requirement-based system being

less relevant. The success of the two 3y LTROs has provided banks with abundant and long-

term liquidity, and the collateral issue has been addressed by the issuance of government

guaranteed bonds as well as securitization programmes. Therefore, a possible decision to go

back to increasing the reserve requirement would not necessarily mean a U-turn,

The use of the long-term deposits (or the issuance of certificates of deposit) is an alternative tool

for the ECB. It could work as the current weekly sterilization auctions through which the ECB

drains on a weekly basis the amount of liquidity corresponding to the SMP outstanding. The ECB

has never issued CDs as such, but some of the NCBs have in the past, and the CDs are expressly

mentioned as one of the available tools for the ECB in the ECB General Documentation.

While in aggregate terms the goal of the two tools is the same, at a micro perspective the

impacts are different, as the increase in the reserve requirement would involve at the same

time all banks in the eurosystem, while the term deposits would only affect the banks that take

part in the auctions, stricto sensu (ie, mainly banks in the core countries or international

banks, which are the main users of the deposit facility and the main buyers of the ECBs

1-week term deposit). Draining liquidity via auctions at the margin exposes the ECB more to

market conditions (available liquidity, willingness of banks to bid, price, etc).

Another important issue on the implementation of the liquidity absorbing tools will be the

size of the drain, which has to be carefully calibrated in order to avoid a more-than-

necessary tightening of the liquidity conditions. This holds true especially for the first tool

(reserve requirement), while for the other tool (term deposit or certificates of deposit), we

believe that they have some flexibility in terms of how to design the operation: one option

could be to allow banks to buy unlimited amount of deposits ( a sort of full investment) at

fixed rate (established in order to eliminate any possibility of carry trade using the ECB

refinancing operations for funding), or the ECB could decide to auction fixed size of term

deposit at different maturities.


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30 March 2012 27

Conclusion

The fact that the ECBs rhetoric has shifted towards the potential inflation risks coming from

the abundance of liquidity currently in the system, is probably a signal that it is preparing its

gradual exit strategy. In the market, apart from an initial reaction, the curves are not pricing

a drastic change in the liquidity conditions in c.2 years time (the forward on EONIA, see the

fixing averaging 65bp in the January 2014, so about 30bp higher than the current level). We

do not expect liquidity absorbing measures to be implemented soon, as the signalling

impact would be dramatic given the still fragile situation in the banking system. Therefore,

we expect money markets rates to remain broadly stable at the current historical low level

in the near term. However, any further comments by the ECB officials on possible measures

to withdraw liquidity would likely fuel volatility in the euro money markets


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30 March 2012 28

EUROPE: SOVEREIGN SPREADS

Eurozone supply expectations for Q2 2012

We take a look at the eurozones issuance requirements in both gross and net terms for

Q2 2012.

In overall terms, the first three months of 2012 saw a slightly higher amount of gross

funding vs. target as in the same period in 2011, with 32% of total estimated funding

completed YTD, compared with c.31% a year ago. In gross issuance terms, c.255.5bn has

been issued thus far in 2012, versus 255.8bn in the same period in 2011.

There continues to be major differences in the progress of issuance by certain peripheral

issuers, however, with Spain thus far having already issued 44% of its official 86bn target

for the year. Given fiscal slippages and possible regional and other funding needs in Spain,

some upside to this target seems likely and the new budget due to be delivered at end March

may be a catalyst for this. However, even if this were revised as high as 100bn, Spain would

still be more than one-third funded for the year. Italy has been somewhat slower off the

mark, although last weeks BTP Italia retail-focused issue has improved this with c. 29% of itstarget achieved so far, which is slightly better than in 2011. We would not be surprised to see

more retail-targeted deals as the year progresses, however any reduction in issuance would

likely be targeted at BOT and CCT issuance rather than a reduction in bonds.

There has been a more mixed picture among the core issuers. Belgium has easily had the

fastest start to the year, with funding some 65% complete, however we suspect that this

will not mean widespread cancelations in auctions later in the year and the 26bn target will

likely be substantially exceeded. Finland has been notoriously slow to issue in the past,

although following a new 15y in late January, it finds itself 26% funded for 2012. A Finnish

tap auction was originally scheduled to take place in Q1, and we now expect this to come in

early Q2 2012. Austria is just over 25% funded for the year as a whole.

Figure 1: Euro government supply YTD 2012

% of 2012 Actual Estimated

Up to 31/03/12 2-3 5 7-10 15+

All

Maturities

Net

isuance

YTD bn

Estimated

gross

issuance

YTD issuance/

Net Issuance

target for

2012

Difference

vs. 2011

Funding -

'11

Funding - '12

(inc.

buybacks)

Germany 14.0 12.0 16.0 3.0 45.0 1.0 25% 222% -3% 190 182

France (inc buybacks) 11.3 17.3 22.3 7.7 58.6 43.5 30% 60% -1% 205 196

Italy 26.2 22.3 14.3 0.0 62.9 -1.1 29% 310% 1% 214 220

Spain 14.6 11.9 11.7 0.0 38.2 36.2 44% 106% 16% 99 86

Belgium 0.5 1.0 9.8 5.6 16.8 12.0 65% NM 29% 40 26

Holland 5.9 7.0 6.0 5.5 24.4 10.1 41% 80% 8% 51 60

Portugal 0.0 0.0 0.0 0.0 0.0 NA NA NA NA 9 9Finland 0.0 0.4 0.0 3.0 3.4 3.2 26% 56% -13% 16 13

Austria 0.0 0.0 4.1 2.0 6.1 3.4 27% 81% -12% 18 23

Greece 0.0 0.0 0.0 0.0 0.0 NA NA NA NA 0 0

Ireland 0.0 0.0 0.0 0.0 0.0 NA NA NA NA 0 0

Eurozone Aggregates 72.5 71.9 84.3 26.7 255.5 108.2 32% 1% 842 804

Eurozone ex-Greece, Ireland and Portugal 255.5

Percentages 28% 28% 33% 10%

Difference vs. 2011 0% 0% 2% -1%


Huw Worthington

+44 (0)20 7773 [email protected]


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30 March 2012 29

In terms of the larger issuers, Germany and France are 25% and 26% funded, respectively.

Notably, Germany announced a 2bn increase to its original issuance schedule for Q2 2012

to reflect the capital it will eventually pay into the ESM in 2012. As a result, we may see

further small revisions upwards in issuance needs by multiple other issuers reflecting the

need for the first stage of payments of capital to the ESM.

Q2 gross and net issuanceLooking forward, we expect Italy to be the largest issuer in Q2, who we expect to issue up to

56bn gross after 63bn of supply in Q1. In net terms, however, the picture in Italy will be

quite different QoQ. In this regard ,the actual net funding requirement in Italy was the lowest

of any active EGB issuer in Q1 at -1.1bn; however, Q2 will see much less support from

redemptions with only a 27.8bn redemption in April to support the market meaning net

issuance will rise to around 23bn in the quarter. Domestic holders account for around half of

BTP holdings, and we assume they will mostly roll this over. As such, the gross issuance will

have less support from this source of demand. However, at the same time the low levels of

redemptions mean that once the April redemption hump is over if market conditions are poor

the flexibility for Italy to reduce issuance sizes is improved somewhat..

Thereafter, we expect France to be the next biggest issuer with up to 52.5bn in Q2.Redemptions of 18bn means this translates into net supply of 34bn leaving France with

the highest net issuance needs of any issuer for the second quarter in a row. Germany has

scheduled issuance of 47bn in Q1; however, 35bn of redemption flows mean this

translates into net issuance of 12bn.

Thereafter, we expect Spain to issue 25bn in gross terms. Spanish bond redemptions are

12.5bn as at end April and thus we expect net issuance needs of 14.5bn in the quarter.

Elsewhere, the Netherlands has announced another quarter of heavy issuance with a

forecast gross bond borrowing requirement of c.21.5bn in Q2, which could possibly be

boosted if they deicide to issue a new 5y via DDA in June. Redemptions are zero however so

gross issuance will translate directly into net issuance. Finally, Belgium has cancelled Aprils

auction after two syndicated issuances in March, and thus gross borrowing will be low in

the quarter at around 6bn we suspect (5.8bn net of bond redemptions).

Figure 2: Forecast gross and net issuance by month and country Q2 2012 ( bn)

Germany France Italy Spain Belgium Holland Portugal Finland Austria Greece Ireland Total

Gross Issuance 17.0 17.5 18.0 9.0 0.0 5.5 0.0 1.0 1.3 0.0 0.0 69.3

Total Redemptions 16.0 18.0 27.8 12.5 0.0 0.0 0.0 0.0 0.1 0.0 0.0 74.5Apr-12

Total Net 1.0 -0.5 -9.8 -3.5 0.0 5.5 0.0 1.0 1.1 0.0 0.0 -5.2

Gross Issuance 15.0 17.5 18.8 9.0 3.0 6.0 0.0 0.0 1.1 0.0 0.0 70.4

Total Redemptions 0.0 0.0 0.6 0.0 0.0 0.0 0.0 0.0 0.3 4.1 0.0 5.0May-12

Total Net 15.0 17.5 18.2 9.0 3.0 6.0 0.0 0.0 0.8 -4.1 0.0 65.4Gross Issuance 15.0 17.5 19.0 9.0 3.0 10.0 0.0 0.0 2.2 0.0 0.0 75.7

Total Redemptions 19.0 0.0 4.1 0.0 0.2 0.0 10.2 0.0 0.0 0.0 0.0 33.5Jun-12

Total Net -4.0 17.5 14.9 9.0 2.8 10.0 -10.2 0.0 2.2 0.0 0.0 42.2

Gross Issuance 47.0 52.5 55.8 27.0 6.0 21.5 0.0 1.0 4.6 0.0 0.0 215.4

Total Redemptions 35.0 18.0 32.5 12.5 0.2 0.0 10.2 0.0 0.5 4.1 0.0 113.0Q2 12

Total Net 12.0 34.5 23.3 14.5 5.8 21.5 -10.2 1.0 4.1 -4.1 0.0 102.3



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30 March 2012 30

Next weeks cash flows

Wednesday sees Germany tap the 5y OBL for 4bn, while Spain will tap 3y, 5y and 8y

bonds. The following day France will auction 7-8.5bn of 5y, 10y, 15y and 30y issues.

Support for the market will be minimal in terms of coupon and redemption flows.

Figure 3: Barclays Capitals cash flow expectations for week-beginning 2 April 2012

Beginning Auction Date Issuance Redemptions Coupons Net Cash Flow

19-Mar -1.74 Germany 4.00 0.00 0.00 4.00

Weekly 26-Mar 3.30 France 8.00 0.00 0.00 8.00

Net 02-Apr 15.67 Italy 0.00 0.00 0.25 -0.25Cash flow 09-Apr -4.06 Spain 4.00 0.00 0.01 3.99

16-Apr -1.10 Belgium 0.00 0.00 0.00 0.00

Greece 0.00 0.00 0.07 -0.07

Finland 0.00 0.00 0.00 0.00

Ireland 0.00 0.00 0.00 0.00

Holland 0.00 0.00 0.00 0.00

Austria 0.00 0.00 0.00 0.00

Total issuance 16.00 Portugal 0.00 0.00 0.00 0.00

Total redemptions 0.00 Total 16.00 0.00 0.328 15.67

Total coupons 0.33

Net cash flow 15.67

Net Cash Flow is issuance minus redemptions minus

coupons. Negative number implies cash returned to

the market.



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30 March 2012 31

UNITED KINGDOM: RATES STRATEGY

Institutional flows and long yields

The latest data on domestic institutional flows in the gilt market suggest that demand

for linkers remains healthy despite real yield levels. A bearish correction in both long-dated nominal and real yields would likely see an increase in demand for both long ends.

The final release of Q4 11 GDP has also seen the release of the latest available data on gilt

holdings by sector. This gives us a fuller picture of flows across institutions. The aggregate

data is outlined in Figure 1. This shows in absolute terms the aggregate size of holdings

across investor classes. We can see that as the size of the market expanded as the fiscal

deficit worsened and overall gilt issuance rose, there were big increases in gilt holdings from

overseas buyers, MFIs, and the Bank of England under its QE programme.

We can see this more clearly when we consider the changes in the composition of

ownership (Figure 2). It shows how, aside from the BOEs asset purchase programme, key

support has come from the overseas buyers of gilts who have preferred the UK to other

sovereign bond markets as the combination of an accommodative monetary policy and

credible fiscal policy has left the market well supported. But while there has been a great

deal of scrutiny of the activities of overseas investors and the buying by banks for their

liquidity portfolios, the one buying trend that has not attracted comment has been the share

of the market from domestic institutional investors the domestic pension funds and

insurance companies. All told, this sectors holdings of gilts have fallen from just over 50%

of the market in Q4 06 to 25% at the end of Q4 11. The outright level has risen from

240bn to 312bn but more aggressive buying from other sectors has seen overall

domestic institutional holdings as a share of the total market fall.

One of the key channels by which the BOE has expected QE to influence the economy has

been through the portfolio route. Simply, this is the idea that domestic holders of gilts

would be willing to sell out of gilts as yields fell and replace their gilt holdings withinvestments in riskier (ie, higher-yieldi

barclays capital - the _w_ides of march

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