EFTA01097815.pdf

Deutsche Bank Markets Research r4 United States Economics Date Rates 4 September 2015 Credit Dominic Konstam Research Analyst US Fixed Income Weekly Aieksandar Kocic Research Analyst a Markets are fixated on the potential for Fed normalization to start earlier than currently priced and whether China's recent FX adjustment is the Joseph LaVorgna beginning or the end. Economist ▪ At a superficial level there appears to be conflicting influences on rates.. The Fed and China may undermine risk asset performance but the consensus is that if risk assets find support, fewer FX reserves are likely to pressure rates higher. Alex Li ▪ On the contrary, we think the most important thing is that both the Fed and China's FX (ongoing?) unwind represent a tightening of global liquidity that clearly is negative for risk assets and clearly, at least for the last decade, has been positive for real rates and the curve. 5y5y is well Stuart Sparks correlated with changes in global liquidity and based on recent trends Research Analyst should be closer to 2 percent. ▪ This reinforces our view that the Fed is in danger of committing policy error. Not because one and done is a non issue but because the market Daniel Send will initially struggle to price "done" after "one". And the Fed's communication skills hardly lend themselves to over achievement. More Reeteereh Aretrat likely in our view, is that one in September will lead to a December pricing and additional hikes in 2016, suggesting 2s could easily trade to 1 1/4 percent. This may well be an overshoot but it could imply another leg Steven Zeng. CFA lower for risk assets and a sharp reflattening of the yield curve. Decline in liquidity implies a lower 5y5y 30 7.0 Maya Bhave Fed plus fx reserves oy 5y5y rhs 25 6.0 Economist 20 5.0 15 4.0 10 3.0 ITable of Content 5 US Overview Page 06 2.0 US Credit Strategy Page 23 0 Chart Pack Page 28 -5 10 10 0.0 20001 20061 20121 sower Fed anCIDeurSea bale Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI IP) 124/04/2015. EFTA01097815  2015 Outlook Recommendations co NJ Trade Detail Rationale Risks Opened Entry Current P/L Option Buy 1x1, 1y1y receiver spreads The post-Fed sell-off has left the spot/forward Maximum total loss is 12/19/14 29c with strikes ATMF and ATMS spread near multi-year post-crisis highs. the premium outlay This curve segment might be expected to steepen if, for example, higher inflation produces Swaps RV Pay 3y1y versus 2y1y greater pricing power, or if the long-absent Curve flattens 12/19/14 +40 bp cyclical increase in productivity finally materializes. Sell 1X2 payer spreads at the Vulnerable to rally below The repricing of Fed hikes could begin in Q2 with Option short end: Sell $100mn 6M3Y the breakevens, with the short end rebounding sharply after initial 12/19/14 ATMF vs. buy $200mn 34.5bp potentially unlimited rally. OTM payers at zero net cost downside. Sell $100mn 6M10Y straddles With expectations of Fed hikes, volatility should Option Unilateral spike in vs. buy $300mn 6M3Y straddles move to the front end of the curve, while the 12/19/14 backend vol. for a net premium of 175K back end movements remains Quiet flatteners: sell $1bn 6M Option 5s/10s 9.5bp OTM curve cap vs. Potential for considerable bear flattening should Curve steepens. 12/19/14 buy$1bn 6M 5s/1Os atmf/9.5 the market reprice the Fed hikes. curve floor spread at zero cost Quiet bulls: Sell $100mn 1Y10Y This captures the risk of bullish flattening of the Option 50bp OTM payers vs. buy curve where growth is unable to take off either Sell-off beyond 3.10%. 12/19/14 $100mn 1Y10Y ATMF/33 due to fundamental weakness or in response to a receiver spreads costless policy mistake of premature hikes. Option Buy $100mn 1Y30Y receivers, Loss equal to the 12/19/14 Bull/flatteners at the back end. struck at spot, at 1270c options premium This is a leveraged expression of a policy-mistake Option 6M dual digital: 2sa F+10bp & Loss equal to the trade where premature hikes cause a rally at the 12/19/14 10s < F-10bp offer 11.5% options premium back end. SONO. Dootiao Salk Deutsche Bank Securities Inc EFTA01097816 Deutsche Bank Securities Inc. 2015 Outlook Recommendations Trade Detail Rationale Risks Opened Entry Current P/L Treasury Further outperformance +5 bp Sell rich bond futures against The classic bond futures look rich in the long end of the 6.25s of 5/2030 12/19/14 +21 bp (Closed on +1,249k RV cheap off-the-run bonds in the long end 2125) Inflation Further decline in The 2yr2yr inflation appears attractive on a long- Buy 2yr2yr forward breakevens medium-term inflation 12/19/14 1.95% 1.60% -1,367k Swaps term history expectations The long and inflation market looks undervalued on Inflation Buy long end inflation Inflation markets further a long-term perspective, with the 30-year TIPS 12/19/14 1.92% 1.71% -3,400k underperform. breakevens trading below 2.00%. Inflation Buy 5yr5yr forward breakevens The 5yr5yr forward breakevens have dropped to Decline in energy prices 12/19/14 2.18% 1.97% -848k as a hedge to high rates their multi-year lows. and a stronger dollar With the Fed moving closer to its first rate hike in a Buy 3nc1y and 5nc6m Higher implied vol Agencies low-inflation, moderate-growth environment, there callables vs. matched-maturity cheapens callables 12/19/14 are few themes as sure as the flattening of the bullets relative to bullets curve, likely going beyond the forwards. On the bullet agency curve, spreads are relatively tight to the level of rates volatility, and they risk Increased GSE risk Agencies 2-year vs. 5-year agency widening 5.10bp from current levels on our model widens intermediate 12/19/14 spread curve flattener incorporating forward vols and the projected level spreads of outstanding debt. Widening of credit With CCC energy bonds trading at 60 cents on the spreads beyond the dollar, and oil just S10 away from matching the breakeven point as well US Credit US High Yield: Sell covered most severe percentage drop in oil prices over as a rally in credit 12/19/14 puts on HY CDX 1997-8, our sense is that we may be reaching the beyond the breakeven, latter stages of a pronounced move lower in a with potentially commodities-driven decline in HY credit valuations unlimited downside in either scenario Sane: Oeussono hat EFTA01097817 1 0 'Other Current Recommendations o (D a Trade Detail Rationale Risks Opened Entry Current P/L Treasury 10s look rich on the curve against 5s Short 10s versus 5s and 30s 10s richen further 5/8115 +9 bp +8 bp -6k RV and 30s Treasury Sell the rich classic bond futures Sell rich bond futures against cheap Classic bond futures off-the-run bonds in the 2026 11/26/14 +21 bp +20 by -106k RV off-the-run bonds versus richen to 2028 sector 30yr underperforrns Inflation 10s/30s breakeven curve steepener Long end TIPS offer good value relative to 10yr 6/26/2015 0.13% 0.30% +1,042k Front end TIPS look cheap to our Inflation Long front end TIPS breakevens inflation forecast Energy prices drop 4/10/2015 1.23% -1.45% -1,563k Possibly delayed first Fed rate hike is Inflation Real yield curve steepeners, either likely to help intermediate sector Long end outperforms 1/20/2015 5s/30*-00.65% 6s/[email protected]% 10s-30s or 5s-30s. outperform in real yields, steepening 10&[email protected]% 105/[email protected]% +3,484k the real yield curve. The spread between 10yr inflation Inflation Long 10yr inflation swaps versus TIPS outperform swaps and TIPS breakevens is too 1/20/2015 +21 bp +17 bp -248k 10yr TIPS breakevens inflation swaps tight Inflation Long 1/2029 breakevens vs 10yr 10yr TIPS to 1/2029 breakeven curve 1/2029 breakeven 10/3/14 +2 bp +6 bp +502k breakevens is too flat cheapen further The long end inflation market looks Long term inflation Inflation Long 30yr TIPS breakevens undervalued; 30yr TIPS breakevens expectations decline 12/12/14 1.91% 131% -2,107k near multi-year lows Inflation We like lyrlyr forward inflation Inflation expectations Long 1yr1yr inflation swaps swaps. Front end breakevens look 3/3/15 1.84% 1.22% 4362k Swaps decline attractive. We like being long 2yr2yr or 2yr3yr Inflation forward breakevens to take advantage Medium term inflation swaps Long 2yr2yr inflation swaps 12/12/14 1.77°S 1.68% -868k of cheap 5s, while avoiding negative expectations decline carry in front end TIPS Reform bill stalls in Buy long-dated GSE debt: Legislative momentum of Johnson- Congress or language 3/14/14 Agencies Buy 3100mm FNMA 6.625 11/30s Crapo on GSE reform is credit bullish +48 bp +62 bp -953k on government vs. T 5.325 2/31s for long-dated GSE debt. modified. Receive $100m 3y3y SIFMA ratio at Further ratio curve Muni 78.2%. (Sorid) Attractive roll down profile steepening 4/25/13 78.2% 72.0% +941k Rally below the Deutsche Bank Securities Inc 1X2 1Y 5Y5Y ATMF/41 receiver Long-end rallies on premature or fast Option spreads costless rate hikes (policy mistake) breakevens; unlimited 9/26/14 0c -18.4c 411k downside EFTA01097818 Deutsche Bank Secunties Inc. Other Current Recommendations Trade Detail Rationale Risks Opened Entry Current P/L Buy $100mn 2Y2Y ATMF receivers vs. sell $22.7mn Trend growth and law inflation Recessionary mode with Option 1013!13 -6 bp -99 bp -925k 2Y10Y ATMF receivers for the net takenut of $55K limit the rise of long rates bull flattening of forwards Payer wreeds: Sell $500mn 2Y2Y 92bp OTM payers Vol differential is favorable for Option vs. buy $50mn 2Y30Y 25bp OTM payers at zero net initiating a positive carry baar The curve baar gatten 1/2114 +2 bp .0 bp -25k cost steepening trade Swaps Receive $1,023.4mm 2y1y rata versus pay Positive carry look at repricing Rv $1,002.7mm tyty rata Fed The curve baar steepens 5/20/14 +95 bp +95 bp +2,305k Swaps Receive $1,023.4mm 2y1y rata versus pay $431.2mm Funher rally via Fed delay 2y1y undemerformance 5/20/14 -10 bp +405k Rv tyty rata and $597mm 3y1y rata benefits 2yly rata -17 bp 5y rata, 10y forward is Swaps Forward fly: Pay fixed on $298.6 mm 10y5y versus hestorically rich versus 5y rata, Funher 10y5y 4/29/14 +22 bp -416k Rv receive fixed on $72.9 mm 5y5y and 5257.6 mm 15y5y 5y forward and 5y rats, outperformance +21 bp 15yloward Risk-on retightening of Bank credit underperforms; +25 bp +30 bp Cross Buy $10m each of SPNTAB 2.95%3/16; SPABOL covered bonds in stable rates Eurozone credit crunch; 7/25/13 +37 bp +25 bp -930k Market 5/16; DNBNOR 2.90% 3/16 on ASW. (Sond) regime Widening in a rata sell-off +31 bp +31 bp Cross US-Europe spread tightener: Receive fixed in $244 mm USD 5y5y rata vs. pay fixed on E165.8mm EUR 5y5y US recovery disappoints Spread witlens 1/24/14 +127 bp +136 bp -10k Market rare PIL as of 09/03/2015 prices. We sond &Dobnp dra performance otaw bacie recommendatrons on Jane r$ 20,0 P, s tabre shows out amant open recommendatem a rabh of our closed pos:jeans d in die bock atlas pubkaten Bod, rabies wik bes regular feature im the Weatdy. Ftrdomance~bers are based on bader end-obday marka end do not ;obiad° lad/offer spreads w transaction casts. We tonda Nie relevant benchmant lor our tredes to benzen‚ positie& gaven rhe hieraged or geneally market neutra, aspecrs of these tat Historica! performance is nora guaraniee afhouw performance Spotte 0—ara EFTA01097819 4 September 2015 US Fixed Income Weekly United States Rates Dominic Konstam Gov. Bonds & Swaps Research Analyst Rates Volatility Aleksander Kocic US Overview Research Analyst • Markets are fixated on the potential for Fed normalization to start earlier Alex Li than currently priced and whether China's recent FX adjustment is the !MEP beginning or the end. • At a superficial level there appears to be conflicting influences on rates. The Fed and China may undermine risk asset performance but the consensus is that if risk assets find support, fewer FX reserves are likely to Stuart Sparks pressure rates higher. Research Analyst • On the contrary, we think the most important thing is that both the Fed and China's FX (ongoing?) unwind represent a tightening of global liquidity that clearly is negative for risk assets and clearly, at least for the last Daniel Send decade, has been positive for real rates and the curve. 5y5y is well • Research Anal correlated with changes in global liquidity and based on recent trends should be closer to 2 percent. • This reinforces our view that the Fed is in danger of committing policy error. Not because one and done is a non issue but because the market Steven Zeng. CFA will initially struggle to price "done" after "one". And the Fed's Research Analyst communication skills hardly lend themselves to over achievement. More likely in our view, is that one in September will lead to a December pricing and additional hikes in 2016, suggesting 2s could easily trade to 1 Yi percent. This may well be an overshoot but it could imply another leg Aditya Bhave lower for risk assets and a sharp reflattening of the yield curve. • We think risk/reward has shifted toward paying spreads in the front end. Financing is challenging with term GC trading high relative to LIBOR, but we think rolling the position ovemight should allow investors to average in financing better than LIBOR, providing some backstop against tightening if significant additional intervention-related selling does not materialize. • We like being long front end breakevens in forwards, e.g., one-year breakevens implied by short maturity TIPS, such as the 7/2016s and the 7/2017s. One can also hedge out energy prices in that trade to create a synthetic exposure to core CPI. A simpler version of the implied front end forward breakevens is to be long front end breakevens outright. They have lagged oil prices. • 5-year inflation basis has recovered, while 30-year inflation basis has done less well, and remains in the low end of the long term trading range. Investors should consider inflation basis steepeners by being long 30-year inflation basis against 5-year inflation basis. The case for more liquidity Investors are rightly concerned about the impact of both a possible early start to Fed normalization and the probably yet-to-be-resolved Chinese FX adjustment. There is a reasonable consensus that both encourage further downside to risk assets. There is more uncertainty around bond yields. Potential FX intervention might imply selling of Treasuries, especially the front end where most reserves are held. But if higher short rates from either those sales or Fed tightening, undermine equities, bond yields might actually fall. Page 6 Deutsche Bank Securities Inc. EFTA01097820 4 September 2015 US Fixed Income Weekly The right framework to view potential Fed tightening as well as China's FX adjustment is in the context of global liquidity and that relationship with financial assets. Liquidity in the broadest sense tends to support growth momentum, particularly when it is in excess of current nominal growth. Positive changes in liquidity should therefore be equity bullish and bond price negative. Central bank liquidity is a large part of broad liquidity and, subject to bank multipliers, the same holds true. Both Fed tightening and China's FX adjustment imply a tightening of liquidity conditions that, all else equal, implies a loss in output momentum. Typically this should be associated with lower yields. This runs counter to a common perception that forex intervention that leads to Treasury sales pushes up yields. To the extent that it does, we suspect this is a short lived temporary affair and will easily be dominated by the more sinister implications of dwindling global liquidity. We note that the recent weakness in global nominal growth that we highlighted last week is highly consistent with weaker global liquidity and that the weakening in liquidity is not new news but has been ongoing since late last year. Not only has it been driven by falling FX reserves but also by the slowing of the Fed's balance sheet. To the extent that other central banks have tried to expand liquidity, in terms of historic relationships to financial assets, FX reserves and the Fed's balance sheet are more important. We think this reflects the role of the dollar as the reserve currency in the global financial system. Let's start from some basics. Global liquidity can be thought of as the sum of all central banks' balance sheets (liabilities side) expressed in dollar terms. We then have the case of completely flexible exchange rates versus one of fixed exchange rates. In the event that one central bank, say the Fed, is expanding its balance sheet, they will add to global liquidity directly. If exchange rates are flexible this will also mean the dollar tends to weaken so that the value of other central banks' liabilities in the global system goes up in dollar terms. Dollar weakness thus might contribute to a higher dollar price for dollar denominated global commodities, as an example. If exchange rates are pegged then to achieve that peg other central banks will need to expand their own balance sheets and take on dollar FX reserves on the asset side. Global liquidity is therefore increased initially by the Fed but, secondly, by further liability expansion, by the other central banks. Depending on the sensitivity of exchange rates to relative balance sheet adjustments, it is not an a priori case that the same balance sheet expansion by the Fed leads to greater or less global liquidity expansion under either exchange rate regime. Hence the mere existence of a massive build up in FX reserves shouldn't be viewed as a massive expansion of global liquidity per se - although as we shall show later, the empirical observation is that this is a more powerful force for the "impact" of changes in global liquidity on financial assets. The chart below shows the RMB vs. the ratio of PBOC to Fed balance sheets, using prevailing exchange rates at the time as the conversion factor. The initial post crisis period sees the Fed balance sheet expand relatively while the exchange rate is unchanged. There is then a phase of RMB appreciation and relative stability in the balance sheet ratio and then the PBOC balance sheet expands with continued RMB appreciation. Deutsche Bank Securities Inc. Page 7 EFTA01097821 4 September 2015 US Fixed Income Weekly IRMB vs. ratio of Fed to PBOC balance sheet 1.7 6.9 1.6 - 6.8 6.7 1.5 6.6 1.4 6.5 1.3 64 ratIn of P 6.3 1.2 sheets 6.2 1.1 -rr— .(fogisrpis 6.1 1 6.0 20084 20114 20144 Sane. Mbnbogron Daman avn. The table below highlights these three periods in terms of the actual notional impact on global liquidity via the combined effects of revaluing the PBOC balance sheet as well as the changes in the underlying domestic liquidity. Under a relatively stable currency the PBOC expanded its balance sheet aggressively in the first phase, presumably in part being obliged to accelerated FX reserve accumulation; the Fed was more or less in between expanding their balance sheet. The second phase saw the more dramatic currency appreciation with a strong Fed expansion but also strong PBOC liquidity expansion. The third phase saw even stronger Fed balance sheet expansion but weaker PBOC expansion and more modest RMB appreciation. The last two phases combined saw global central bank liquidity expand by notionally similar amounts i.e. $1500 billion. More than double the first phase when the currency was more stable and the Fed was quieter. However note that as expected, the reserve accumulation was almost the same in each period, around 500-600+ billion. So even though the Fed wasn't expanding the balance sheet much, the hangover of the previous expansion and capital flows in general required a more aggressive intervention by PBOC to acquire reserves and maintain the a stable currency. So a notionally less aggressive expansion in global central bank liquidity under a stable exchange rate regime was disproportionately more skewed to reserve accumulation. IChanges in central bank balance sheet liquidity ...Wu as dig ChM PAIS &meg WI On %68• 88416060 dunte 14214 knew, chi Ste bit Wait MUM, bit bit 201022-200824 41% 93 173% 3586 684 682 23% 532 622 508 201.241.201040 252% MI 142% 3534 6)7 631 7.2616 827 1.41:6 657 201981-82120 393% 1126 7.734 2274 624 609 251% 492 1618 510 Sayre. eMaya, a Daman &Mk The next issue is given changes to liquidity how does it impact asset prices. We can think of the three components of liquidity: the Fed's balance sheet, the accumulation of FX reserves by other central banks; and the residual of other central banks' liquidity expansion after the accumulation of FX reserves. As the chart below shows in terms of growth the explosion of the Fed stands out during the crisis but there have been strong expansions in other central banks' liquidity excluding reserve increases. FX reserve accumulation has been quite weak since 2012 and is now negative. In absolute terms liquidity is strongest in FX reserves and other central banks ex reserves by a factor of three times for the Fed's balance sheet. Page 8 Deutsche Bank Securities Inc. EFTA01097822 4 September 2015 US Fixed Income Weekly Sources of central bank liquidity - change yoy Sources of central bank liquidity - $ billion 180 16000 160 —FX reserves 14000 140 —Fed 120 12000 r B s ex Reserves 100 10000 80 8000 60 6000 ao ry 4000 20 2000 20 0 20031 20081 20131 20031 20081 20131 Saar ObowboRgtealDeutsch,Dint Sown INoombep ow Detachsrank Let's start with risk assets, proxied by global equity prices. It would appear at first glance that the correlation is negative in that when central bank liquidity is expanding, equities are falling and vice versa. Of course this likely suggests a policy response in that central banks are typically "late" so that they react once equities are falling and then equities tend to recover. If we shift liquidity forward 6 quarters we can see that the market "leads" anticipated" additional liquidity by something similar. This is very worrying now in that it suggests that equity price appreciation could decelerate easily to -20 or even 40 percent based on near zero central bank liquidity, assuming similar multipliers to the post crisis period. From q2 levels that implies an MSCI level of around 1350 for 2015q4 (reference q2 @ 1735), the end August level was 1645 i.e. still another 10-15 percent decline. World equities yoy vs. central bank liquidity yoy World equities yoy vs. components of liquidity yoy 50 40 WORLD EQUITIES YOY 40 50 30 Fed plus fx reserve lu then c (ex fx) yoy rhs 35 20 30 10 25 10 0 20 10 j \ s/ 15 10 20 FX e es 10 30 30 -40 5 Othe ks ex Reserves —world quitiesyoy 50 0 50 20041 20101 20031 20081 20131 Sages Bbornbug andDarse-no &ht. Source Beonnboop oneWound* Mat Interestingly, the components of liquidity themselves behave a little differently with FX reserves and Fed balance sheet being more in line recently than other central bank liquidity. This reflects the ECB and BoJ tardier reactions to balance sheet expansion in the post crisis period. If we only consider the FX and Fed components of liquidity there appears to be a tighter and more contemporaneous relationship with equity prices. The suggestion is at one Deutsche Bank Securities Inc. Page 9 EFTA01097823 4 September 2015 US Fixed Income Weekly level still the same, absent Fed and FX reserve expansion, equity prices look more likely to decelerate and quite sharply. The tie out, presumably with the "leading" indicator of other central bank action is that other central banks have been instrumental in supporting equities in the past. The largest of course being the ECB and BoJ. If the Fed isn't going doing its job, it is good to know someone is willing to do the job for them, albeit there is a "lag" before they appreciate the extent of someone else's policy "failure". And just to ram home the point — this differential relationship is entirely consistent with the idea that FX reserves are accumulate don the