EFTA01123162.pdf

Deutsche Bank Markets Research r4 United States Economics Date Rates 27 March 2015 Credit Dominic Konstam Research Anal t US Fixed Income Weekly Aleksander Kocic Research Anal • There are plenty of minefields out there but none are likely to dominate Joseph LaVorgna what we still think for now is a powerful rational that warrants the current Chief US Economist term structure. Long rates are well defined by low to negative term premium and a low terminal Funds rate. While we still see plenty of reasons why the Fed struggles to lift off making it as hard as it always has been to make money on shorting front rates to say a 3M forward horizon. Alex Lo • There are reasonable risk reward trades that we like including using bullish rate views to buy cheap risk on protection e.g. on SPX. We also for choice rather receive the market than pay it based on term premium staying very negative (Europe) but also the risk of some softer US data. This would favor curve caps and some relief steepening. Volatility should be higher in Stuart Sparks the front end relative to the back end. Research Analyst • The round out for 2014 GDP data was fascinating because like Rip Van Winkle after 5 years of would be accelerating recovery, we realize that there has been no acceleration - for five years! A rock solid dullness of sub Daniel Sand 4 percent nominal growth. And everyone is so afraid of inflation! More Research Analyst importantly it clearly justifies the low terminal funds rate that the market is pricing as it leaves as many questions unanswered in terms of productivity and profits especially. • We look at the potential for Japanese financial sector demand for overseas Steven Zeng, CFA securities to pick up in 2015 and conclude there is up to $200 billion to Ftneafflonth &naive. come based on dollar yen moving to 130 and recent sensitivities of asset allocation decisions as well as pre-announced pension asset reallocations. 'Actual, fitted, and projected wage acceleration Table of Content —Actual AXE acceleration US Overview Page 06 — Fitted AXE acceleration Treasuries Page 16 --- Projected ME acceention,no unemployment decline --- Projected ME acceention,rapid unemployment decline. LBO NAIRU Derivatives Page 22 --- Projected ME aceeention,rapid unemployment decline. FOMC NAIRU Agencies Page 26 LS LO US Credit Strategy Page 28 as Mortgages Page 32 AO Bond Market Strategy Page 41 Economics Page 44 Chart Pack Page 48 .10 ilta Ise 11 info non mil 1104 no! 1001 tile Moe Ical Dace 2431 acal 1001, axe 2011 1002 an4 100S 01 41 01 CO 41 01 01 QS 01 0) 01 OA CO 01 CO 01 41 Os 01 QS 01 4S &war 'OweManx salDeverch, Orme Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/0.4/2014. EFTA01123162  2015 Outlook Recommendations Trade Detail Rationale Risks Opened Entry Current P/L Overly aggressive Fed could produce a FVH5 Sell FVH5 puts versus buy like "tightening tantrum" which is negative for Spreads tighten in a Option +10.bp structured swaption for zero risk asset valuations, likely producing sell-off beyond the 12/19/14 Swaption premium hedging flows in swap spreads that push strikes +9bp spreads wider. The post-Fed sell-off has left the Option Buy 1x1, 1y1y receiver spreads Maximum total loss is spot/forward spread near multi-year post- 12/19/14 29c with strikes ATMF and ATMS the premium outlay crisis highs. This curve segment might be expected to steepen if, for example, higher inflation Swaps RV Pay 3y1y versus 2y1y produces greater pricing power, or if the Curve flattens 12/19/14 40 long-absent cyclical increase in productivity finally materializes. 1X2 receiver spreads: Buy Vulnerable to rally Option $100mn 3M10Y ATMF vs sell This a positive carry trade that captures the below the breakevens 12/19/14 $200mn 3M10Y 19bp OTM central path for the 10Y sector during 01. with potentially receivers at zero net cost unlimited downside. Sell 1X2 payer spreads at the Vulnerable to rally The repricing of Fed hikes could begin in Option short end: Sell $100mn 6M3Y below the breakevens, 02 with the short end rebounding sharply 12/19/14 ATMF vs. buy $200mn 34.5bp with potentially after initial rally. OTM payers at zero net cost unlimited downside. Sell $100mn 6M10Y straddles With expectations of Fed hikes, volatility Option vs. buy $300mn 6M3Y straddles should move to the front end of the curve, Unilateral spike in 12/19/14 backend vol. for a net premium of 175K while the back end movements remains Quiet flatteners: sell $1bn 6M Option 5s/l0s 9.5bp OTM curve cap vs. Potential for considerable bear flattening Curve steepens. 12/19/14 buy$lbn 6M 5s/10s atmf/9.5 should the market reprice the Fed hikes. curve floor spread at zero cost This captures the risk of bullish flattening Quiet bulls: Sell $100mn 1Y10Y of the curve where growth is unable to Option 50bp OTM payers vs. buy take off either due to fundamental Sell-off beyond 3.10%. 12/19/14 $100mn 1Y10Y ATMF/33 weakness or in response to a policy receiver spreads costless mistake of premature hikes. Option Buy $100mn 1Y30Y receivers, Loss equal to the Bull/flatteners at the back end. 12/19/14 struck at spot, at 1270c options premium This is a leveraged expression of a policy- 6M dual digital: 2s> F+10bn - & Loss equal to the Deutsche Bank Securities Inc Option mistake trade where premature hikes 12/19/14 10s c F-10bp offer 11.5% options premium cause a rally at the back end. Given the impressive run equities have had Equity/rates hybrids: Buy 19-Jan- on the back of both normalization of the Limited downside with Option 2015 SPX 100/90 put spreads markets as well as the accommodation. maximum loss equal to 12/19/14 subject to ss > Fwd+25bp, offer Fed exit is likely to be disruptive for their the options premium. short-term performance. Seurat. Lbutlab ILYA EFTA01123163 Deutsche Bank Securities Inc. 2015 Outlook Recommendations Trade Detail Rationale Risks Opened Entry Current P/L Further Treasury +5 bp Sell rich bond futures against The classic bond futures look rich in the outperformance of the 12/19/14 +21 bp (Closed on +1,249k RV cheap off-the-run bonds long end 6.25s of 5/2030 in the 2/25) long end Further decline in Inflation The 2yr2yr inflation appears attractive on a Buy 2yr2yr forward breakevens medium-term inflation 12/19/14 1.95% 2.03% +329k Swaps long-term history expectations The long end inflation market looks Inflation Buy long end inflation undervalued on a long-term perspective, Inflation markets 12119/14 1.92% 1.91% -1,305 with the 30-year TIPS breakevens trading further underperform. below 2.00%. Inflation Buy 5yr5yr forward breakevens The 5yr5yr forward breakevens have Decline in energy prices 12119/14 2.18% 2.06% -206k as a hedge to high rates dropped to their multi-year lows. and a stronger dollar With the Fed moving closer to its first rate hike in a low-inflation, moderate-growth Higher implied vol Agencies Buy 3nc1y and 5nc6m callables environment, there are few themes as sure cheapens callables 12119114 vs. matched-maturity bullets as the flattening of the curve, likely going relative to bullets beyond the forwards. On the bullet agency curve, spreads are relatively tight to the level of rates volatility, Increased GSE risk Agencies 2-year vs. 5-year agency spread and they risk widening 5-10bp from current widens intermediate 12/19/14 curve flattener levels on our model incorporating forward spreads vols and the projected level of outstanding debt. Widening of credit With CCC energy bonds trading at 60 cents spreads beyond the on the dollar, and oil just $10 away from breakeven point as well US Credit WHOYiMd:Sacovwed puts .matching - . the most severe percentage drop ---- - - in oil prices over 1asi-a, our sense is that as a rally in credit 12/19/14 on HY CDX beyond the breakeven, we may be reaching the latter stages of a with potentially pronounced move lower in a commodities- unlimited downside in driven decline in HY credit valuations either scenario Stamm Lboacts Ea * EFTA01123164 1,1 (Other Current Recommendations CO CO CD a Trade Detail Rationale Risks Opened Entry Current P/L Treasury Sell rich bond futures against Sell the rich classic bond futures versus Classic bond futures 11/26/14 +21 bp +12 bp +337k RV cheap off-the-run bonds off-the-run bonds in the 2026 to 2028 richen sector Treasury Short ultra long futures vs 30s Ultra long futures are rich Ultra continue to richen 6/12/14 +12 bp +6 bp +480k RV Inflation Short 1/2026 breakevens vs 5yr 10s look rich; sell the rich 1/2026s 10s richen further 1/23/15 +15 bp +0 bp +229k and 30yr breakevens Inflation Long 30yr TIPS breakevens 10s-30s breakeven curve appears too flat Long term inflation 11/26/14 +16 bp +6 bp +389k versus 10yr TIPS breakevens on a long term basis expectations decline Inflation Long 1/2029 breakevens vs 10yr 10yr TIPS to 1/2029 breakeven curve is too 1/2029 breakeven 10/3/14 +2 bp -2 bp +206k breakevens flat cheapen further The long end inflation market looks Long term inflation Inflation Long 30yr TIPS breakevens undervalued; 30yr TIPS breakevens near 12/12/2014 1.91% 1.91% -862k expectations decline multi-year lows We like being long 2yr2yr or 2yr3yr Inflation forward breakevens to take advantage of Medium term inflation Long 2yr2yr inflation swaps 12/12/2014 1.77% 2.04% +2,467k Swaps cheap 5s, while avoiding negative carry in expectations decline front end TIPS Reform bill stalls in Buy long-dated GSE debt: Legislative momentum of Johnson-Crapo Agencies Buy $100mm FNMA 6.625 on GSE reform is credit bullish for long- Congress or language 3/14/14 +40 bp +2,039k +48 by on government 11/30s vs. T 5.325 2/31s dated GSE debt. modified. Receive $100m 3y3y SIFMA Further ratio curve Muni Attractive roll down profile 4/25/13 78.2% 77.8% +590k at 78.2%. (Sorid) steepening Rally below the 1X2 1Y 5Y5Y ATMF/41 receiver Long-end rallies on premature or fast rate Option spreads costlass hikes (policy mistake) breakevens; unlimited 9/26/14 Os -87.85 -1,004k downside Buy $100mn 6M 2y1y 25bp OTM MC payers vs. Sell 100mn -0.65 -5k Option Curve flattens on a hawkish FOMC Curve bear steepens 9/12/14 Os 1Y 4Y1Y 45bp OTM MC payers at zero net cost Sell $100mn 6M5Y ATMF vs. Rates sell off half-way Option buy $200mn 6M5Y 30bp OTM Skew trades rich in a sell-off and stay there till the 9/12/14 0 bp 0.0 bp -2k payers at zero net cost expiry Buy $1bn 6M 5s./10s ATMF/15 Deutsche Bank Securities Inc Curve flattens beyond curve cap spread vs. sell Si bn Curve steepens as the market converges Option the floor strike; 9/5/14 6M 5s/10s 5bp OTM curve floor to Fed unlimited downside at zero net cost &yew Deur* &ink EFTA01123165 F Other Current Recommendations Trade Detail Rationale Risks Opened Entry Current P/L co co Option Buy $100mn 2Y2Y ATMF receivers vs. sell $22.7mn 2Y10Y ATMF Trend growth and low inflation limit the rise Recessionary mode with bull flattening of 10/3113 -6 bp -160 bp -1,538k receivers for the net takeout of $55K of long rates forwards Payer spreads:Sell n 2Y2Y F 92bp 01'M ptrierd SS Sell rs p vsa buy 550mnnet V00ai ldniee ffeo reanov tial is frazte orearabelenifnogr itn raitdiaeting a Option 2Y30Y25bp "yersat zero The curve bear flattens 1/2/14 +2 by -10 by -127k eo cost curve payer: e mn 5Y5Y ATMF mid-curve payers vs buy 5Y5Y.has.a limited upside while IY2Y could Option $200mn 1Y2Y ATMF payers for the see significant repricing due to adjustments The curve bear steepens 3/14/14 -18e 0.00 +184k net takeout of 28c of monetary policy Swaps Receive $1,023.4mm 2yly rate Positive carry look at repricing Fed The curve bear steepens 5/20/14 +95 bp +78 bp +1,701k Rv versus pay $1,002.7mm lyly rate swaps Receive $1,023.4mm 2yly rate versus pay $431.2mm iyi y rate and Further rally via Fed delay benefits 2yly rate 2yly underperformance 5/20114 -10 bp -11 bp -179k Rv $597mm 3yly rate Swaps Foiward steePener: Receive fixed on Slope of 10s30s too fiat given level of lOy 11,1 41g1mmmmi W 0y , pay fixed on Rate Curve flattens 3/28/14 +45 bp +34 bp -2,769k Rv Swaps cefiixvv edfiovi22 09n86 rr.t4r1 versus,51 vOryatft j arfo dnv is ahriya orZiagy Tait Oy°4v5ii:reiveirt:IsPreay y Further 10y5y 4/29/14 +22 bp +10 bp -781k nv mm 5y5y and $257.6 mm 15y5y 15ytoward outperformance Cross Buy S1Om each of SPNTAB 2.95% Bank credit +25 bp +9 bp 3/16; SPABOL 2.625% 5/16; DNBNOR Risk-on retightening of covered bonds in stable rates regime underperforms; Eurozone credit crunch; Widening 7/25n3 +37 bp +11 bp -567k Market 2.90% 3116 on ASW. (Sodd) in a rate sell-off +31 bp +11 bp US-Europe spread tightener: Receive Cross fixed in $244 mm USD 5y5y rate vs. US recovery disappoints Spread widens 1/24/14 +127 bp +178 bp -15k Market rate pay fixed on 5165.8mm EUR 5y5y P/L as of 03/26/2015 prices. We stoned &sarong the penbernance °four trade recommendettons on June 1$ 2010. This rabic shows ow current open tecommendattonv a rabic of our dosed posidons is in the bock or publication Both tables wig be a stout feature in the Weedy. PenO1171•7OCO numbers are based on trader end-a'day marks and do not include &Wolfer ;ores& or transaction costs. We consider the relevant benchmark for ow trades b be a rare position given the leveraged or omen* meeker neubal aspects &these trades Thstancal performs/me is no:asuman:ea °Maury performance Scene Deutstiv gent EFTA01123166 27 March 2015 US Fixed Income Weekly United States Rates Dommt Konstam Gov. Bonds & Swaps Research Analyst Rates Volatility 1+1) 212 250-9753 Aleksandar Kocic US Overview Research Analyst 1+1) 212 250.0376 e There are plenty of minefields out there but none are likely to dominate Alex Li what we still think for now is a powerful rational that warrants the current Research Analyst term structure. Long rates are well defined by low to negative term 1+1) 212 250.5483 premium and a low terminal Funds rate. While we still see plenty of reasons why the Fed struggles to lift off making it as hard as it always has been to make money on shorting front rates to say a 3 month forward Stuart Sparks horizon. Research Analyst e There are reasonable risk reward trades that we like including using bullish (+11212 250-0332 rate views to buy cheap risk on protection e.g. on SPX. We also for choice rather receive the market than pay it based on term premium staying very negative (Europe) but also the risk of some softer US data. This would Daniel Sond favor curve caps and some relief steepening. Volatility should be higher in Research Analyst the front end relative to the back end. (+1) 212 250-1407 e The round out for 2014 GDP data was fascinating because like Rip Van Winkle after 5 years of would be accelerating recovery, we realize that Steven Zeng. CM there has been no acceleration - for five years! A rock solid dullness of sub Research Analyst 4 percent nominal growth. And everyone is so afraid of inflation! More (+1) 212 250.9373 importantly it clearly justifies the low terminal funds rate that the market is pricing as it leaves as many questions unanswered in terms of productivity and profits especially. e We look at the potential for Japanese financial sector demand for overseas securities to pick up in 2015 and conclude there is up to $200 billion to come based on dollar yen moving to 130 and recent sensitivities of asset allocation decisions as well as pm-announced pension asset reallocations. e Historically, consistent bullish flattening of 1O53Os has increased the probability of falling CPI yly inflation over the subsequent six months. Bull flattening was pervasive enough to suggest an elevated risk of falling inflation following November, December, and January, and the indicator is hovering around "true" levels at present. e The median bond fund manager will likely finish the first quarter being close to flat to the benchmark. Our excess returns model and SMRA survey responses show that portfolio managers have reduced their exposure to corporate bonds and increased allocation into Treasuries. Still Play the Range Markets seem choppy without a lot of direction. Investors in general seem more occupied with long Eurostoxx, Nikkei and the still the dollar although since the Fed, the "handover" of dollar strength from Europe led to Fed led is undermining. In rates while everyone "wants" higher rates, we are of the view that the market isn't going anywhere and the range should continue to be traded. Our bias is still to buy dips rather than sell rallies. We also think investors should be more convinced not to short the front end. It didn't help you in the rally and it probably won't help you in a rangy market. This suggests carry trades and curve caps are more attractive now than before, relative to outright duration plays. Page 6 Deutsche Bank Securities Inc. EFTA01123167 27 March 2015 US Fixed Income Weekly There are some quiet bear trades that we continue to like. More volatility in the front end than back end; accumulator trades that put you into deferred payers conditional on short rates underperforming their forwards. We also still like cheap risk on protection trades that knock out if rates do breach their forwards. There are lots of issues that will likely roil markets. Greece is unresolved. The US jobs data has been so strong that it could lose a beat. The Fed is entering a decision zone that could rattle risk markets if too aggressive or the back end if too much of a "relent". With falling reserves and the end of bank HOLA purchases, investors are wondering who are the new buyers - especially as fx reserves are now falling, partly China but also petrodollars. Domestic insurance/pensions for now perhaps and maybe Japan again after their year end? While in Europe bonds are hard to come by and the ECB has only just begun! All said and done though 2 percent 1Os seem a very good mid point around which to trade with 5y5y around 2 1/2 percent. Daily realized volatility has been as high as 15 bps compared with more like 5 bps last year. So whatever the conviction, make it less so! Term Structure There has been just one day this year when being short the five year rate made money versus the 3 month forward. So for all the focus on "being in flatteners", it is important to appreciate that flatteners have worked to the extent that the long leg has rallied. Pushing the Fed up till now has been a fool's game. Over the past twelve months it is not much better with 5s beating the forward as around 10 percent of the time and that was concentrated in September before the Fed meeting. Note that the forward on March 6th was exceeded by 2.8 bps. It is hard not to take the moral of the story as not to push the Fed and that was before the latest FOMC meeting. Of course the curve is actually not flattening this year. 5s10s has been impressively stable around 45/50bps. If you can't make money from shorting the front end leg and the curve is stable, by definition this year is being defined by a range and performance is dictated by identifying the limits of that range. The range itself is anchored around a 2 I/2 percent 5y5y rate in our view which is consistent with our original outlook for 2015. If 5s gravitate towards their forwards (but not exceeding them!), 10s can budge a little higher to say 2 Vs percent for a 2 1/2 percent 5y5y rate. 5y5y has already traded close to 2'/4 and back up towards 3 percent as 10s came close to 1 12 / percent and traded in swaps over 2'/< percent. We think what we have seen so far this year remains a good template for trading through q2 and into the second half. Our view remains that we are likely to finish the year when 10s around current levels and 5s still no exceeding their forwards. Deutsche Bank Securities Inc. Page 7 EFTA01123168 27 March 2015 US Fixed Income Weekly l5y5y less 5y I 5Y realized vs. 3mth forward 5 yr rate 2.5 0.2 2 Sy+3mths less 0 1.5 0.1 - 0.2 - . 1 0.3 —5y5y less Sy OA 0.5 At 0 -0.6 3/27/2014 7/27/2014 11/27/2014 3/27/201S 6/27/2014 9/27/2014 12/27/2014 3/27/201S Sant BAN ham.LPond Detsischo Bea Samar Oka**,Mums LP•nd Amway Sant There are three themes that form this outlook and various risk factors that could force a reappraisal and need to be closely monitored. Two, the terminal Funds rate and term premium, relate directly to longer term rates, where we use the 5y5y as a proxy. One, the Fed, relates to the evolution of the front end in terms of the timing and speed of normalization. Terminal funds can be viewed as the sustainable terminal rate for the Fed in the sense that it is an equilibrium i.e. the Fed does not have to keep raising rates or reverse course. 5y5y has been a good proxy for the terminal rate in that it pretty much sits on top of Funds at the end of each cycle -- therefore represents an upper ceiling i.e. the fed would not have had to reverse course if funds never reached 5y5y ex ante. In the Fed's ACM term premium model 5y5y has averaged in 2015 2.59 percent. This is a little higher than the Treasury 5y5y and about 30 bps higher than the market pricing for 5y5y OIS, currently around 2.3 percent. Whichever way we look at it the market is clearly pricing for a terminal Funds rate somewhere around 2 1.6 percent if not a little below. For this rate to be higher we think there would need to be a sustained shock higher in sustainable growth expectations. With 2014 GDP now in, what is once again so impressive is that GDP has not failed to disappoint. Nominal growth finished the year a p