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European Rates Research

11 May 2012

European Rates Weekly

The exit discussion is now . . . open
Overview (p2): this past week has showed there are few FI longs. I think the risk of a yield plunge is higher than a yield sell-off. Watch now for reversal of those Q1 FI->equity trades. This would make you bullish 30s, but 10s remains safe sweetspot, in bunds. Though everyone wins: witness JGBs. The cat is out of the bag. The EMU exit debate is now finally in the open about whether exits would be devastating for the economy or not. We know what we think - it has been perfectly clear for 2 years how EMU will play through. Next steps: markets will educate on what exits looks like, deposit flight risk is next coming big theme.
Andrew Roberts Head of European Rates Research +44 20 7085 1702

Harvinder Sian Senior European Rates Strategist +44 20 7085 6539

Par Magnusson Chief Analyst Scandinavian Rates Strategy +46 8 506 198 79

Euro Area Strategy (p7): Remain bullish core rates for instance still in 3F1Y and at the long end. FRA/OIS basis expected to drift wider but prefer via cheap 1x1 puts in front Euribor or forward basis spreads. The rally to new yield lows in Bunds is not done. Target 10y at 1.25%. 10s30s has flattened back to normal valuations. There is some risk of CVA and Danish long buying. We still like fwd steepeners, with 20y a sweet spot. New Greek elections likely and the hope is disaffected voters back pro-bailout parties. If not, Euro exit risks rise. Absent a pro-Euro response, opening up of exit risk means deposit risk across periphery. Spains bad bank plan: The headline provisions are more realistic but will still be revised higher in our view which is a risk given market conditions. We do not think this plan is enough around the crisis for SPGBs. UK Strategy (p31): 10s30s is too steep, and is tempting; but for now this remains a bear trade, 78% correlated to 10y. We look for the BoE Inflation Report on Wednesday to signal that the MPC has made a small move towards a more neutral bias, but this is discounted. Scandinavian Strategy (p34): The Riksbank prepares for financial war as it establishes a framework for QE and LTRO. Macro data are deplorable in Sweden, so the road to more aggressive monetary policy is paved. We move your profit target levels. Inflation-Linked Strategy (p38): Euro Area fundamentals suggest sticky inflation and a tight supply side. I argue to use the recent steepening to put on breakeven flatteners in 5s30s. In UK RPI, expect directionality in level and curve to remain until we break at least 10bp higher in real yield. The IL62s syndication makes me less positive on the ultra-longs. Volatility Strategy (p 44): Euro Area and GBP volatilities have been very well bid, particularly in the top left in GBP and top-right in EUR. Scope for instability over the coming months is high and I would expect that disaster protection will keep volatility relatively supported. Futures & Options Strategy (p49): Fade the sell-off in front Euribors. Consider EUR 2s10s or 5s30s flatteners. For Short Sterling, prefer high delta put structures in greens vs. selling 99.00-plus calls. Technical Strategy (p56): Bunds have reached the 142.85 target, but displayed signals of possible short-term correction before continuing to move higher. A similar picture is Sweden. EMU Issuance Update (p57): Weekly bond flows (p63), Auction Calendar (p64), Coupon & Redemption (p65), Portfolio of Trade Ideas (p66), Macro forecasts (p71)
Important disclosures can be found on the last page of this publication.

Giles Gale European Rates Research +44 207 085 5917

Simon Peck European Rates Research +44 2033611931

Dmytro Bondar European Rates Research +44 20 3361 4160

Biagio Lapolla European Rates Research +44 2033617597

Brian Mangwiro European Rates Research +44 20 3361 3848

Claire Tucker European Rates Research +44 207 085 8480

Overview: the exit discussion is now open

Andrew Roberts Net: things can only get worse. My key theme of last week that very few are believers in our scenario and so there are very few who are long, let alone limit long, seems the correct theme. I think the risk of a yield plunge is higher than a yield sell-off, especially since all those FI->equity trades in Q1 (when the world was allegedly fixed), have not been reversed yet. This would make you bullish 30s, but 10s remains safer sweetspot, bunds favoured market. But this is not just about bunds: witness the incredible moves in JGBs where shorts are being squeezed. The cat is out of the bag. The debate is now finally - on for Greece, and whether countries can live outside EMU, and whether this would be devastating for the economy or not (I know what I think I show how Greece is a huge winner in total debt terms, if it left EMU and executed a currency or hard default on its debt, its circumstances would be changed). We are extremely clear on this: it has been obvious for a number of years how EMU will play through. It has worked to plan since Q2 2010, so next steps are a) markets will educate now on what exiting looks like, expect chat on Iceland, Argentina, Uruguay, etc; b) next big theme will be deposit flight risk; which in turn makes c) increasing discussion about others being affected. Short periphery. I think the risk now is for a yield plunge. Too many are still looking the wrong way, ie are looking for exit trades on the overriding global financial theme of safe havens rallying. There are many ways to view this, such as via EMU 5y25f, where you can enter a 1x2 spreads and as long as yields are above -6bp in 25 years, you make money. Note that long end EMU, which has been lagging the 5 & 10yr sectors as we would expect in this lower yield move, has seen a strong end of week performance, leaving 10s30s 2bp flatter on the week. And in forward space, such as EMU 5y25f mentioned above, there have been severe downward yield spikes. At the time of writing (Friday afternoon) this is -26bp on the day. A tempting sell at 1.81%? Perhaps, but I will not be selling it. It is clear what is happening no one is long, and eventually this will become an issue for ALM funds. Impossible to time, but not impossible to call as a theme. Also see Simon Pecks very timely UK article about the UK pension fund solvency update this is all very similar to that of EMU, ie, we know there is a mismatch, we know there is a latent bid, and we know that bid will eventually potentially disconnect yields much lower. We want to have such trades onside. We cannot risk a flattener in a bull steepening world, but it does make you more outright bullish. I discussed last week another 3 pointers that show a marketplace that is underweight risk in our safe haven trade (ie long 10y bunds is the sweetspot, or however you wish to position for this, eg 5y5y, or long of lower for longer trades in 1y3f in EMU, or long of 10y UK/US/Canada/Australia/Sweden we will make or lose our years via absolute market-level bets). To recap, those pointers were the violent reaction to the Australian 50bp rate cut; the fact USTs made strong new highs and broke to new yield lows post payrolls despite our survey showing the highest proportion in a year of clients alleging (in advance) they wanted to sell upticks; and the sharp rally in Gilts two weeks ago as many short positions were squeezed out. You could argue in the UKs case that the same has just happened on Friday. After an alleged watershed last Thursday of no more QE from the MPC (merely locking in the move to neutral from Mr Posen/Tucker/MPC minutes even we were not seeing more QE at that meeting), many jumped on the end of QE view, and 10y Gilts took back most of the weeks gains yet they then immediately bounced back the next day.

European Rates Weekly | 11 May 2012 Page 2

Yet again, the market is causing most pain where it can there is enough evidence to suck in bond bears for a day, but the overriding theme is still lower yields (for the record, even with that blowout +8bp day, 10y Gilts rallied net -5bp in the past week). It is dangerous being short any safe haven product given Europe is hastening now to its conclusion. My website of the week: For a great look at how money circulates on a currency exit, click on stamps on notes Is this just about EMU? Not only. Some other very bullish pointers for you before we even start on the biggest theme in Europe deposit flight which will soon be everyones top theme. 1) Sweden this week followed through on end-April proposals to set up a Swedish govt bond portfolio, readying itself for QE if it needs to do so. An SEK10bn fund is not going to excite anyone, and this is just about increasing the available tools to the Riksbank, but the signal it sends is powerful. Well, it is to us - the reaction we were fed back with was old news (it had been suggested on 27 April). Yet 10-yr Sweden has this week moved back below 10-yr Germany for the first time since February. Do read Par Magnussons piece where he discusses the portfolio in detail. UK construction data was revised from -3% to -4.8%, which cuts GDP by an extra -0.14%, which means a revision down in UK Q1 GDP at next print from -0.2% to at least -0.3%. Japan is not on everyones radar screens. We suspect this is partly because yields have been so low for so long that there has been an unwillingness to invest. I remember an old boss, 10 years ago, making the point that global investors had been underweight JGBs in their global govt portfolios for 15 years. Well, not much has changed. Being short JGBs has been a more popular trade in Q4 2011 with growing fears about lack of household sponsorship I certainly had numerous conversations about it in November/December. I can see the reasons why Japan is inevitably a terrible credit in a few years time, but I would not consider that a trade for now. We have just updated our RBS sovereign risk index (which takes into account total debt levels, rule of law, bank assets, loan to deposit ratios, etc), and Japan is now the worst credit in the developed world. Last time published in the year ahead - it was 2nd worst, after Greece. But the idea they sell-off now misses the large corporate surpluses which can and will be put to work, or the policy flexibility to keep JGB yields low (ie, it becomes a yen trade, not an FI trade we will return to this in a year or perhaps longer). Anyway, the point is that all the payer swaptions were entered at 1-1.1% on 10y JGB equivalent, and Japan is showing one of the worlds most violent bond rallies. This is an absolute value world, do not be short any safe havens.



On that subject, read an ECB paper in the monthly bulletin which compares Europe to Japan. My new catchword is Japanification (of Europe). See Giles Gales volatility articles for more (especially last weeks). 1y forwards have converged from 20yrs onwards, but EMU forwards sit substantially higher than Japan further up the curve (eg 1y10f in EMU is 3.06%, over 100bp above the 2.01% in Japan). In my view, another strong support for longs in bunds at 5-10yr sector.

European Rates Weekly | 11 May 2012 Page 3

Gross debt/GDP ratio: EMU is following the identical path to Japan. US and EMU have some optimistic forecasts

. . . and Japan started with a far better primary balance than EMU (& US)

Source: IMF Word Economic Outlook, October 2011; RBS; ECB Monthly bulletin

Source: IMF Word Economic Outlook, October 2011; RBS; ECB monthly bulletin

Leaving aside the interesting charts above, which show that Japan did not start its recession/deleveraging period with terrible numbers, it was the ongoing lack of credit creation, and devastating cut to trend GDP that had such long lasting corrosive effect. One of my big themes some years ago was that trend GDP in Japan had moved from 4.1% in 1990 to sub 1% by the mid 2000s. This is a primary support for much lower structural bond yields in developed majors trend GDP is on its way down once you overlay deleveraging and demographics, the 2 overriding themes in my opinion. The below chart shows how the US is going some way to getting through its deleveraging (well, only in a private sector sense), but EMU has done nothing.
House prices. Adjustments can take a long time

Source: RBS; ECB monthly bulletin; S&P; Fiserv; MacroMarkets LLC; Japan Real Estate Research Institute

We apologise if this does not seem very weekly, but it is absolutely relevant as your big overarching theme. And it goes a long way to explaining why bonds are not rich right now. Sure, they may be close to the rich end of our fair value models for bunds and Gilts, but I would not describe them as over-expensive. It just requires an adoption of the concept of JAPANIFICATION to see that perhaps rates stay long forever (it was only a month ago that many were seeing early Fed & MPC exits etc), and term premia are too high along the curve out to 10 years.

European Rates Weekly | 11 May 2012 Page 4

Back to Europe I introduced last weeks overview with the following view on Greece Greeces elections are woefully under focused on, a no result/weak majority is very possible, we are sceptical of the idea that PASOK/ND are an easy done deal (in financial market estimate terms), and suspect that immediate talk come the week ahead will be about exit & renegotiations. Why was Greece so underdiscussed? This past week has suddenly seen all those telling us that Greece was a one-off with no effect on anything else (well, 10yr Spain is net +28bp on the week) being replaced with the media now starting to talk about the most relevant point as far as I can see it: if a country exits, you have a blueprint, and it risks a bushfire across some European countries. Why? Whether you believe or not that any other country will follow the path that Greece is about to tread (I personally believe they will, but have never wanted to be seen as stoking the fire of the crisis by writing such over the past two years), the prospect of the private sector removing their deposits risks making events self-fulfilling. We suspect many will start discussing Argentina a lot more in coming weeks. Harvinder Sian and Biagio Lapolla write about it at length in this document. Remember that under exits from currency unions, you will not necessarily leave all your debts in other currencies could Hellenic Telecom be paid in new drachmas but have its debt still in euros? which is why Argentina, with its dollarized economy (90% of its mortgages were in USD), just passed a law converting everything to pesos. Once you take this on board, you realise that the key numbers to be following are bank deposit data, which we have been discussing in every meeting for some months. It is not falling off dramatically yet in Italy, but it is doing so in Spain. We have a responsibility not to be overly aggressive in this debate, which we hope you will feel we have not been, and there are many sensitive parties out there, but we have finally reached the point at which a sensible debate can start, about the economic viability of certain countries membership of EMU. I focus on total debt all the time. For me, we are in a debt deleveraging world, and it is ludicrous to just look at government debt. I do not understand why the market concentrates on just government debt. For starters, as Spain showed last week, and everyone did in 2008, bank debts can quickly become government debts! As can household & corporate debts if you turn into recession and bad debts start to rise etc.
Total Debt: Greece is a big winner. Major implications for the economy post-EMU . . .

Source: RBS; McKinsey; Haver Analytics

European Rates Weekly | 11 May 2012 Page 5

As such, the chart above is a favourite in my presentation. Greece is actually a net winner, once you take off the cloud hanging over the country of its un-surmountable government debt mountain. This has major implications for risky asset performance there once they leave the currency zone. This also, sadly, has implications for those who wrongly see Greece as a one-off.
2012 real GDP, change in forecast from Autumn 2011 to May 2012. Spainand EMU
1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 Hungary Lithuania United Kingdom Netherlands Slovakia Romania Luxembourg Euro area Germany Denmark Czech Republic Slovenia Finland Malta Japan China Latvia Portugal Bulgaria Austria Croatia Sweden Belgium Estonia Cyprus Poland France Ireland Greece Spain USA Italy

Source: RBS; European Commission

If global growth were to take off, my theme here would be less powerful. But we are still in a woeful growth environment across EMU (see the growth chart above, still falling, momentum is downward, not upward), debt is being paid down, and we still hold a E5trn forecast cut to total European bank assets. Total debt is without any question going to haunt many economies and Spains total debt is 100% greater than that of Greece. (As an aside, if of interest, the USA does exceedingly well in this regard, total debt is <300%, other winners are Canada and Australia, both at the same level as the USA). This is the essence, for me, of why I do not agree with the idea that Greece is a one-off. Low and weakening growth + high debt levels = continuing upgrades for expected write-downs (such as the E98bn we see for further Spanish bank write-downs under our credit specialist, Alberto Gallos, adverse scenario). One last point. In the week ahead the Eco-fin may ease the fiscal adjustment process, and there is much chat about whether this makes the periphery short trade less solid, since it does throw the sovereigns a life-line? No. The key point is that this is happening in response to some terrible growth forecast revisions, visible in the chart above. Spain is in the unenviable position of having had its 2012 GDP forecast cut by 0.8% even from the last update in February. Harvinder Sian is expressing this via short 10-yr Spain.

European Rates Weekly | 11 May 2012 Page 6

Euro Area Rates Strategy

Harvinder Sian Biagio Lapolla There is no change in strategy or tactics from last week. We remain bullish in core rates with lower for long seen as favouring ongoing exposure to rates such as 3F1Y and also at the long end. FRA/OIS basis is expected to drift wider but ability of the ECB to restrain bank risk is an important variable and means that we prefer to take on only cheap 1x1 puts in front Euribor or longer dated forward basis spreads. In German bonds, the rally to new yield lows is not done. We continue to target 10y at 1.25% and below, if the Euro exit risk is for real, which we think is the case. New Trade: Receive EUR 18m forward starting of the 7y tenor versus paying EUR 3F 2y. 10s30s has flattened back to normal valuations and there is some risk of CVA activity and Danish ALM but not Dutch ALM. We continue to see forward steepeners, with 20y as the new sweet spot on the curve, as attractive. Sovereign Strategy The volatility and higher spreads that we expect come from two sources. Firstly, the Greece Euro exit risk and secondly, the prospect that the ESM will subordinate SPGB and BTPs will see these markets have more self-fulfilling crisis features. New Greek elections are likely and the hope is that disaffected voters come back to pro-bailout parties. If not, then Euro exit risks rise as Europe can not offer a gift sizeable enough to bribe Greek voters to stay the course. This means, on another hung parliament, that Greek government IOUs could trade as proxy currency as early as July. If this does not galvanise a large pro-euro vote intention into accepting Troika demands the actual exit looms. Opening up the Pandoras box of exit means deposit risk across the periphery. The future of the euro would then be dictated by the subsequent policy response. Spains new bad bank plan: We assess the news and the risks for SPGBs. The overall headline provisions are more realistic but will still be revised higher in our view which is a risk given that market conditions are not benign. We think that the provisions for small banks means more private to public sector risk transfer and this will also be necessary to make the bad bank plan work. Ultimately, we do not think this plan is enough around the crisis for SPGBs.

European Rates Weekly | 11 May 2012 Page 7

Lower core rates set to push lower still

The rally in core rates has continued with Bund yields hitting new lows. The near term bias from here is determined largely by the flow of events from Greece (on which we think the markets underestimate risk). Perhaps the most surprising feature of the rally is just how many investors have been looking to fight the move despite the fact that long 10y Bund has been one of the best trending performers with volatility low enough to deliver some attractive Sharpe ratios. Our trading plan for the crisis and the macro data remains vanilla in that both call for Much more ECB accommodation near term (policy easing and further large scale ECB balance sheet expansion). Accommodation to be maintained medium term (lower for longer). Portfolio rebalancing towards core markets favours Bunds, as evidenced in the fact that non resident exposure is rising and this data maps well the decline in Bund yields. Our targets in 2y Schatz remain at negative yields and 10y Bund at 1.25%. Given the heightened risk of a Greek Euro exit (see the Sovereign section) we do not think that 1.25% is a floor for Bunds with levels below 1% feasible on flow.

Is FRA/OIS basis turning higher?

The past few sessions have seen front futures push lower. This partly reflects the long positioning (bullish trades) and the subsequent unwinding but there has also been a hiatus in the lower 3m Euribor fixings. Our models of the 3m FRA/OIS have focused on the correlation with the average Euribor panel banks CDS (our series trims the mean CDS in line with the Euribor fixing calculation). This shows a good broad directionality of the basis but this has broken down since the end of last year. Not so coincidentally this was the period of large ECB balance sheet expansion following the 3y LTRO an operation that Draghi has said is meant to ensure the ECBs lender-of-last-resort functioning.
FRA/OIS versus the trimmed mean Euribor bank panel CDS
450 400 350 300 250 200 150 100 50 0 Jun-10 Feb-10 Apr-10 Oct-09 Dec-09 Bank CDS (left) 3x6 FRA/OIS 90 80 70 60 50 40 30 20 10 0 Jun-11 Aug-11 Feb-12 Apr-11 Dec-11 Oct-11 Apr-12

ECB balance sheet expansion has underpinned banks

3300 3000 ECB Bal Sheet size 2700 2400 2100 1800 1500 Oct-09 EUR mn









Source: RBS

Source: RBS

There are various ways that this could be corrected to arrive at a fair value calculation such as removing the weaker banks and concentrating on only the Prime banks that are the focus of the Euribor question on the lending rate to other Prime banks. The chart below shows a model using the above banks CDS index and the YoY% rise in the ECB balance sheet. The inference is that FRA/OIS risks are still to the upside and that there is cheap optionality in forward basis spreads such as 2y2y and even further out. Alternatively, buy the ERU2 99.25/99.125.

European Rates Weekly | 11 May 2012 Page 8

Higher FRA/OIS basis is likely

90 80 70 60 50 40 30 20 10 0 Apr-11









Source: RBS

European Commission projections for nominal GDP growth

6 5 4 3 2 1 0 GER SPA FRA ITA EMU
Source: RBS

Bund risk premia continue to fall

The European Commission forecasts for growth and inflation make sobering reading for the periphery. The projections for nominal GDP are shown in the chart on the left. The trend lower in bond yields have been partly validated by the drop in nominal GDP across the Euro area. Recall, that Ireland and Spain used to grow at EM style 7% handles. The chart on the left below shows a long times series of Bund 5y5y yields versus a trend of nominal GDP. The difference between these two series is shown in the chart below, on the right, and is something we dub the macro risk premium, which is now clearly negative. We feel that this chart is akin to some of the psychological tests for insanity where a psychiatrist will show the patient an outline picture that is clearly a butterfly but the patient sees only an elephant. Most investors will look at the risk premium chart and see that levels are rich. We look at the chart and see that levels are only as rich as those that prevailed during the LTCM/Asian crises in 1997/98, when (a) central banks had more firepower and (b) the crisis was not Euro centric. Moreover, the risk premia has been in deeper negative territory in the past and by the time this crisis is done, we suspect Bunds will be closer to these historical benchmarks given the need for quality collateral, capital flight and as the debt shuffle from risky paper to safer Euro paper continues.




5y5y Bund yields versus nominal GDP

12% 10% 8% 6% 4% 2% 0% Jan-67 4% Bund 5Y5Y Nominal GDP , exponential MA, (Right) 10% 8% 6%

The risk premium is negative and at 97/98 crisis levels.

3% Risk premium 2% 1% 0% -1%
2% 0%

Risk premium is 5y5y minus moving average of nominal GDP, all minus the historic average

-2% -3% Dec-70






Source: RBS






Source: RBS

European Rates Weekly | 11 May 2012 Page 9

Richer term premium

Our expectation that core rates will continue to push lower is obviously synonymous with flattening risk and lower curvature. To date the lower for longer theme has been played out to 5y but we are expecting longer tenors to 10y to also gain and this throws up some interesting trades. For instance, the spread between EUR 18m forward start 7y and EUR 3F 2y looks attractive versus historical levels. The spread shows some long term mean-reverting features and the fact this spread has crossed the lower two-standard deviations band (based on an eight-year history) makes the risk reward compelling at these levels. The trade shows some directionality, evident when looking at the correlation with 10y swaps. That said, the 32% R-squared is hardly impressive and secondly, the scatter chart on the right suggests that even if rates drop from here, the fact current levels are well below the fair value implied by the OLS regression, makes the trade compelling.
EUR 2Y Swap, 3Y Forward - EUR 7Y Swap, 18M Forward
bp 15 10 5 0 -5 -10 -15 -20 -25 -30 -35 Jun-04

Scatter of EUR 18m 7y and EUR 3F 2y vs. 10y Swaps

15 10 5 0 -5 -10 -15 -20 -25 -30 -35 1.9 2.4 2.9 Rec EUR 18m 7Y vs 3F 2y R = 32%

Rec EUR 18m 7Y vs 3F 2y Sep-05 Dec-06 Mar-08 Jun-09 Sep-10 Dec-11

Source: RBS

EUR 10y Swap 3.4 3.9 4.4 4.9 5.4

Source: RBS

New Trade: Receive EUR 18m forward starting of the 7y tenor versus paying EUR 3F 2y from current -26bp to target -11bp. Place stop loss at -32bp. The carry and roll is negative by 1 bp per month.

Long end swaps reach new lows: will there be an ALM push
The all time low in swaps is causing some concern that forced buying at the long end of the curve may be seen by ALM. This has been partly behind the recent flattening in 10s30s swaps though fast money exiting steepeners has also been very prominent.
Long end swap rates have hit new lows
5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 May-07 Feb-08 Nov-08 Aug-09 May-10 Feb-11 Nov-11
Source: RBS

EUR 10s30s versus 30y swap rate

50y swap

30y swap

40 35 30 25 20 15 10 5 0 2.20


R = 0.0223

30y rate 2.40 2.60 2.80 3.00 3.20 3.40

Source: RBS

European Rates Weekly | 11 May 2012 Page 10

The correlation of the 10s30s slope to 30y levels has been modest in recent years. Our preferred valuation metric is given below where we regress the slope on front end levels, vols and also EUR-JPY long dated forward spreads as rate levels approaching JPY forwards have tended to see lower buying activity and have even generated regulatory shifts. The valuation in the charts below show the recent flattening has corrected the excess steepness.
EUR 10s30s versus fitted level
80 60 40 20 0 -20 -40 -60 -80 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Source: RBS

residual is back to flat now

Fitted 15 10 5 0 -5 -10 -15 -20 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Source: RBS





Going forward, a risk is that ALM or other forced buyers come to buy long end rates. One such flow that has been an influence are CVA desks. This risk still exists but is blunted by a couple of factors. Firstly, many banks have re-struck collateral documentation with sovereigns in recognition of the more risky environment and so the total receiver demand risk has been blunted. Second, the CDS level of Spain is at new highs but the need for CVA desks to hedge this risk is limited owing to the low swaps activity of the Tesoro in the past. Italy CDS is below the peak by some 140bp. Crucially, however, the size of the potential CVA flow is unknown and is likely to continue working against sharp steepening. We do not expect Dutch ALM to be active any time soon. The pension and regulatory system are evolving and there is little appetite to Receive long end rates at these levels and even a feeling that the forced buying of 2008/09 must be avoided. Mercer Consulting even went so far this week as to advise its clients to look for strategic paying opportunities. Danish buying flows may be seen given that the regulatory Traffic Light tests stress down 100bp in rates and some funds are not as well covered in duration terms (given convexity effects) as previously thought. At the same time, the solvency of the sector is not at critical levels so the level of activity on this theme is expected to be sporadic rather than a persistent buying flow. EUR 10s30s can flatten further from here but we are not expecting an aggressive move lower like Q4-11. We continue to prefer forward steepeners such as 10y forward starting EUR 10s30s and EUR 5s10s30s in forwards as Solvency II makes the 20y progressively more important and rates beyond the last liquid point (30y) much more irrelevant for ALM.

European Rates Weekly | 11 May 2012 Page 11

Sovereign Strategy
Harvinder Sian Biagio Lapolla The volatility and higher spreads that we expect come from two sources. Firstly, the Greece Euro exit risk and secondly, the prospect that the ESM will subordinate SPGB and BTPs will see these markets have more self-fulfilling crisis features. New Greek elections are likely and the hope is that disaffected voters come back to pro-bailout parties. If not, then Euro exit risks rise as Europe can not offer a gift sizeable enough to bribe Greek voters to stay the course. This means, on another hung parliament, that Greek government IOUs could trade as proxy currency as early as July. If this does not galvanise a large pro-euro vote intention into accepting Troika demands the actual exit looms. Opening up the Pandoras box of exit means deposit risk across the periphery. The future of the euro would then be dictated by the subsequent policy response. Spains new bad bank plan: We assess the news and the risks for SPGBs. The overall headline provisions are more realistic but will still be revised higher in our view which is a risk given that market conditions are not benign. We think that the provisions for small banks means more private to public sector risk transfer and this will also be necessary to make the bad bank plan work. Ultimately, we do not think this plan is enough around the crisis for SPGBs.

Trading plan update

There is little new in the tactical game plan as we are maximum long Bunds and short periphery. If anything, we would want to raise sizes on the periphery shorts into the likely Greek election as exit risk is deemed higher than the market thinks. Moreover, we continue to think the ESM is a crisis accelerator. As such, we still think our risk and trading calendar timing motivates moving from tactical risk to structural stress trades. What is the biggest near term positive? If this weekends German NRW election brings a federal government containing the SPD closer. We remain in full size risk in BTP 2s10s flattener using BTP 2.25% Nov-13 and 5% Mar-22s, with a target of 150 bp initially. Stay outright short SPGB 3.15% Jan16s. The initial target was 4.50% and then 5.0%. We are approaching our anticipated summer risk-off moves so target now 7%+. Stay long DBR2 01/22 versus FRTR3 04/22 (DV01 weighted) from 135 bp to target 200 bp initially and place stop below 100 bp. Short Italy versus Spain in 2026 paper. The fate of Italy and Spain is unlikely to be separated as far as the ESM is concerned and so current spreads at this point of the curve look attractive. Remain in Bund ASW widening box versus Bobl; Remain in Dutch 5s10s steepening versus France; Remain in short DSL versus RFGB in 2028 bonds. We are also long German 5y CDS protection from our Year Ahead publication and keep the trade. The long Bunds view is driven by a flow argument but that does not mean Germany is impervious to the crisis. The heatmaps of cross-market bond spreads and EGB slope spreads presented below show some potential interesting trades.

European Rates Weekly | 11 May 2012 Page 12

EGB rich-cheap heatmap

EGB 2y
ATS BEF FIM FRF DEM IEP ITL NLG PTE ESP 2 ATS 1.37 1.07 0.03 1.07 0.83 0.02 0.02 0.76 1.53 1.98 BEF 1.07 1.22 0.80 1.11 1.00 0.54 0.78 0.99 1.38 2.40 FIM 0.03 0.80 2.78 1.09 2.03 0.01 0.01 1.88 1.49 1.82 FRF DEM 1.07 0.83 1.11 1.00 1.09 2.03 1.39 0.56 0.56 1.67 0.08 0.13 0.11 0.18 0.41 0.48 1.56 1.56 1.79 1.40 IEP 0.02 0.54 0.01 0.08 0.13 0.23 0.01 0.11 1.45 0.95 ITL NLG 0.02 0.76 0.78 0.99 0.01 1.88 0.11 0.41 0.18 0.48 0.01 0.11 0.31 0.16 0.16 2.49 1.45 1.53 1.60 1.61 PTE ESP 1.53 1.98 1.38 2.40 1.49 1.82 1.56 1.79 1.56 1.40 1.45 0.95 1.45 1.60 1.53 1.61 1.60 1.75 1.75 1.31

The tables to the right present a rich-cheap heatmap, based on 100d history Z-scores. Each point in the matrix shows the Z-Score for a given market spread. A positive number means the countries on the column header is trading Cheap (or Steep, in the case of slope spreads) versus the country on the row header. The numbers on the main diagonal are simply the z-score of a single market. For instance, the -1.12 number in the first cell of the EGB 2y matrix says that RAGB 2y are trading 1.21 standard deviations below their 100d average. We have not added Greece to the study to avoid distortions in the analysis.

EGB 5y
ATS BEF FIM FRF DEM IEP ITL NLG PTE ESP 5 ATS 1.47 0.64 0.37 1.53 0.59 0.62 0.31 0.71 1.15 2.13 BEF 0.64 1.16 0.53 1.04 0.62 1.05 0.71 0.70 1.11 2.05 FIM 0.37 0.53 2.24 0.81 0.90 0.43 0.16 1.04 1.16 2.04 FRF 1.53 1.04 0.81 1.24 0.13 0.31 0.00 0.02 1.20 2.12 DEM IEP ITL 0.59 0.62 0.62 1.05 0.90 0.43 0.13 0.31 2.20 0.29 0.29 0.02 0.03 0.63 0.35 0.26 1.18 1.34 1.90 0.89 NLG 0.31 0.71 0.71 0.70 0.16 1.04 0.00 0.02 0.03 0.35 0.63 0.26 0.31 0.01 0.01 2.51 1.16 1.17 1.41 2.10 PTE ESP 1.15 2.13 1.11 2.05 1.16 2.04 1.20 2.12 1.18 1.90 1.34 0.89 1.16 1.41 1.17 2.10 1.26 1.40 1.40 1.66

EGB 10y
10 ATS BEF FIM FRF DEM IEP ITL NLG PTE ESP ATS 1.85 0.20 0.56 1.52 0.36 0.48 0.50 0.73 1.37 2.20 BEF 0.20 1.23 0.44 1.00 0.32 0.89 0.80 0.54 1.32 2.04 FIM 0.56 0.44 2.24 0.54 1.02 0.20 0.26 0.82 1.36 2.00 FRF 1.52 1.00 0.54 1.39 0.72 0.04 0.15 0.25 1.41 2.24 DEM 0.36 0.32 1.02 0.72 2.37 0.27 0.31 1.16 1.35 2.02 IEP ITL 0.48 0.89 0.20 0.04 0.27 0.33 0.23 0.11 1.49 1.21 0.50 0.80 0.26 0.15 0.31 0.23 0.19 0.18 1.40 1.15 NLG 0.73 0.54 0.82 0.25 1.16 0.11 0.18 2.32 1.36 2.05 PTE ESP 1.37 2.20 1.32 2.04 1.36 2.00 1.41 2.24 1.35 2.02 1.49 1.21 1.40 1.15 1.36 2.05 1.50 1.65 1.65 1.67

EGB 2s5s
25 ATS BEF FIM FRF DEM IEP ITL NLG PTE ESP ATS BEF FIM 1.36 1.37 1.37 1.00 0.76 1.03 1.21 1.05 0.44 1.48 0.78 0.34 0.70 0.68 0.26 1.27 0.81 0.40 0.58 0.30 FRF 0.76 1.03 0.76 0.10 2.24 0.67 0.46 0.72 0.72 0.40 1.21 1.05 0.10 0.53 1.21 0.64 0.40 0.52 0.68 0.38 DEM IEP ITL 0.44 0.78 1.48 0.34 2.24 0.67 1.21 0.64 2.21 0.87 0.87 0.62 0.93 0.57 1.46 0.78 0.85 0.18 0.73 0.55 0.70 0.68 0.46 0.40 0.93 0.57 0.29 0.68 0.55 0.17 NLG PTE ESP 0.26 0.81 0.58 1.27 0.40 0.30 0.72 0.72 0.40 0.52 0.68 0.38 1.46 0.85 0.73 0.78 0.18 0.55 0.68 0.55 0.17 1.61 0.74 0.57 0.74 0.63 0.42 0.57 0.42 0.31

EGB 5s10s
510 ATS BEF FIM FRF DEM IEP ITL NLG PTE ESP ATS BEF 0.25 0.93 0.93 0.86 0.30 0.69 0.07 0.86 0.63 1.25 0.72 1.10 0.57 0.01 0.32 1.05 0.79 0.74 1.45 1.83 FIM 0.30 0.69 0.79 0.44 1.33 0.78 0.37 1.00 0.80 1.64 FRF 0.07 0.86 0.44 0.64 1.34 0.63 0.52 0.66 0.81 1.58 DEM 0.63 1.25 1.33 1.34 1.69 0.27 0.99 0.98 0.88 1.17 IEP ITL 0.72 1.10 0.78 0.63 0.27 0.43 1.08 0.47 1.02 0.19 NLG PTE ESP 0.32 0.79 1.45 1.05 0.74 1.83 1.00 0.80 1.64 0.66 0.81 1.58 0.98 0.88 1.17 0.47 1.02 0.19 0.81 0.70 2.03 0.01 0.83 1.78 0.83 0.84 0.95 1.78 0.95 1.39
Source: RBS

0.57 0.01 0.37 0.52 0.99 1.08 0.66 0.81 0.70 2.03

European Rates Weekly | 11 May 2012 Page 13

Key events with some comments on influence for markets where appropriate


German regional election in North Rhine-Westphalia Eurogroup/ECOFIN meeting Redemption of foreign law bonds Francois Hollande inaugurated as French president President appoints caretaker govt if coalition absent Greek redemption 5.25% May 2012 GGB E3.334bln G-8 summit EU leaders summit on growth compact German final vote on ESM & fiscal pact EU Head of State Summit Deadline for Spanish bank to submit recap plans

Will be assessed for implications on the German Federal election in Sep-13. NRW losses for the SPD precipitated the fall of the last SPD/Green government and while this is possible for the CDU/FDP, it remains an outside risk. May 15 due date for 435.9m foreign-law bond; redemption has 15-day grace period Francois Hollande meets German Chancellor Angela Merkel in Berlin for the first time since his election

14/15May EMU 15-May 15-May 16-May 18-May Greece Fra/Ger Greece Greece

18/19May G8 25-May 25-May 25-May 31-May EMU Germany EU Spain

Interest in IMF funding for Europe. The Heads of State summit will review EMU budget plans, rubber stamp plans to expand the EIB, deploy stability pact funds and attempt a compromise on EMU fiscal targets Tentatively planed for 25 May. Expected to finalise support for the firewalls. Polling suggests this will pass, but at this stage it is unknown precisely what the fiscal compact will be, given especially French demands. The polling however suggests that the No campaign is making up ground and there are large amounts of undecided votes. Note that this date may be changed and that if it is No access to the bailout facilities could be problematic. Up to 4-notch downgrades possible and while markets will eventually adjust the ratings related mandates mean some fallout expected. The delay in the Moodys report could be more protracted.



Referendum on Fiscal Compact

01-Jun June Early June 10 -June 10 -June 14-Jun

EU EMU Global Greece France EU

EC Presents Draft Rules on Shadow Banking Euro area deadline for bank recaps Moodys ratings reviews on banks Earliest date for new Greek elections (most likely on June 17) France to Hold Legislative Election (1st Round) Eurogroup meeting Leaders of G20 gather for a summit IMF reviews for Portugal/Ireland France to Hold Legislative Election (2nd Round) Head of State Summit The EC will issue country specific recommendation on their budget and reform plans Eurogroup meeting Eco-Fin Meeting EU leaders summit Deadline for banks for 9% Tier 1 Capital Ratio Audit of pubic finances

French Legislative Election. All 577 member seats in the assembly including overseas possessions go to election. In Mexico. Ireland widely expected to be on track but with more budget cutbacks needed. Portugal largely on track but more remedial measures also likely. French Legislative Election. All 577 member seats in the assembly including overseas possessions go to election.

15/17 Jun G20 15-Jun 17-Jun IMF France

18/19 Jun G20 19-Jun 21-Jun 22-Jun EU EU EU

The recommendation will be then ratified at the EU heads of State meeting

28/29 Jun EU 30-Jun Late Jun ?? France



IMF review



ESM starts life (though there may be delays)

France's public audit office, finishes a "special audit" of public accounts. We expect deficits to be revised higher and test whether budget targets which in turn are likely to be contingent on the economic outlook. Weakness here may see any Hollande pursue a more Keynesian agenda. Greece expected to miss targets and remedial measures will be demanded which we expect to be problematic for the new Parliament, but some scope to view Sep review as more important. Firewall headline likely to be near 1trn total (with EFSF & IMF) = sounds like a bazooka. It is dangerous, in our view, because (1) politicians will take more risks with Greece in belief a firewall works (2) firewall subordinates periphery debt. The probability of default does not fall far enough to mitigate lower recovery because there is not enough money to carry Spain & Italy through an economic cycle, and other normal shocks. Risk-on initially (on idea of bazooka) then ESM to drag yields higher, as the ECB steps back.

01-Jul 30-Jul Jan-2013

Italy Spain EMU

BTP bond redemption for E17.06bln Bond redemption for E12.9bln CAC documented bonds will be issued for all EGB >1y The EMU govt bond CAC project is found on
Source: MarketNews, Reuters, Bloomberg, RBS

European Rates Weekly | 11 May 2012 Page 14

Paths towards a Greek end-game

New Greek elections are likely. The hope is that disaffected voters come back to pro-bailout parties. If not, Euro exit risks rise. We do not think Europe can offer a gift sizeable enough to bribe Greek voters to stay the course. This means, on another hung parliament, that Greek government IOUs could trade as proxy currency as early as July. This may then galvanise a large pro-euro vote intention into accepting Troika demands. If not, exit looms. Opening up the Pandoras box of exit means deposit risk across the periphery. The future of the euro would then be dictated by the subsequent policy response. New Greek elections will be a referendum on the Euro The Greek political establishment is trying to cobble together a coalition and while the leading parties, New Democracy and SYRIZA, have attempted and failed, there is a residual hope that PASOK may be successful. Its leader, Evangelos Venizelos, is courting the Democratic Left leader Fotis Kouvelis though this also includes the negotiation of a gradual disengagement from bailout austerity measures. No party in Greece has a mandate to rewrite the bailout austerity measures and the comments from EU officials suggest there is little scope for large changes a point we made in Greece: updated thoughts (7 May) when we argued that it is hard to see anything other than token efforts to relieve some of the austerity pain for Greece. In terms of commentary: the rhetoric from core Europe, there is little confusion over what Greece needs to do: ECBs Jrg Asmussen: Greece needs to be aware that there is no alternative to the agreed reform programme if it wants to remain a member of the Eurozone. German Foreign Minister Westerwelle: If Greece ends the reform process it has undertaken, then I cant see that the respective tranches [of aid] can be paid out. German Chancellor Merkel: It is of utmost importance that the programs that we agreed on with Greece continue to be implemented. The process is a difficult one, but despite that it should go on. German Finance Minister Schuble: If Greece does not decide to stay in the Eurozone we can't force them to stay in it. Former SPD Finance Minister Steinbrck: If I had political responsibility, I would want to prepare myself for a plan B in which the Eurozone is no longer necessarily composed of 17 members. (Bloomberg)

European Rates Weekly | 11 May 2012 Page 15

In other words, any compromise coalition while likely to be welcomed near term is likely to unravel as the full scale of the austerity programme demands comes clear with 11.5bn in new austerity measures needed as the first policy action. (The details of the MoU are presented on the next page.) Equally, Greece may simply move to new elections, most likely on 17 June or perhaps as early as 10 June. A short-lived coalition or new election should not be a surprise. After all, and as the election results below show, the bulk of the population voted against the austerity programme which is hardly a surprise five years into a recession that is verging on depression, with an unemployment rate of 21.7% in February 2012.
Greek election result, % of vote
Democratic left, 6.1 Golden Dawn, 7.0 New Democracy , 18.9

Greek election result, seats allocated to parliament.

Democratic Golden Dawn, left, 19 21 Greek Communist party, 26 New Democracy , 108

Greek Communist party, 8.5

Independent Greek, 33

Independent Greek, 10.6

Radical Left Coalition, 16.8 PASOK, 41 PASOK, 13.2

Source: Bloomberg, RBS

Radical Left Coalition, 52

Source: Bloomberg, RBS

It is particularly perturbing that unemployment is 53.8% for those aged below 24 years and a still a very high 29.1% for those between 25-34 years. It is these age cohorts that historically tend to be antagonists for change.
Unemployment rate by age cohort (February 2012)
60 50 40 29.1 30 20 10 0 15-24 years old 25-34 35-44 45-54 55-64 17.6 16.2 11.2 % 53.8 Feb-2012

General government employment

800 700 600 500 400 300 200 100 0 end-2009 end-2010 Nov. 2011 Target
Source: EC,

Source: El.Stat, RBS

Moreover, the MoU outlines plans to cut an extra 150,000 staff from the general government sector. This compares to a total employment level of 664,223 persons (as at November 2011), and so represents a total cut of 23%. While this is a necessary condition for Greek solvency, it also means that highest political hurdles are yet to come if the MoU is to be followed, especially given the post military-rule history of Greek parties buying votes with public sector largesse. Put simply, the disenfranchisement of large elements of the population to the Troika and, we suspect, eventually to the Euro is not accidental.

European Rates Weekly | 11 May 2012 Page 16

Prior to first disbursement of the new programme, the government is to adopt the following measures, according to the latest MoU:
Reduction in pharmaceutical expenditure by at least 1.076bn in 2012. Reduction in overtime pay for doctors in hospitals by at least 50m. Reduction in the procurement of military material by 300m (cash and deliveries). Reduction by 10% in the remuneration of elected and related staff at the local level and reduction in the number of deputy mayors and associated staff in 2013 with the aim of saving at least 9m in 2012 and 28m in 2013 and onwards. Reduction in the central government's operational expenditure and election-related spending by at least 370m (compared to the 2012 budget), of which at least 100m is to come from military-related operational expenditure, and at least 70m from electoral spending. Reduction in operational expenditure by local government with the aim of saving at least 50m. Frontloading cuts in subsidies to residents in remote areas, and cuts in grants to several entities supervised by the several ministries, with the aim of reducing expenditure in 2012 by at least 190m. Reduction in the public investment budget of 400m. Changes in supplementary pension funds and pension funds with high average pensions or which receive high subsidies from the budget and cuts in other high pensions, with the aim of saving at least 450m (net after taking into account the impact on taxes and social contributions). Cuts in family allowances for high-income households, with the aim of saving 43m. Prior to the disbursement, the government also is to adopt the following pending acts: Ministerial Decisions for the implementation of the business tax (minimum levy on the self-employed) provided for in Article 31 of Law 3986/2011; Ministerial Decisions to complete the full implementation of the new wage grid in all the pertinent entities, and legislation on the modalities for the recovery of wages paid in excess from November 2011 on. By end-June 2012, the government is to legislate an average reduction by 12% in the so-called 'special wages' of the public sector, to which the new wage grid does not apply. This will apply from 1 July 2012 and deliver savings of at least 205m (net after taking into account the impact on taxes and social contributions).
Source: IMF, EC

Exit threat: the only bargaining chip

We had expected a mixed election result and one that would begin to test markets on the idea of the Greek EMU exit risk. The rationale for this view (which alongside the activation of the ESM) is seen as a key structural story behind wider EGB spreads this summer). On Greece the situation is clear. The threat of another default from core EMU to Greece makes little sense as the bulk of loans to Greece are now in official hands and the PSI bonds are pari passu. Greece would embrace a default that means less pain and reform but markets would question just how it can remain in the Euro long term given that competitiveness and governance issues have not been addressed. Given the weak bargaining position of core EMU to Greece, in the likely event of Troika non-compliance, the only feasible threat that may work in motivating real reform is the threat of exit from the Euro. Core Europe will have noted that 80% of the population wants to remain in the Euro but there is an equally high portion of the population that is against the austerity programme.

The exit threat is credible, a priori We believe if there is a time in which core EMU may play the Greek exit card, it is when the ECB is backstopping banks and the ESM/EFSF/IMF firewall is in place. The latter is intended from July 2012. Given this, politicians may reason that contagion costs will be limited or at the least would be more inclined to take that gamble. Second, the ability of Greece to survive in the Euro, even on a larger debt relief, is limited in the absence of economic restructuring. Third, politicians have hinted at this threat before and the distrust is high enough to mean Greek bondholders get paid from an escrow account separate to other Greek bailout money. The main argument against core EMU exercising the exit threat is the contagion it poses to other periphery countries, something that we explore below. Note that this does not prevent the a priori threat of exit. The ex post action of core EMU will surely depend on the scale of the contagion to the rest of Europe, but there will be no easy choices here for the political elite as caving in to the fear of a Greek exit by offering Greece fiscal gifts will lead to huge moral hazard and a race to the bottom. If this were to be the case, then we would expect to hear about new bailout discussions which would involve more money for Greece.

European Rates Weekly | 11 May 2012 Page 17

Assessing the paths for Greece

Latest Greek polls (10 May) show a rise in voting intention for SYRIZA vs election results
Democratic -1.9 left

In the chart on the next page, we outline various paths Greece may take; under the assumption of new elections (which are seen regardless of any near-term coalition deal). Our heavy bias is to an eventual exit of Greece from the Euro (90% risk in our view) but the exit risk for 2012 is path dependent on choices that are made, both by Greece and core EMU countries. One of key takeaways is the reflexive nature of the choices the Greek electorate and core EMU will make in response to market pressure and prior choices. The most straightforward case for Greece is that new elections are seen as a genuine Euro referendum and that disaffected voters flock back to ND and PASOK to actually implement the reforms. As the chart on the left shows, there is nothing in the polls that points that way. If the pain is taken, then this will be deemed a success, but Greece will still require a large debt relief in the future. If the austerity programme fails to be delivered or new elections produce another antibailout configuration, then we see risk markets selling off on fear of a Greek Euro exit. At this juncture, there are various options for core EMU. If core policymakers panic on market risks and perhaps general periphery deposit risk, and offer Greece a pass with effective fiscal transfers, then the situation is soothed near term but increases risk of a race to the bottom further out as incentives for reform elsewhere get destroyed. It is not easy to fix Greece this way without huge moral hazard. Conversely, if core EMU is either politically unable or unwilling to give over more resources to Greece, then we see risk of a Greek Euro exit rising more materially. This is likely to be accompanied by sharp contagion. If the crisis so far has been about removing debt risk from non-residents to domestic and official hands as risks become apparent, then the next stage of the crisis on Euro exit is more dangerous. At this stage there are two genies that need to be put back in the bottle. First, on Greece: If there is no payment to Greece then, given a primary deficit, the government is likely to issue IOUs akin to those seen in Argentina to pay pensions and other benefits. If this scares the population into pro-bailout policies then the process begins again. If there is no appeasement with the MoU, then matters are likely to move quickly to a new Greek currency involving lots of social and economic risk. Second, and for the rest of EMU, this will also be a defining moment. One avenue is the contagion will require a huge response from politicians to move forward with political and fiscal union that involves commitment to Euro-wide bank regulation, deposit insurance, and eventually Eurobonds. None of this can be done quickly, so in the interim, there will be uncertainty but also the need for the ECB to step in with huge system support. In this instance, given possible trauma in markets, the ESM may need a bank licence with the ECB. The stresses may also involve further balkanisation of the ECB balance sheet where financial risks become yet more domestic via use of ELAs though the NCBs. This does not have to mean break-up; but it does have parallels with the Russian currency break-up and, if most of the risk is between governments, then break-up costs are themselves more muted. Where do we think the crisis is heading? Our probability of 90% that Greece will exit is a medium-term assessment based on social risks from persistent and higher unemployment. The risk for 2012 is harder to pin down given the dimension of alternative paths outlined above but forced to put a number here, we assess 50%.

Golden -2.1 Dawn

Greek Communist -2.5 party

Independent -1.9 Greek

PASOK -2.4

Radical Left Coalition


New Democracy






Source: RBS, Bloomberg

European Rates Weekly | 11 May 2012 Page 18

Where will the Greek drama end? The schematic shows the broad contours of risks and developments in markets with subsequent policy maker reactions.

Pro-bailout countries get a mandate for Troika reforms

New Greek elections

No popular consent for bailouts as the depression bites and unemployed have a low stake in the . Greeces history of buying votes via public sector largesse means there is not enough critical mass to support the reforms not matter voter views on the itself.

3rd elections

Greek electorate reconsiders its destructive stance


Reforms enacted with GDP and employment eventually rising and deposits return to Greece.

Try to enact and implement austerity & reforms

Failure: political/ social and/or economic (growth continues to slide)

Markets drop in Greece with large cross border contagion possibly including bankruns across the periphery

Greece issues government IOUs in paying state benefits with the idea that these can be money-good in Greece and eventually for Euro cash. Greece accuses EMU & Germany of trying to starve it into submission

Debt overhang still huge. A few years later another default is needed but this one cements Greeces place in the Euro given earlier reforms restore competitiveness and erode corruption. Core EMU panics. Wants a quick fix offers Greece fiscal gifts in the guise of a new bailout (Bailout 3.0). IMF still can not contribute.

Core EMU panics in response to the markets but can not coordinate a fiscal gift to Greece owing to domestic political risks.

EMU decides to stop payments to Greece based on concerns about precedent and helped by a ECB backstop for banks & fiscal firewalls.

IOUs defacto new currency (mimics Argentina) = EMU exit

Cross border contagion is large and with risks of bank runs in the periphery. Mervyn King: "Once a bank run has started, it is rational to join in.

Negotiations on a more orderly exit (e.g. a reverse ERM & free trade)

Economic/social consequences very high: capital controls and military support.


A move towards a transfer union would take another huge step and one where risk is increasingly shared among members without conditionality. This will ultimately destroy Bunds.

Crisis galvanises an aggressive political response via political & fiscal union, including wide deposit insurance. Vast ECB balance sheet expansion is necessary in the interim to prop up EMU.

Germany decides further mutualisation of risk can not occur (probably also eyeing political failure) so contagion impact (e.g. deposit outflow) can be compensated via local NCB based ELAs with oversight from Frankfurt. This would look like the Russian (CIS) currency break-up.


European Rates Weekly | 11 May 2012 Page 19

RBS Rates Research

Source: RBS

When does Greece run out of money?

The IMF programme details are given in the table below. There is no breakdown in terms of actual dates in the quarter. Officials, however, have noted that Greece will run out of money in July (See for instance German Deputy Foreign Ministers comments). In terms of Greeces cash requirements: There is a debt servicing need on 15 May for foreign law bonds (450m) but this bond has a grace period of 15 days. There is also 3.3bn of GGBs, which issues owed to the ECB/EIB from the Greek PSI. The Commission has indicated the next tranche of the loans to Greece are 5.2bn (10 May) and it appears that only 4.2bn of the total has been released.
Schedule of disbursement for the new programme (provisional)
2012 Q1
Financing needs A. General government cash deficit Primary deficit ("-" is surplus) Interest payments B. Other government cash needs Estimated cash adjustments Arrears Cash buffer ESM capital C. Maturing debt Bonds & loans after exchange Bonds after exch. (inc ECB hdgs & inelig.) Loans EU repayment IMF repayment Short-term debt (reduction with official funds) D. Cost of PSI Cash upfront Bank recapitalisation E. Gross financing needs (A.+B.+C.+D.) Financing sources F. Private financing sources Market financing Privatisation 1/ G. Additional OSI GLF margin reduction (retroactive) ANFA profits H. Financing needs per quarter I. Official assistance disbursements IMF disbursements* EU disbursements EU disbursements 0.0 0.0 0.0 0.0 0.0 0.0 57.1 75.7 1.6 74.0 0.0 0.0 0.0 0.9 0.2 0.7 18.6 31.3 1.6 29.6 1.0 0.0 1.0 0.2 0.2 0.0 31.3 5.0 1.6 3.4 2.2 0.0 2.2 0.0 0.0 0.0 5.0 8.3 1.6 6.7 1.1 0.0 1.1 0.0 0.0 0.0 8.3 8.8 1.6 7.1 1.1 0.0 1.1 0.6 0.0 0.6 8.8 4.8 1.6 3.2 1.1 0.0 1.1 0.0 0.0 0.0 4.8 2.3 1.6 0.6 1.1 0.0 1.1 0.0 0.0 0.0 2.3 6.7 1.6 5.1 1.1 0.0 1.1 0.0 0.0 0.0 6.7 12.3 1.6 10.7 1.1 0.0 1.1 0.5 0.0 0.5 12.3 3.6 1.6 1.9 1.1 0.0 1.1 0.0 0.0 0.0 7.1 3.6 1.6 1.9 1.1 0.0 1.1 0.0 0.0 0.0 2.1 2.1 1.6 0.4 11.8 0.0 11.8 2.2 0.5 1.7 164.5 164.5 19.8 144.7 6.9 0.5 6.4 1.0 1.0 0.0 0.0 0.0 4.8 4.8 4.6 0.2 0.0 0.0 0.0 44.5 29.5 15.0 57.1 1.8 0.5 1.3 1.2 0.3 0.0 0.0 0.9 6.4 4.4 3.7 0.7 0.0 0.0 2.0 10.0 0.0 10.0 19.5 1.8 0.5 1.3 1.6 0.3 1.3 0.0 0.0 5.3 3.3 3.1 0.2 0.0 0.0 2.0 23.8 0.0 23.8 32.5 1.8 0.5 1.3 3.0 0.3 2.7 0.0 0.0 2.4 0.3 0.0 0.3 0.0 0.0 2.0 0.0 0.0 0.0 7.2 4.2 -0.9 5.2 1.5 0.5 0.8 0.3 0.0 3.7 0.6 0.4 0.2 0.0 0.0 3.1 0.0 0.0 0.0 9.4 1.5 -0.9 2.4 1.9 0.5 0.8 0.3 0.5 7.0 7.0 6.5 0.5 0.0 0.0 0.0 0.0 0.0 0.0 10.5 0.7 -0.9 1.6 1.5 0.5 0.8 0.3 0.0 3.8 3.1 2.8 0.2 0.0 0.7 0.0 0.0 0.0 0.0 5.9 0.8 -0.9 1.7 1.5 0.5 0.8 0.3 0.0 1.1 0.1 0.0 0.1 0.0 1.0 0.0 0.0 0.0 0.0 3.4 3.1 -2.3 5.5 1.4 0.4 0.0 1.0 0.0 3.3 2.0 1.8 0.2 0.0 1.3 0.0 0.0 0.0 0.0 7.8 0.2 -2.3 2.5 1.8 0.4 0.0 1.0 0.5 11.9 10.0 9.3 0.7 0.0 1.9 0.0 0.0 0.0 0.0 13.9 -0.9 -2.3 1.5 1.4 0.4 0.0 1.0 0.0 7.7 5.9 5.6 0.3 0.0 1.9 0.0 0.0 0.0 0.0 8.2 -0.6 -2.3 1.8 1.4 0.4 0.0 1.0 0.0 2.4 0.1 0.0 0.1 0.0 2.3 0.0 0.0 0.0 0.0 3.2 21.3 -11.0 32.3 19.1 5.3 7.0 5.0 1.8 59.9 41.6 37.9 3.7 0.0 9.1 9.2 78.3 29.5 48.8 178.6

2013 Q3 Q4 Q1 Q2 Q3 Q4 Q1

2014 Q2 Q3 Q4 Total


Source: European Commission, IMF, RBS

European Rates Weekly | 11 May 2012 Page 20

Contagion: hard to avoid

One of the key lessons from the LatAm crises was the interdependence of the regions. For instance, the Argentina default was well anticipated but economic integration with Uruguay provoked a severe crisis with a loss of one-third of bank deposit and a loss of two-thirds of FX reserves, with a subsequent banking crisis and deep recession. The Argentina crisis then partly contributed to the subsequent Brazilian crisis in 2002 on the misconception that default was commonplace. The financial integration of Europe is even more profound and the big worry for the region must be in deposit risk if the Pandoras box of break-up is opened. After all, a Euro in Germany is fungible exactly with a Euro in the periphery, and if this were to be seriously questioned then the risk of cross-border deposit flight becomes real. Partly, this is due to the fact that if nothing happens then only shoe leather costs have been wasted. A key part of the crisis to date has been the de-risking to periphery debt by non residents, but it is also important to note that deposit erosion is already here. The charts below show the deposit in the programme countries and Spain and Italy.
Non-MFI deposits excluding central government ( bn)
250 240 230 220 210 200 190 180 170 160 150 Jan-09 (EUR bn) Greece Portugal Ireland

Non-MFI deposits excluding central government ( bn)

1760 1740 1720 1700 1680 1660 1640 1620 Spain Italy (rhs) 1600 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 1250 1200 1150 1100 (EUR bn) 1450 1400 1350 1300

Jun-09 Nov-09 Apr-10 Sep-10 Feb-11


Source: RBS , ECB

Source: RBS, ECB

The most risk averse elements of the deposit base tend to be non-domestic corporate or even domestics where often there is a bank or country ratings threshold to consider. In the case of Spain, the erosion of non financial corporate deposits is interesting already and we think that the risks on any actual serious Euro break up tension will point in the same direction.
Spanish non financial corporate deposits (YoY %)
25% 20% 15% 10% 5% 0% -5% -10% -15% Jan04 Jan05 Jan06 Jan07 Jan08 Jan09 Jan10 Jan11 Jan12
Source: RBS, ECB

Italian non financial corporate deposits (YoY %)

Italy 20% 15% 10% 5% 0% -5% -10% Jan04 Jan05 Jan06 Jan07 Jan08 Jan09 Jan10 Jan11 Jan12


Source: RBS, ECB

It is possible for bank deposits risk to become a cross-border feature. It would be an analogue of BoE Governor Mervyn Kings remark that: "Once a bank run has started - it is rational to join in.

European Rates Weekly | 11 May 2012 Page 21

Summing up
We have been expecting Greek exit risk to rise. The austerity push is getting to a tipping point for the social and electoral fabric of the country. We are convinced that any new election will clearly be seen as a referendum on the Euro as core EMU countries will have no other way to impress upon Greece the need to stay the course. This may work but there is little basis to make that judgement at present. If the anti-austerity vote remains strong and in the absence of large fiscal gifts to Greece that 1) may not be politically feasible to deliver and 2) would encourage huge moral hazard then the risk of a Greek Euro exit in 2012 rises notably. A failure to make the bailout payments could see IOUs trade as proxy Greek currency as early as July. If these IOUs remain, because the electorate still is not willing to observe the reforms, then the exit will be cemented. Just how the rest of Europe reacts here will dictate no less than the future of the Euro. The ECB will have a role to play in propping up the system to a far larger degree than now, but it will be political decisions on integration or balkanisation that should be most closely watched. In terms of trades and given that the Greek exit risk has been part of our trading plan we stick to the themes and risk outlined in the last Rates Weekly and indeed much before that. Namely, remain limit long 10yr bunds (target 1.25% and perhaps below 1%), own 'lower for longer' (e.g. 1y3f) but also consider that the sweet spot can be 10yrs, while butterfly trades such as 5s10s30s in forward space are also excellent carry and performance vehicles. We expect the periphery crisis to take a turn for the worse and remain short Spain outright and France versus Bunds, with BTP flatteners and some other macro/RV switch ideas.

European Rates Weekly | 11 May 2012 Page 22

Appendix: A stylised history of currency break-ups for EMU investors

Currency crises and currency break-ups are rare but not without precedent. In fact, there have been over 100 currency break-ups and exits from currency unions over the last hundred years (Checking Out: Exits from currency unions, A.K. Rose, 2007). While most of these events are not directly comparable with the EMU, they do provide a useful guide. The scope of this section is not to conduct an in-depth analysis into previous episodes of currency break-ups, but a glimpse into past experiences that might present useful similarities with the Euro crisis.

1. Argentina: from IOUs to Lecop burgers

Argentinas experience is one of the most interesting cases from which to draw comparisons with the Euro crisis. In fact, Argentinas crisis unfolded around similar dimensions to those seen in the EMU: a partly self-inflicted economic grief linked to an artificially overvalued currency and exacerbated growing debt strains (especially external debt) that eventually filtered into the banking system. Following a series of shocks that hit the country (starting with the 1999 recession), Argentina found itself trapped. Its choices: break the dollar currency board arrangement would be at the cost of bankrupting many domestic institutions (including the government) or muddle through a deflationary backdrop which could ultimately lead to an identical outcome. In November 2001, Argentina converted domestically held international bonds into loans. Although the loans were issued under Argentine law and carried a lower interest rate, they were backed, at least in theory, by revenues from a financial transactions tax. By end-2001, the economy and public finances were in deep crisis. In December, activity collapsed, with industrial production falling by 18% (year-on-year), construction by 36% and imports by more than 50%. Tax revenues plummeted 17% (year-on-year) in the final quarter of 2001 (in December, tax collections fell by almost 30% year-on year), and despite across-the-board spending cuts, the federal government ran an overall deficit of 4.5% of GDP in 2001 against a (revised) programme target of 2.5%. Provincial finances also deteriorated. Out of Arg$17bn of federal transfers to the provinces, about Arg$1bn were in the form of federal guarantees of provincial T-bills (Lecops). As the crisis progressed, provincial governments issued about Arg$1.6bn in bills (quasi-monies) to pay wages and suppliers in the liquidity crunch and this money was also acceptable by the federal government in lieu of tax payments. The movement towards regional money is neatly captured by the fact that McDonalds started selling Lecop burgers.
An example of Argentinas Lecop (Letras de Cancelacion de Obligaciones Provinciales)

Source: Google Images

European Rates Weekly | 11 May 2012 Page 23

On 3 January 2002, President Duhalde the fifth president in three weeks confirmed the debt moratorium (as well as the intention to negotiate with private creditors) and announced the end of the convertibility regime. Three days later, Congress effectively replaced the convertibility regime with a dual exchange-rate system based on an official exchange rate of Arg$1.40 per US dollar for the public sector and most trade-related transactions (except luxury imports); all other transactions would take place at prevailing market rates. At the same time, the monthly deposit withdrawal limit was raised to 1,500 pesos (previous limit: Arg$1,000), coupled with a freezing of term-deposits. US dollar deposits would remain frozen until at least 2003. To dampen inflation pressure, prices of privatised utilities (gas, electricity, telephones and water) were frozen indefinitely. Congress approved an emergency law that severely curtailed creditors rights. USSR to the CIS Following the break up of the Soviet Union and despite the independence of many post-Soviet states, the money supply was still officially controlled by the new Central Bank of Russia (CBR), which took over the role of the old Soviet central bank (Gosbank). Gosbank branches in the other post-USSR countries (now the Commonwealth of Independent States) became 14 independent central banks. The old Soviet system was based on a dual monetary circuit: enterprises could convert Rubles in the bank into cash only for specified purposes chiefly the payment of wages, which were paid in cash. All inter-enterprise transactions were required to be in non-cash Rubles to facilitate central planning and control. This dual circuit continued in the post-soviet Ruble zone. The implication was that while the CBR had monopoly on cash Rubles, the other central banks could and did create non-cash Rubles. This institutional structure not only led to a competition for seigniorage among post-Soviet states but the non-Russian states also found that they could finance their trade deficits with Russia by issuing credit to local commercial banks, which could extend it to local importers, with the resulting Ruble credit balances ending up in the accounts of the CBR. The obvious flaw in this system was that credit creation was feasibly unlimited and created a free-rider problem, which eventually created much higher inflation that progressively saw the independent states abandon this monetary arrangement. The parallel with the Euro area is simply that if NCBs are allowed to extend local collateral rules and perhaps some form of ELA (to prop up local banking systems), then the freerider/inflationary risk will also be apparent. The CBR in July 1993 announced, without warning, that all Ruble notes printed between 1961 and 1992 would no longer be legal tender, leading to a crisis of Russians confidence in their monetary system. The behaviour of the second director of the CBR, Viktor Gerashchenko, led the Harvard economist Jeffrey Sachs to call him, famously, the worlds worst central banker. The Ruble fared little better outside Russia. The currency was subject to severe exchange-rate instability, and to repeated speculative attacks. Several post-Soviet governments rejected the occupation Ruble in early 1992 and introduced their own national currencies. Czechoslovakia During late 1992 and throughout January 1993, many Slovak firms and individuals transferred funds to Czech commercial banks in expectation of Slovak devaluation shortly after the political split. This was reflected in the apparent undervaluation of the Czech currency as the Czech exports to Slovakia rose 25% YoY at 1992 while Slovak exports to the Czech Republic increased by only 16%.

European Rates Weekly | 11 May 2012 Page 24

A consequence of this expectation of future devaluation of the Slovak currency was that Slovak importers sought to repay debts as soon as possible while Czech importers did exactly the opposite. All these developments led to a gradual outflow of currency from Slovakia to the Czech Republic. The central bank (SBCS) attempted to balance this outflow by credits to Slovak banks but this became increasingly difficult in December 1992 and January 1993. Thus, the Czech government and the CNB decided on 19 January 1993 to separate the currency. After secret negotiations with the Slovak side, the separation date was set as 8 February 1993, and the Czech-Slovak Monetary Union ceased to exist less than six weeks after it came to being. The separation was publicly announced on 2 February 1993. Starting from 3 February, all payments between the two republics stopped and border controls were increased to prevent transfers of cash from one country to the other. During the separation period between 4 and 7 February (Thursday through Sunday), the old Czechoslovak currency was exchanged for the new currencies. The new currencies became valid on 8 February 1993. Regular Czechoslovak banknotes were used temporarily in both republics and were distinguished by a paper stamp attached to the face of the banknote. The paper stamp is a common feature of new currency regimes.
Interim Slovakian Korun with control stamp, circulated until new notes could be printed

Source: The significance of stamps used in bank notes by A. Keller and J. Sandrock

The public was also encouraged to deposit cash in bank accounts prior to separation since a person could only exchange CSK4,000 in cash. Business owners were not subjected to this limit. Coins and small denomination notes (CSK10, 20 and 50 in the Czech Republic and CSK10 and 20 in Slovakia) were still used after the separation for several months. Nevertheless, such notes and coins only accounted for some 3% of currency in circulation each. On the other hand, notes of CSK 10, 20 and 50 accounted for some 45% of the total number of banknotes. The stamped banknotes were gradually replaced by new Czech and Slovak banknotes. This process was finished by the end of August 1993.

European Rates Weekly | 11 May 2012 Page 25

Spain's bad bank plan

The Spanish government announced the second phase of the Royal-Decree-Law of 3 February, which details the plan to resolve the banking crisis in the country. The measures discussed today are as follows: The government will hire two auditors to undertake the valuation of all banks' entire loan portfolios. General provisions on real estate exposure will increase to 30% from 7%, an extra EUR 30bn, before the year end. This is in addition to the EUR 53.8bn announced in the RDL. This EUR 83.8bn in total provisions compares to estimates of pre-provision income for 2012 of EUR 43bn across all the banks. Total provisions of Spanish banks against real estate assets and other loans will be EUR 137bn, vs. EUR 184bn of problematic exposure, giving a coverage ratio of 74.5%. Spain will improve the flexibility of rental markets, which currently account for only 17% of total houses. FROB will purchase CoCos in those banks unable to raise the provisions independently in order to recapitalise them. These will be charged interest at a rate of 10% and must be bought back within 5 years. These purchases are expected to be below EUR 15bn. Spain will create a 'bad bank', which will take the form of an asset management company that will purchase non-performing and foreclosed real estate loans from the other banks. There is no information at this stage on how the bad banks will fund themselves or on what prices will be paid for these loans (i.e. market values, book values or some value in between), apart from that it will likely be linked to the values ascribed to the loans by the auditors. The expectation is that private investors will buy into these real estate asset management vehicles. From a credit point of view, Alberto Gallos team in Macro Credit Strategy take on the announcement is that the plan is a positive step for Spain to get ahead of the curve in the bank recapitalisation process and to regain credibility, with the involvement of external auditors. Yet, the measures take into account problematic real estate exposure only (EUR 184bn), which is a small fraction of the total domestic loan book of Spanish banks (EUR 1.7tn). We discuss at the end of this chapter the implication for the Sovereign.

Some background info on Bankia

Our Frequent Borrower team in Bankia partly nationalised (Special) has news. In March 2011, seven savings banks (Caja Madrid, Bancaja, Caja Insular de Canarias, Caja Avila, Caixa Laietana, Caja Segovia and Caja Rioja) agreed to transfer all of their assets and liabilities to BFA (except for social welfare projects). The savings banks together owned 100% of BFA. Bankia was constituted in April 2011. In May 2011, BFA as the initial 100% owner (it currently holds a 45.5% stake) transferred all of its assets and liabilities to Bankia - with a few exceptions. A portfolio of assets worth 43.2bn including foreclosed land (3bn), doubtful land development loans (4.6bn), industrial stakes (2.9bn), public debt (10.2bn) and other long-term debt (22.5bn) was kept at the BFA level. On the liability side, liabilities including 14bn sub-debt (4.5bn FROB's convertible preference shares, 4.1bn of other preference shares and 5.4bn dated sub debt),

European Rates Weekly | 11 May 2012 Page 26

8.5bn GGBs (according to Moody's) and around 14bn other senior liabilities (our own estimates) remained with BFA. Bankia had total assets of 305.8bn at end 2011. Its loan book at the end of 2011 was 193bn. Retail mortgages accounted to 86bn whilst the real estate development and construction loans were 32bn. In its latest presentation from February 2012, BFA-Group stated that it needs to increase its capital by 3,055m to reach the minimum core capital ratio of 8% by end2012 and to also cover the additional capital cushion required by RDL 2/2012 (Royal Decree-Law 2/2012 on financial sector restructuring).

BFA Group Structure

FROB 7 involved savings banks (incl. Caja Madrid) Unclear

Likely close to 100%

Banco Financiero y de Ahorros (BFA) 45.5% (plus option for another 2.9%)

Listed shares


Source: BFA, CNMV, Press Reports, Bloomberg, RBS

European Rates Weekly | 11 May 2012 Page 27

The Role of FROB

Consolidation of the Savings Bank Sector: The savings bank sector has consolidated from 45 institutions in June 2010 to 11 entities as of March 2012. A number of commercial banks have also been involved in the merger process. Of these, seven mergers received assistance from FROB (see below). Functions: FROB essentially has three functions: (1) It takes-over and restructures non-viable entities (e.g. CajaSur), (2) FROB aids merger processes by subscribing to convertible instruments to aid integration, and (3) Providing equity capital to recapitalise single name entities needing increased capital (i.e. as a "capital provider" of last resort).1 Capital: FROB was initially furnished with 9bn of capital (6.75bn from the Spanish government and 2.25bn from the deposit guarantee fund). The Spanish government has pledged a further 6bn in February 2012 but this has not yet been disbursed. Debt Raising Capacity: FROB can also raise long-term bonds, explicitly, irrevocably and unconditionally guaranteed by the Kingdom of Spain. FROB Debt Treatment: FROB debt is included on the Spanish government balance sheet by Eurostat, increasing the public debt. As such from a national debt perspective there is no difference on the impact on the debt level of the Kingdom of Spain from injecting capital into FROB (funded by increase Bono issuance) or FROB raising money in the bond market. Governance: FROB governing committee (of 9 members) is split between the Bank of Spain (4 members), the Finance & Economic Ministries (one each) and the Deposit Guarantee Fund (3 members) EU approval: FROB must seek EU approval that it is acting within the 'state-aid' rules on a case-by-case basis for all three pillars of its mandate. Initially FROB has an overarching EU-approval scheme for the support of mergers, however this expired at year-end 2010 and now approval must be sought for such support as well.

Existing FROB support

Existing FROB support has totalled 13.869bn across all operations. This can be essentially divided according to the different pillars of its mandate: (a) Injections into the savings bank sector Under the second pillar of its mandate, FROB has provided capital toward seven merged entities, which have received 9.67bn of capital in the form of convertible preference shares. This accounts for ~70% of all FROB assistance. The aforementioned shares have a 7.75% coupon and must be repurchased in a period of 5 to 7 years. This includes the 4.645bn of convertible preference shares provided by FROB for BFA, which will now be converted into common equity. Please see a breakdown of the capital injections below:

European Rates Weekly | 11 May 2012 Page 28

FROB Aid for Merger Process (Preference Shares)

Merged Entity 1 2 3 4 5 6 7 Caixa Catalunya Unnim Ceiss BFA-Bankia
2 1

Institutions Involved Catalunya, Tarragona, Manresa Manlleu, Sabadell, Terrassa Espana, Duero Madrid, Bancaja, Laietana, Insular, Canarias, Avila, Segovia, La Rioja Galicia, Caixanova Murcia, Peneds, Sa Nostra, Granada Navarra, CajaSol, Guadalejara, General Canarias, Municipal de Burgos

FROB Approval 25/03/2010 25/03/2010 25/03/2010 29/06/2010 29/06/2010 29/06/2010 22/12/2010

Aid ( bn) 1.250 0.380 0.525 4.465 1.162 0.915 0.977 9.674

NovaCaixa Galicia Banco Mare Nostrum Banca Civica Total

[1] These were subsequently converted into equity in September 2011, [2] Will be converted into equity

Source: FROB, RBS

(b) Recapitalisation These are the more recent activities of FROB following the EBA capital stress-test done in October 2011. So far and in addition to the support provided above, FROB has provided an additional 4.183bn in ordinary share injections to Caixa Catalunya (1.718bn) and NovacaixaGalicia (2.2465bn). This is in addition to the preference share injections they had previously received (1.25bn and 1.162bn as above). (c) Restructuring Under its mandate for non-viable entities, FROB has provided an asset-protection scheme (APS) for CajaSur prior to its sale to BBK. Currently FROB estimates the losses from this operation will amount to 392mln. FROB is also providing contingent liability support for the CAM (which has been sold to Banco Sabadell). Most other support for non-viable entities has instead come via the deposit guarantee fund, which has provided aid in the Unnim sale to BBVA, as well as both an asset-protection scheme and a significant capital equity injection for the CAM restructuring (in excess of 5bn in ordinary shares).

Remaining FROB Resources

Ample for Bankia, more questionable for the whole sector Even without raising further debt, FROB currently has 5.3bn of unpledged cash in its liquidity portfolio. This will also be topped up by the 6bn of equity due from the Spanish State (pledged in February this year). In addition to this FROB has a 3bn available credit line. As such we would certainly not expect the first port of call to be a bond issue in the market. Taking into account these resources, FROB will almost certainly use these to cater for any immediate capital needs. The government will probably use some of this to inject new capital into Bankia in addition to the conversion of the preference shares. Previous FROB Issuance FROB has previously entered the market four times with new issues and has tapped these a number of times. As of end April 2012, it has raised just shy of 11bn in the bond market. The benchmarks have maturities between October 2013 and July 2016 and currently trade about 40-55bp over the Spanish government curve. If FROB were to significantly increase its funding needs, spreads over Bonos would likely widen by some margin. Nonetheless, with current firepower available to FROB and considering both the more expensive cost to the State of FROB issuance compared to Bonos and the treatment of such debt, should significantly higher volumes be required for the whole sector, direct capital injections by Spain into FROB (even funded by Bono issuance) rather than FROB issuance would be a far more

European Rates Weekly | 11 May 2012 Page 29

What does this mean for the sovereign?

The key takeaways for SPGB investors are: The 83.3 bn provision total is now not far off our Credit analysts calculations of total capital requirement near 100bn but further provisions will be required on the residential mortgage lending book and SMEs in light of the recessionary conditions. A truly independent valuation of bank risk is important and necessary. It would allow markets to quantify risk rather than deal with Knightian uncertainty (where there is no clear probability risk distribution) on loan losses and remove the distrust of markets on the size of the problem. There are execution problems. For instance, even if the level of provisions is realistic, it is a different matter as to whether banks can get there. The 84 bn needed over the year when pre-provision income across the sector is c. 43bn is very tough as capital can therefore not be raised via earnings and where most of the 43 bn earnings anyway are with Santander and BBVA (34 bn combined). As such, smaller banks will find the task too onerous (lending cannot shrink fast enough to create CT1 ratio increases without cutting financing for SME's which then hurts in other loan books.) To help banks with these provisioning targets, Spain is proposing to buy Cocos with 5y maturity from the banks. The 10% interest rate is prohibitive and increases the likelihood that banks that need this end up having to convert the cocos to equity. On the bad bank option, more detail is required. It seems the bad bank will be mandatory and banks will be forced to place problem real estate assets in a "real estate management vehicle". Spain somehow believes this will be funded by private investors with no detail yet on funding for the bad bank.

News of the clean up needs some further detail before a full assessment can be made but our initial read is that the measures do not turn around Spanish problems. Why? The latest move by Spain results in another migration of private sector risk to the public sector. Importantly, in this context, the total numbers may be getting more realistic but are unlikely to be the final word. Spain does not have many chances left to clear the information vacuum and provide a one-off solution to the bank risk. The lesson from Ireland, where the size of problem continued to be revised higher, is that markets eventually lose patience. In addition, a large role for the private sector in the solution is inconsistent with historical success stories in clean-up policy. This will simply mean Sovereign bad bank backstops and funding are ultimately necessary - and allied to the provisions needed by smaller banks - we expect that Spain is likely to end up holding stakes in these banks. Finally, the market and economic backdrop for Spain to execute the clean-up is not benign and is made harder by the existence of the ESM which if needed will subordinate Sovereign debt holders. This threat, which on the deficit risk alone, means that we see no low yield equilibrium.

European Rates Weekly | 11 May 2012 Page 30

UK Strategy QE complete (for now)

Simon Peck With the end of QE confirmed (for now) we look for the 16th May BoE Inflation Report to uncover upward revisions to the 2y/3y forecasts (RBS economists expect 0.1% in both cases), signalling that the MPC has made a small move towards a more neutral bias, but we believe this is fully discounted. Gilt 10s30s is two standard deviations too steep in our model. For now this remains a bear trade, 78% correlated to outright 10y over a two year history. There can be further steepening yet before any long end bull flattening. The April PPF 7800 index update (which shows 10.6bn deterioration in funding) is also supportive of 10s30s being too steep. . . . . but 30y Gilts look rich on ASW. We hold our short position and target of 22bp, currently 11bp. QE over for now.but lower yields stem from Europe Scheduled QE has come to an end and there is no doubt that the past seven months have been supportive for Gilts. Though this aid is no longer in place, we do not believe there is reason to bring into question Gilts safe haven status. Our long running view of the UK as a safe home for capital has been premised on the governments commitment to austerity and the fiscal factors remain very much in place. The high domestic ownership of the Gilt market also provides more insulation from any foreign selling. Over the next few weeks market direction will continue to be dominated by the developments in Europe, with the potential for a new round of Greek elections in June. What remains clear is that the longer the process is drawn out, the greater the scope for the market to price in exit risks. Gilts can continue to benefit from safe haven flows and continue to perform, in our opinion. May inflation projections to show less of an undershoot than in February As expected, the MPC left policy settings unchanged in May, maintaining the asset purchase target at 325bn. The decision was taken in light of the forecasts from the May Inflation Report, which will be released on Wednesday 16th May. The February BoE Inflation Report placed the two and three year forecasts at 1.78% and 1.90% respectively, thus a small undershoot from the 2.00% target. Given the overshoot in inflation in Q1 (3.49%, so 14bp above the central projection in the February Report) in combination with the recent rhetoric from the MPC focusing around price stickiness, we believe the May Inflation Report CPI projection is likely to be raised. RBS Economists expect a marginal undershoot of CPI at the two-year horizon (at, or fractionally above, 1.90%) with the three-year point at its 2% target. In so far as the central projection in two and three years' time is primarily a near-term policy signalling device (as opposed to a pure, high-conviction forecast) it would represent a small shift by the MPC from a mildly dovish bias towards a neutral position. A higher mean CPI projection would also act as further evidence of a dilution in the dovish policy stance. We look for the tone of the May BoE Inflation Report to reflect a modest shift in the balance of risks. Whilst rate hike premia can reflect expectations on the far horizon, do not be under the impression that rate hikes are coming anytime soon. We think the bad news is discounted in terms of new CPI forecasts.

European Rates Weekly | 11 May 2012 Page 31

10s30s flatteninglooks steep, but still a bear trade

With no further Bank of England buyback operations on the horizon, the obvious question now is what happens to the long end and can 10s30s flatten?
10s30s model implies curve is 22bp too steep
150 100 50 0 -50 -100 Jan-05 bp Fitted Actual

Residual is 2 standard deviations too high

60 bp 50 40 30 20 10 0 -10 -20 -30 -40 Jan-05 Feb-06

2x st dev

-2x st dev
Mar-07 Apr-08 May-09 Jun-10 Jul-11 Aug-12






Source: RBS, Bloomberg

Source: RBS, Bloomberg

On a fundamental basis, 10s30s appears statistically steep and this is supported by our long end curve model, which shows that the current level is almost 2 standard deviations above the implied level. [The model is based upon a linear regression of 10s30s vs. GBP 2y swap rate/10y10f GBP vol/1y1f GBP vol/20y20f GBP swap rate/JPY 20y 20f swap rate] However, though the curve appears too steep at first glance, as we highlighted last week, the spread remains strongly directional and correlated to the outright yield of 10y bonds. The relationship between 10s30s vs. 10y yields suggests that there is scope for bull flattening; but we do not believe we are there yet. 10s30s aggressively flattened post MPC meeting, but this was driven almost entirely by 10y yields selling off 8bp.
10s30s correlation to 10y suggests flattening can occur But there can still be further steepening to go
50 1.40 1.20 10s30s 1.00 0.80 0.60 0.40 1.8 2.3 2.8 10y
Source: RBS


40 30 20 10

y = -0.19x2 + 0.85x + 0.19 R2 = 0.76

3.3 3.8

0 -10 -20 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12

Source: RBS

Whilst we like the idea of 10s30s flattening, until we see evidence of a breakdown in the correlation we do not think it is right to enter the trade given our bullish outlook for Gilts. PPF 7800; funding levels turn back down The latest update from the Pension Protection Fund (which gives an estimated funding position on an s179 basis for defined benefit schemes) shows deterioration in the funding position of schemes in April, with the aggregate deficit of the schemes in the PPF 7800 index having increased to 216.8bn in April from 206.2bn in March.

European Rates Weekly | 11 May 2012 Page 32

PPF 7800- small uptick in deficit in April. Continues in May?

1300 1200 1100 1000 900 800 700 600 500 400 Mar-03 200 150 100 50 0 -50 -100 -150 -200 -250 -300 Mar-12
Source: RBS

Assets (billion)

Liabilities (billion)

Balance (billion) (RHS)










50 100 150 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12
Source: RBS

Long end Gilts still too rich on ASW

The one piece of bad news for 30 yrs is that, in our view, long end swap spreads have yet to fully reflect the end of QE. An update of our model suggests a further 10bp of widening to go. We continue to be short 30y on ASW (entered on 20th April 2012) with a target of 22bp (currently 11bp) and stop at 5bp.
30y swap spread model.10bp of widening required to reflect the end of QE
100 50 0 -50 -100 -150 -200 Jan-00 model actual






Source: RBS

European Rates Weekly | 11 May 2012 Page 33


The aggregate deficit of the 6,432 schemes in the PPF 7800 index is estimated to have increased over the month to 216.8 billion at the end of April 2012, from a deficit of 206.2 billion at the end of March. As a consequence, the funding ratio decreased from 83.4% to 82.6%. Total assets were 1031.4bn and total liabilities 1248.2bn. There were 5,228 schemes in deficit and 1,204 schemes in surplus.

Though the rise in the deficit in itself means funds have less to invest, there will likely be a requirement at some point for significant cash injections from sponsors companies. The recent UK Pension Regulator statement has suggested that pension scheme contributions are going to rise as a result of the widening scheme deficits and with new money tending to be directed towards bonds, this should continue to support long end Gilts. The chart below shows 10s30s Gilts vs. the PPF index and corroborates with the statistical evidence that 10s30s is too steep.
PPF7800 index vs. Gilts 10s30s
200 150 100 50 0 -50 -100 -150 -200 -250 -300 Mar-03 PPF 7800 balance UK10s30s (rhs inverted) -100 -50 0

Scandinavian Strategy
Par Magnusson

Tensions are rising. The Greek exit debate is becoming louder and bank downgrades loom large in Scandinavia. Remain long safe haven assets as a default position. We take note of the Riksbanks announcement that it now prepares for financial war by establishing a framework for QE and LTRO. This is covered bond vs. ASW bullish. We are happy to take profits on some of our outstanding trades, but will not argue against moving the profit targets further to stay the course. We believe the market is still largely in denial when it comes to accepting the risks we are facing, and the scope for drastic monetary policy action. Keep selling SEP12 RIBA.

Preparations for war

The main event in the Swedish market in the week that passed was not the very weak macro data, on which I will comment in a while, but the announcement by the Riksbank that it will now establish a tool for QE. It should be noted that there was no mention of any plans for QE in any form, but the mere act of making the preparations for such an eventuality tells us that something probably is afoot. The monetary policy armament will come in two forms: Establishing a bond portfolio in SEK, which can be used to invest in bonds in the secondary market. The starting sum will be 10bn SEK, but it can grow over time as deemed necessary. I suspect that the prime investment target will be in covered bonds, as there hardly will be any need for additional support at the short end, which already suffers from a chronic shortage of t-bills, nor the long end, as even lower yields in 10-30yr bonds would be to the detriment of the L&P sector. Restarting the LTRO-programme. The Riksbank also stated that is ready to reintroduce LTROs with a special focus on covered bonds. This makes sense, since the monetary transmission mechanism from the policy rate to the actual borrowing rate among households has been jammed by high ASW-covered bond spreads. Compressing this spread could serve to lower rates for the end users, as well as lending support to banks as the demand for, and profitability of owning, covered bonds would increase. The precedent is the 2009 LTRO where covered bonds could be funded at the policy rate +15bp at the Riksbank. The graph below shows how the 5yr covered bond vs. ASW spread came down by 60bp in a few weeks time.

While the Riksbank did mention a bond portfolio as a possible monetary policy tool in a report published on 27 April, the fact that these plans are now put to work in combination with the raised possibility of LTRO has great symbolic value. It is well known to the market and perhaps even better known at the authority responsible for financial stability that a number of Scandinavian banks are facing potential downgrades by one to three notches in the near future. Moreover, the EMU crisis has no doubt accelerated in the wake of the Greek elections with rising exit risk. Consequently, the timing of this announcement is suspicious to us.

European Rates Weekly | 11 May 2012 Page 34

Effect on 5yr covered bond-ASW spread when the last LTRO was announced in 2009

Source: Bloomberg

It is often said that actions speak louder than words, and while the Riksbank has downplayed the risks to the financial system and the economic development from the EMU crisis in its normal communication, this preparation for financial war suggests that the Riksbank remains true to its character as a swift mover. Remember that the Riksbank went from hiking rates in September 2008 to cutting them by 450bp and introducing an LTRO in the span of nine months. (It even cut rates by 175bp in one go.) So, whats the takeaway? No one can say with certainty that the Riksbank will cut rates by 25bp at a time at each meeting for the remainder of the year to reach a policy rate of 0.50%. But, I do believe that there is bigger scope for drastic action in terms of expansive monetary policy than the opposite. Indeed, as I write the market doesnt even appear to expect two more 25bp rate cuts by the Riksbank, which means that the downside in rates still dominates, in my opinion.
Downside risk to rates dominate in Sweden - Fair value spread to current SEP12 RIBA

Jul-12 0 0 0 -25 -25 -25 -50 -50

Sep-12 0 -25 -50 0 -25 -50 -25 -50

Fair value 1.50 1.48 1.46 1.31 1.29 1.27 1.10 1.08

Spread to SEP12 RIBA 17 15 13 -2 -4 -6 -23 -25

Source: RBS

However, having been a proponent of being long the SBG1041 outright for quite some time, I must say that there seems to be better value in the RIBA or FRA market for those who wish to take on a long position in the short end of the Swedish curve. The average RIBA rate until the SGB1041 matures in May-14 is 1.10%, which is 15bp richer than the bond. Such a difference can be attributed to either a positive carry in the bond position or by the safe haven quality in the bond for real money investors that cannot be emulated in a money market derivative. Since carry is actually negative by some 2bp/month in the SGB1041, it is reasonable to assume that the bond is given additional

European Rates Weekly | 11 May 2012 Page 35

intrinsic value by virtue of being a place to park your money in a risk-averse world, and for being a potential target for Riksbank bond purchases. As argued above I dont think the Riksbank would be a heavy buyer in government bonds once it activates its bond portfolio, so we are left with the SGB1041 being particularly rich due to its store-of-value characteristic. A more daring trade could be to short the SGB1041 and sell the SEP12 RIBA, which would give you positive carry, while hedging the delta exposure.

Great expectations is the mother of great disappointment

Regular readers of the Scandinavian research will know that I have been very sceptical of the industrial confidence data in Sweden. The confidence indictor in March jumped, but it was solely due to increased expectations, while current conditions remained in the doldrums. I had a hard time believing that there was a bright future for a high-beta industrial economy as the Swedish one, when the world was moving close to the brink risk-wise.I also thought that any optimism would soon be turned into disappointment, especially since I suspect the positive expectations was a case of misguided optimism on the back of LTRO effects. Now we have the result. Or, at least, two months worth of results. Industrial production fell in both February and March. I know that Februarys weak numbers were attributed to the fuzzy accounting in the pharma sector, and there was certainly something to that. But we ascertained from the March numbers that the industrial production ex pharma fell by 1.6% mom, and that March was the second consecutive month of negative growth in industrial production. Since the Riksbank held up the improvement in the industrial sector as an important pretext for not cutting the rate at its last meeting, I think its fairly safe to say that it no longer can make that argument. Add to that the continued low inflation and its clear that the road for new rate cuts is paved.

Sweden is in an industrial recession the road to rate cuts is paved

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 01 02 03 04 05 06 07 08 09 10 11 12

Industrial production ex chemicals and pharma [ma 12] Sweden, Industrial production, Total excl energy [ma 12, c.o.p 1 month]

Source: Ecowin

European Rates Weekly | 11 May 2012 Page 36

The week ahead

With no macro data with market-moving potential in Sweden or Norway next week, we will remain focused on two things: the Greek exit debate and the pending bank downgrades. I wrote about the risks to the financial system in Sweden in the event of large downgrades for the banking sector last week, but I will take the liberty to simply reiterate what I wrote then. Should banks ratings be downgraded, their ability to conduct swap business with both corporates and covered bond issuers will potentially become hampered. Consequently, it is reasonable to assume that weaker bank ratings will imply greater demand for collateral among banks if they wish to retain their business. Perhaps that wont even be practically possible in some instances, so there is a risk of some market participants being forced to migrate or unwind parts of their swap books. In other words, downgraded banks may stoke higher swap spreads on the back of deteriorated bank credit in combination with an accelerated demand for safe haven assets to be used as collateral. That is - ceteris paribus - bullish for Scandinavian government bonds. The risk of bank downgrades in combination with the Riksbanks preparedness for QE in one form or another does point towards a compressed covered bond-ASW spread, as mentioned in the previous section.

Trading recommendations
Consider taking profit on the SGB1041 position as we have hit the 0.95% target. Sell SEP12 RIBA at 1.33% for an intermediate target of 1.27%. The target of 100bp spread between the SGB1041 and the ASW has just been reached. Feel free to take profits, but there is still a case for an even wider spread as bank downgrades loom large. I do admit, however, that the potential for ASW spread trades is bigger in covered bonds as we may see Riksbank LTRO put into effect and the covered bonds should outperform swaps. The 2-4yr relative SEK IRS steepener vs. USD is still alive and well. 9bp in the money with more to go. Keep it on with a profit target of 10bp, currently at 21bp.

European Rates Weekly | 11 May 2012 Page 37

Giles Gale

Inflation Linked Strategy

Euro Area French supply

HICPx Forecasts (RINF1 <GO> on Bloomberg)

NSA Apr May Jun Jul Aug Sep Oct Nov Dec 115.57 115.51 115.54 114.71 114.95 115.7 115.99 115.99 116.39 m/m 0.47 -0.05 0.03 -0.72 0.21 0.65 0.25 0.00 0.34
Source: RBS

The AFT has announced that the supply for Thursday will be 800m-1.2bn of OATei22s, OATi23s, and OATei27s. This is smaller size than usual, perhaps reflecting market conditions that might reasonably be viewed as moderately adverse. The choice of bonds, on the other hand, is relatively long. This seems sensible sub 10y paper has been distinctly unloved recently. There was little market reaction to the announcement and I would not expect it to pose difficulty unless conditions deteriorate substantially. Trade ideas: The recommendation to receive 5y5y breakeven in bonds against swaps has been stopped out. I reinstate it at current levels (75bp Buy OATei20s vs OATei15s in equal cash amounts on b/e, against pay 10y swaps, receive 5y swaps in equal notionals with whole package duration neutral), looking for 35bp profit, with a stop at -15bp. The remainder of this article is adapted from Linked-Up, published on May 10.

Forecasts and the front end

Although energy price quotes are clearly lower over the week, the low sensitivity of European inflation to these means that we have not adjusted our inflation forecasts terribly much we still see year end inflation at nearly 2.2%. From this we should probably remove the Italian hike, however, which would take this down to around 2%. There are still possible VAT hikes in Spain and the Netherlands, however, so there is a higher degree of uncertainty around this projection than usual. Against this, OBLIs have been continuing to perform very well, and other short linkers have also been relatively well supported. The outperformance of OBLei13s, however now looks a spent trade.
Short-dated breakevens resilient, OBLeis bulletproof
150 100 50 0 -50 -100 -150 -200 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12
OBLei13 OATi13 OATei15 DBRei16
Source: RBS

European Rates Weekly | 11 May 2012 Page 38

Japanification or inflationary muddle through?

This is a theme that can be played in many ways, which is just as well, because there are lots of people whose base case (and, for many of those, best case) for Europe is a form of muddle through in which politicians get away with doing the minimum at the last moment rather than committing to grand plans. In this scenario, it is generally held, growth will be sclerotic, demand weak, and inflation pressures very, very low. I have sympathy with some parts of this view. But I do not share the conclusions on inflation. I also think that the risks around it make it dangerous to play for. It remains a point of some debate, I think, exactly why Japan has suffered such protracted deflation. For me the most persuasive reasoning simply that asset price falls and a very strong yen, which failed to correct fully until late last decade, combined to create weak demand and a struggle for efficiencies which were mutually reinforcing. I also believe that government activity crowded out consumption, and the price of government consumption may have been rising in compensation for consumer prices. Lastly, particularly over the last decade, I think that the global disinflationary forces of cheaper overseas production added to the problem. There are parallels, but there are important differences. Asset price falls in Europe are localised and mild compared to those suffered by Japan. Parts of Europe need to work to improve efficiency, but it is not the case at the Euro Area level. The Euro is not overvalued, and indeed arguably threatens to become undervalued. Other problems said to be associated with Japanese deflation I take issue with. Aging, in particular should be disinflation only while it bolsters the ranks of the productive, but lots of retired should be inflationary because it raises the consumption pressure per unit of productivity. Clearly moves to keep people in work, then, could be disinflationary, but I think that this just slows the process rather than puts it into reverse. Government austerity may be disinflationary in the short term (once indirect tax rises have been exhausted), but with reference to the above may not be over the long-haul. Perhaps most importantly also think that the disinflationary force of cheap foreign goods is likely to slow. Turning to the standard analysis, I also reject the idea that the output gap will drag substantially on inflation. The charts below show standard estimates from the IMF and the OECD suggest that there is an enormous amount of slack to be taken up before inflation pressures should bite. But how to explain, then, that unit labour costs are rising in the Euro Area as a whole nearly as quickly as in Germany? Clearly the productivity story doesnt support the notion that there is spare capacity to be used up. On the contrary, it suggests that rising unemployment may have legs. Secondly, the right hand chart strongly suggests that the output gap is mainly in the periphery. No surprises perhaps, but I would argue that spare capacity there may well in fact not be located in industries with a viable future. Construction springs to mind. The Bank of England appears to be coming round to the idea that spare capacity after a period of years either goes stale or is revealed to be obsolete capacity.

European Rates Weekly | 11 May 2012 Page 39

Spare capacity

or obsolete capacity? Industrial capacity utilisation

3 2 1 0 -1 -2 -3 -4 -5 -6 Apr-01 Jan-04 Oct-06 Jul-09 Apr-12

90 80 70 60 50 40 30 20

95 90 85 80 75 70

10 0 Dec-14

65 60 Jun-02 Jun-04 EMU Capacity util'n Italy

Output gap (IMF)

Output gap (OECD)

EMU Capacity util'n

Jun-06 Jun-08 Germany Spain

Jun-10 France
Source: EU, RBS

Source: OECB, IMF, RBS

This in turn suggests to me that the Euro Area might in fact face more price stickiness and a higher bar for core inflation. I also expect that this should mean that lax monetary policy is more effective and that the Euro Areas response to inflationary shocks (and, whether oil or a secular trend to higher import costs resulting from abroad will be greater pass-through to HICP. But perhaps thats a good thing. The Euro Area needs higher inflation. A rebalancing in price levels cannot be drawn out in an environment of real social pain for the best part of a decade. Inflation, not alarming inflation, but inflation above 2% will help. German hair shirt wearing insistence to the contrary is unhelpful. But fortunately it is unlikely to get its way. I dont believe that Germany has the upper hand in the debate regarding the appropriate policy mix and I dont think that the ECB, inflation fighter or no, will prize low inflation over financial stability and Euro Area cohesion. Besides Germany had ECB forbearance when it was disinflating in 2003-5 (at a time when to do was relatively easy because the global economy was entering and the riding a robust upswing) inflation was stuck stubbornly above 2% for almost all of 2000-2006, including for nearly all of the period of 2% rates. Indeed Germany was also naughty with its public finances at the time. Naturally I dont expect them to remember things this way, but it shows that it may be forced to tolerate higher inflation than it would like as the ECB sets rates according to Southern needs. Finally I think that the experience of H1 2011 when the ECB hiked rates is significant. I therefore think that it is entirely reasonable to assume that the ECB will accommodate price shocks and use an output-gap methodology to justify it. My conclusion, then, is that Euro Area stagnation is possible, even likely. But I dont think that Japanification is likely to extend to chronic low inflation or deflation.

European Rates Weekly | 11 May 2012 Page 40

EUR HICPx swaps 5s10s

0.35 0.3 0.25 0.2 0.15 0.1 Nov-11

A whistlestop tour of the risks around Euro Area breakup and so on reinforces the idea that inflation, not deflation is most likely to arise from breakup scenarios. Essentially I expect an exit (Greece?) to be met with alarm, to which the first reaction of policymakers will be more liquidity, possibly more public sector assistance, and recognition that Greeces path may be that of others if too much is demanded of voters. That means inflation to me. Should the measures fail, however, then I expect Euro Area inflation to take off as more countries leave. This is not a 10-year story it is a five year one at most. Regulation is perhaps the final nail in this one. Although it is not clear how the dutch pension reform will proceed without a government to address the tricky bits, I think that the pension funds feel that they are winning the debate, and will remain quiet until after there is clarity, at least. That is likely not to be until late this year now. I still expect the new regulations to deemphasise long-dated inflation hedging (and probably also rates hedging). Note that I am uncertain about the impact this may ultimately have on the 10y point, since extrapolation methodology might add a bid to the last liquid point (LLP), if this is the way chosen.



Source: RBS

Trade idea: Use the steepening to put on b/e flattening. I like 2s10s but prefer 5s30s as the short term sensitivity is are lower. Enter at 59bp. Target 25bp profit, stop at 10bp.

Other trade idea maintenance.

Greece is important for Italy
While I am positive on Italy from a pure credit perspective, at least for now, Fitch has said that Italy would face an automatic downgrade if Greece left the Euro Area. I would expect other agencies to do the same. This brings a risk to the near term that I expect shorts of Italy will wear the negative carry to maintain. Take off Italy real yield 7y3y. This has performed well given the widening in spreads, but long Italy is not for now an exposure I like. I also withdraw my interest in being long Italy 19s on breakeven for the same reason.

French inflation
Keep French vs European inflation. I still expect that the raising of the Livret-A ceiling will support the BTANi.

Keep 5y5y iota & long 5y5y breakeven in bonds. The bond/swap spread remains much too wide.

European Rates Weekly | 11 May 2012 Page 41

The DMO has announced IL62s will be reopened by syndication the week after next. I believe that this confounds expectations that had been moving toward a new 30y linker. While a new 30y is likely before long, this is a small negative for linkers generally and for ultra-longs specifically. Trade ideas: Ultra-longs have been a little scarce in the market in the last few days and have outperformed the 30y area, but I now no longer expect this to continue and close my 30s50s breakeven steepening suggestion. The remainder of this article was published on May 10 in Linked-Up. As I write I dont have the benefit of knowing the MPCs mind regarding QE, the announcement coming at lunchtime. Clearly this will have some relevance for the linker market, but there are some observations that are still worth making in advance.

Breakevens are in thrall to nominals, and nominals are in demand

30y nominal gilt spreads are rich despite expected end to QE
0 -5 -10 -15 -20 -25 -30 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12

Firstly, regarding QE, RBS officially expects discontinuation, and this is also my view although the rather worse data recently does suggest that there is a small chance, say 20% of extension. I believe that I am not far from the market in this which means I am confused at gilts strong performance outright and against swaps where not only are we in the QE (Oct-11 to date) range, we are at the tight end of it (sidebar). A robust 52s syndication and 42s auction yesterday make it impossible to argue that there is no demand at these levels. I can only assume that this is mainly about safe haven flows, but I dont see disappointment in QE giving way to much weakness in conventionals and linkers have been very directional with conventionals recently so I dont see much upside for linkers in the near term from this either. The counterargument is that nearly all the rally in nominals recently has been in breakeven contraction. Real yield resistance at zero in 30-years may be partly due to supply and partly because linker buyers still do hope that the end of QE will give rise to higher real yields. On the latter there may be disappointment by the looks of things, but the linker syndication later this month is likely to keep buyers hoping, and that may keep a lid on valuations.

Source: RBS

So is the curve, but supply might push 10s30s away from nominals
If breakevens are steep in 10s30s, it is naturally because conventionals are steep in 10s30s. The chart below shows just how tight the relationship has been for nearly two years. Nevertheless unless we get a 10-year linker next week (which I think is very unlikely), supply looks like it might push the yellow point below above the trend line. We have IL29s next month, but thats a relatively long way off, and a new 30y linker looks more likely to me than a third IL62s syndication. In the Rates Weekly last week, I argued that at these yield levels, and with very high uncertainty in risk markets, a 30-year might be felt a more sensible and safe option than 62s. But in any case, the 62s are already over 8bn, and can be topped up sufficiently by auction now. The 10-year area also looks cheap and the 30-year expensive. The right-hand chart on the next page (the zero-coupon iota) pretty clearly illustrates that, and although the L22s are still significantly rich against this, the bond-specific RV is small compared to the kinks in the fitted curve. Finally, QE and flight to quality alike have been supporting 10s in conventionals much more than the long end. Even if QE is extended, there must be some chance that the medium bucket is underweighted due to the pure technical constraint of low free-float. I therefore think that 10s30s may finally start to flatten. If you have this bias (and given

European Rates Weekly | 11 May 2012 Page 42

the tight correlation illustrated below between 10s30s conventionals and breaks, Id say only if you have this bias), I think that 10s30s breakeven flattening is a sensible trade. Trade idea: Enter 10s30s breakeven flattening. I like IL20s, so I suggest IL20s/IL42s at 67bp. Target 12bp, stop at -6bp.
10s30s breakevens are steep, but in-line with nominals


10s30s ILG b/e




0 20 Since Nov-08 40 Since Dec-20 60 current 80 100 10s30s conventionals 120 140 160

Source: RBS

European Rates Weekly | 11 May 2012 Page 43

Volatility Strategy
Giles Gale

Market update
Volatility has been exceptionally well bid this week. Short expiries, which had become relatively cheap, have jumped very sharply, but bids have extended all the way down the expiries. The 30y column has been better bid than the 10y, reflecting the volatility in the long end that has revived some CVA receiving concerns. Interest in pinning shortdated rates in 1x3x2 receivers has also been ongoing. Long forward rates are now so low that selling long-dated OTM receivers break even at very low rates indeed and I imagine some yield enhancers may take note.

A week in European politics

A week is a long time in politics, and a very long time in European politics. The brief conclusions for me at this stage are: The new French government promises to meet its short-term promises on deficit reduction but its wider policy agenda will make ongoing deficit adjustment harder. There is growing recognition of and tolerance for Spains efforts to reduce its public deficit and manage its banks back to health. Germany is increasingly isolated in setting the European policy agenda. This is politically as dangerous for the Euro Area as discontent in the periphery. The reaction against suggestions that the Bundesbank might tolerate higher inflation in Germany for the good of the Euro Area. (I noticed the emphasis on the Bundesbank rather than the ECB in local commentary.) In practice, this is a relatively innocuous suggestion and the ECB should be able to deliver on it without the Germans noticing too much, but the furore is indicative of deeper misgivings. Greece is likely to leave the Euro Area. See here for much more on this from my colleagues in Rates Strategy. New elections are likely in the near term and it will be clearer than ever that it is a referendum on Euro membership. While polls suggest that Greeks want to stay in the Euro Area, it also makes clear that it doesnt want the austerity. This matters more, judging by early polls on voting intentions, for a hypothetical second general election that show the Radical Left polling more strongly at the expense of all other parties. The most feasible scenario in which Greece does not leave, in my opinion, is where a government misses its targets and runs out of money, leading to IOUs to be introduced, which scare the public into submission on the austerity roadmap. Nevertheless, I think this is grasping at straws and would give the markets a rough ride in the meantime. Greeces bargaining position with the Euro Area is strong in principle: other European countries would lose very substantial claims on it and contagion could be very damaging. But pride and populism are more likely to drive the agenda. It is unlikely that Greeces choices will look better in the future than they do now, in my opinion. Clearly the scope for instability over the coming months looks very high and I would expect that disaster protection will keep volatility relatively well supported. The main problem here is that it is not entirely clear what strategies work in EUR options as disaster protection other than just buying volatility: in the worst events, I am not even sure whether the curve would steepen or flatten, for example.

What is the matter with asset swaps?

Given the flight to quality, asset swaps have perhaps been surprisingly soft. In the same week that gilts have had the support of QE removed, 10y gilts are near their

European Rates Weekly | 11 May 2012 Page 44

tightest against swaps in recent history compared to bunds (chart below). Of course there may come a time when we wonder about German credit quality, but that time is not now, and I would have expected the flight to quality to push bunds from the range that has really been established since late March.
German asset swaps have not behaved like flight-to-quality should
90 80 70 60 50 40 30 20 10 0 Nov-10 UK 10y asw

Feb-11 May-11 Germany 10y asw





Source: RBS

Options on September contracts suggest a give-up of 6bp to enter bullish wideners. This looks reasonable to me. But on the other hand, while the implied tightening in a sell-off is aggressive compared to recent history, it is worth wondering if the failure to push wider now is indicative of a belief in liquidity that may cheapen asset swaps further on the way back up in yield. Shatz vol in puts looks cheap as top-left has been bid in swaptions.
Zero cost entry levels for September (24-Aug expiry) contracts and historic yield/asw levels for CTDs
-30 bp -40 bp -50 bp ATM Spread -60 bp -70 bp ATM -80 bp -90 bp -100 bp 0.0% Bund Hist ATM


0.4% Bobl Hist

0.6% 0.8% 1.0% Schatz Bobl

1.2% Bund





Source: RBS

ATM vol multi-map: Euro Area

Gamma appears relatively cheap on a two-year PCA basis. The middle of the surface in longer expiries has been supported and looks expensive historically.

European Rates Weekly | 11 May 2012 Page 45

ATM normvol surface historical 4-in-1 heat-map colouring denotes 3m z-score of each measure

In/For 1y 2y 3y 5y 7y 10y 20y

1y 46.7 bp 54% -18.5 bp -18.7 bp 66.0 bp 77% -8.8 bp -8.5 bp 80.3 bp 75% 2.1 bp 2.5 bp 88.7 bp 98% 5.8 bp 6.2 bp 88.2 bp 94% 6.2 bp 6.8 bp 83.9 bp 88% 1.1 bp 2.0 bp 72.1 bp 72% -2.4 bp -1.2 bp bp vol level (3m z-score) PCA (with rates) (3m z-score)

2y 51.8 bp 59% -15.9 bp -15.7 bp 69.5 bp 77% -3.9 bp -3.7 bp 81.9 bp 82% 4.1 bp 4.6 bp 86.3 bp 96% 6.2 bp 6.5 bp 84.9 bp 89% 5.7 bp 6.2 bp 80.6 bp 85% 0.8 bp 1.6 bp 70.7 bp 72% -1.9 bp -0.8 bp Imp/Act ratio (3m z-score) PCA residual (3m z-score)

5y 70.6 bp 0.4 bp 80.3 bp 5.0 bp 84.6 bp 7.0 bp 84.6 bp 4.2 bp 82.2 bp 0.6 bp 78.9 bp 1.9 bp 71.0 bp 0.7 bp

80% 0.8 bp 92% 5.4 bp 93% 7.4 bp 92% 4.3 bp 88% 0.7 bp 81% 2.2 bp 72% 1.5 bp

10y 76.7 bp 88% 2.2 bp 2.7 bp 81.9 bp 94% 4.9 bp 5.2 bp 83.0 bp 91% 5.0 bp 5.1 bp 82.6 bp 89% 2.5 bp 1.8 bp 81.2 bp 85% 0.3 bp -0.2 bp 78.4 bp 79% 0.4 bp 0.2 bp 69.9 bp 70% -1.7 bp -1.1 bp

20y 77.9 bp 86% -1.1 bp -0.7 bp 80.7 bp 90% 2.6 bp 2.5 bp 80.1 bp 86% 2.5 bp 1.4 bp 77.7 bp 81% -1.1 bp -3.0 bp 73.9 bp 76% -1.9 bp -3.6 bp 69.8 bp 70% -1.2 bp -2.7 bp 58.8 bp 60% -3.9 bp -3.9 bp

30y 78.8 bp 84% -5.4 bp -5.1 bp z-score 81.1 bp 89% Rich 3 -1.9 bp -2.4 bp 2.4 80.5 bp 85% 1.8 -2.2 bp -3.6 bp 1.2 77.1 bp 79% 0.6 -4.3 bp -6.4 bp 0 72.9 bp 74% -0.6 -3.7 bp -5.6 bp -1.2 67.2 bp 68% -1.8 -3.5 bp -5.2 bp Cheap -3 54.7 bp 57% -5.5 bp -5.8 bp

Source: RBS

European Rates Weekly | 11 May 2012 Page 46

Market update
Vol has also been well bid in GBP in general, in sympathy with the Euro Area. Top left has been particularly well bid, with the MPCs decision to pause (stop?) QE, allowing top-right to soften relatively, particularly as pausing QE maintained the sense that there has been a shift in the Banks view of inflation. This dynamic is clearly visible in the PCA analysis below. Vega has been a little softer.

Trading the change in the MPCs stance

L is not strong, but after years of higher than hoped-for inflation, there appears to be concern growing in the MPC about the supply side. This shouldnt be overstated at this point. The minutes to the April meeting were still quite dovish and downplayed inflation risks at nearly every turn. But the evidence from speeches and as revealed by the Banks decision not to continue Asset Purchases this week suggest that there is concern that poor productivity and perhaps less spare capacity than previously thought may support inflation. The Inflation Report next week explaining the policy decision this month will be where we get the best steer on how far MPC thinking has moved in this direction. Euro Area risks have kept a lid on the front end, and supported volatility: 2y2y is mid range, although 2y spot is at the high end of its range (Chart below left), while volatility is not high, it is up sharply from the lows (below right).
Front end is pushing highs in spot, but mid-range in forwards Vol has picked up sharply on Euro Area worries

2 1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 Nov-11 Dec-11 Jan-12 2y2y 2y spot










Source: RBS

40 May-00 May-02 May-04 2y2y 1y2y





Source: RBS

This combination suggests selling exposure to lower rates if you believe that the Bank is likely to pay more attention in the future to inflation overshoots. Selling ATM receivers on 2y2y, for example gives protection in a rally to around 1.2%, which is close to the lows in spot (at around 1.15%), and selling 10bp OTM receivers will not lose until below this level. On the other hand, selling receivers carries badly in the rates and in the current environment of high anxiety on the Euro Area may not be particularly attractive. 1x2s in receivers are an alternative: to express a modestly bearish view buying deep in the money receivers and selling the ATM can be done at a spread wide enough that the strategy can be protected in a rally down to 1% in 2y at expiry. To illustrate, P&L regions for 1x2 receivers with front strike 42bp in-the-money are shown below.

European Rates Weekly | 11 May 2012 Page 47

P&L regions for 1x2 receiver spreads with front strike set 42bp OTM
2 .5
A ll e xp ire O T M

2 .0

1 .5 (%) 1 .0
Lose Lose

Ma x P ro f it


0 .5

0 .0 O c t-1 0 A p r-1 1 2y swap B /E le ve l

O c t-1 1

A p r-1 2
F ro nt s trike F o rw a rd s

O c t-1 2

A p r-1 3
Ma x P &L

O c t-1 3

A p r-1 4

Source: RBS

The prototype triangle monitor

Please see p15. If you have any comments on this analysis (or any other in this document) please contact me.

ATM vol multi-map: UK

ATM normvol surface historical 4-in-1 heat-map colouring denotes 3m z-score of each measure

In/For 1y 2y 3y 5y 7y 10y 20y

1y 59.9 bp 92% -12.5 bp -9.5 bp 77.4 bp 90% -10.8 bp -7.5 bp 86.3 bp 78% -4.3 bp -1.0 bp 90.1 bp 84% 2.5 bp 3.9 bp 85.3 bp 65% 5.6 bp 6.5 bp 76.8 bp 77% 5.1 bp 6.5 bp 64.8 bp 74% -0.1 bp 1.9 bp bp vol level (3m z-score) PCA (with rates) (3m z-score)

2y 67.3 bp 92% -12.3 bp -9.0 bp 80.9 bp 89% -7.0 bp -3.8 bp 87.6 bp 84% -1.4 bp 1.4 bp 88.3 bp 80% 3.4 bp 4.8 bp 83.3 bp 70% 5.4 bp 6.6 bp 75.8 bp 84% 4.2 bp 6.0 bp 63.9 bp 76% -0.8 bp 1.0 bp Imp/Act ratio (3m z-score) PCA residual (3m z-score)

5y 78.5 bp 91% -6.8 bp -5.2 bp 82.9 bp 86% -3.0 bp -1.5 bp 85.4 bp 79% 0.9 bp 2.2 bp 84.7 bp 75% 3.7 bp 4.6 bp 80.0 bp 76% 4.4 bp 5.1 bp 73.6 bp 83% 1.6 bp 2.8 bp 61.2 bp 71% -2.5 bp -1.2 bp

10y 84.2 bp 91% 0.0 bp -0.7 bp 83.6 bp 87% 0.4 bp 0.1 bp 82.1 bp 82% 1.3 bp 1.2 bp 79.3 bp 79% 2.5 bp 3.2 bp 76.1 bp 80% 3.2 bp 3.7 bp 71.0 bp 84% 0.6 bp 0.7 bp 59.1 bp 67% -2.8 bp -2.5 bp

20y 78.3 bp 93% 0.1 bp -2.2 bp 77.8 bp 90% 0.8 bp -1.3 bp 76.1 bp 85% 1.0 bp -0.5 bp 73.3 bp 82% 1.2 bp 1.1 bp 69.5 bp 79% 0.4 bp 0.3 bp 64.2 bp 76% -2.1 bp -2.8 bp 51.9 bp 62% -5.2 bp -5.6 bp

30y 73.4 bp 91% -1.2 bp -4.3 bp z-score 73.8 bp 89% Rich 3 0.4 bp -2.5 bp 2.4 72.4 bp 84% 1.8 0.5 bp -2.1 bp 1.2 69.8 bp 80% 0.6 0.1 bp -0.9 bp 0 65.4 bp 75% -0.6 -0.7 bp -1.5 bp -1.2 59.7 bp 71% -1.8 -3.0 bp -4.1 bp Cheap -3 47.0 bp 56% -6.2 bp -7.1 bp

Source: RBS

European Rates Weekly | 11 May 2012 Page 48

Brian Mangwiro

Futures & Options Strategy

Stay long front Euribors. Buy 99.50 & 99.62 strikes in call options. We expect a deeper EMU crisis, more ECB easing and more upside; Short Sterling: we are still bearish, especially in greens. Rate vol is high in reds and greens, so high delta put structures are ideal. Finance via selling 99.00-plus calls. Sticky 3m GBP LIBOR and widening FRA-OIS limit upside risks; Bund futures: Buxl open interest is at record highs. Yield grab is extending along the curve. 10y is the new sweet spot. Consider 2s10s flattener, spread is at 117bp on CTD yields (142bp on generics), target 25bp tightening, stop at 130bp; Long Gilt futures: Safe haven bid has renewed the rally. A CTD switch from 5 25s to 4 22s is still on the cards.

Have you hedged your Greeks?

Key focus this week is on all things Greece. Harvinder and Biagio have given the full testament in the Sovereign section. All we ask is: have you hedged your risks in the event of a Greek EMU exit? Markets seem uncomfortably calm (vols floored, gamma well-offered) ahead of such a (highly probable and) monumental event. Perhaps market exposure to Greece is much smaller now after the PSI, but it echoes the complacency that pre-dated the Lehman collapse. Then, it was just another bank, until those dendritic connections were exposed. Be wary. This week we give a quick re-affirmation of our thoughts on front-end and long-end Europe.

Load up on front Euribors; the crisis is your little helper

Last week we highlighted that we thought the hot Greek election aftermath was going to increase market stresses, widen EUR FRA-OIS and drag down Euribor futures. It happened. Euribor futures sold-off 5-9 ticks, but we think the sell-off in fronts (June-12 to Dec-12) was overdone. We recommend fading these moves. On the contrary, Short Sterling rallied in anticipation of more Bank of England (BoE) QE. That was wrong, hence the sharp correction post BoE rate announcement.
EUR and GBP FRA-OIS (2nd IMM dated contracts). Both spiked in the election aftermath, and the basis is still widening
60 55 4 50 45 widening basis 40 35 30 -10 25 Jan-12 -12 10-Jan 2 0 -2 -4 -6 -8 EUR FRA-OIS change GBP FRA-OIS change bp EUR FRA-OIS GBP FRA-OIS

EUR and GBP FRA-OIS changes (2nd IMM dated contract). EUR FRA-OIS has tightened sharply. Complacency?
8 6 bp post-election spike




Source: RBS




Source: RBS

Note that (i) FRA-OIS widened most in EUR, and is reversing these moves much faster in EUR too. Is this a mark of complacency? Vol down, FRA-OIS down, while event risks

European Rates Weekly | 11 May 2012 Page 49

loom large. (ii) FRA-OIS basis between GBP and EUR has been widening since Jan12. This weighs on Short Sterling much more, hence our preference to sell Short Sterling versus Euribor. One could argue that credit risk in the Eurosystem is being under-estimated, especially with the Euribor bank panel CDS still widening. Simply, this reflects the direct pumping of liquidity in Europe via ECB LTROs versus its absence in the UK. Excess liquidity distorts credit risk premia, in our view. Recommended strategies: For Euribor, we recommend to maintain longs in June-12, Sep-12 and Dec-12 contracts. Our reasoning is two-pronged: (i) copious amounts of liquidity in the Eurosystem, but more importantly, if the crisis deepens, the ECBs hand will be forced. We believe that currently, only the ECB has the pre-disposition and balance sheet to respond. More easing will come, Euribors will richen, hence our bias to play for upside in front white Euribors. RBS economists still expect two more ECB rate cuts in 2012: in June-12 and Sep-12.
June-12 Euribor: price and open interest
99.45 99.40 99.35 99.30 99.25 99.20 99.15 99.10 99.05 99.00 Jan-12 Mar-12 May-12
Source: RBS

Sep-12 Euribor: price and open interest

99.50 99.45 99.40 99.35 99.30 99.25 99.20 99.15 99.10 99.05 99.00 Jan-12 Sep-12 price Open Int 560000 540000 520000 500000 480000 460000 440000 420000 400000 Mar-12 May-12
Source: RBS

Dec-12 Euribor: price and open interest

99.50 99.45 99.40 99.35 99.30 99.25 99.20 99.15 99.10 99.05 99.00 Jan-12 Dec-12 price Open Int 490000 470000 450000 430000 410000 390000 370000 350000 Mar-12 May-12
Source: RBS

June-12 price Open Int

650000 600000 550000 500000 450000 400000

Open interest in June-12 Euribor 99.50 and 99.625 call options is down. Buy.
400000 350000 300000 250000 200000 150000 100000 50000 0 Jan-12 ERM2C 99.50 ERM2C 99.625 Mar-12 May-12
Source: RBS

Open interest in Sep-12 Euribor 99.50 and 99.625 call options is down. Buy.
300000 250000 200000 150000 100000 50000 0 Jan-12 ERU2C 99.50 ERU2C 99.625 160000 140000 120000

Open interest in Dec-12 Euribor 99.50 and 99.625 call options is down. Buy.
250000 200000 150000 100000 50000 0 Jan-12 ERZ2C 99.50 ERZ2C 99.625 250000 200000 150000 100000 50000 0 Mar-12 May-12
Source: RBS

120000 100000 80000 60000 40000 20000 0

100000 80000 60000 40000 20000 0 Mar-12 May-12

Source: RBS

We would buy (i) outright futures; (ii) 99.50 and 99.62 call options (the decline in open interest implies suggests shorts exited in size. We see good value and recommend to stay long), or (iii) tactical whites/reds steepeners. Our convictions and trades remain unchanged. The sell-off was mainly driven by panic profit taking, in our view, and liquidations were much sharper on the 99.50 strike. Front Euribor futures are still 7 ticks off their recent highs; vol is still floored and entry levels are still good. Recent flows suggest that investors are returning back to these rate cut trades (open interest has a 2-day lag). FRA-OIS outlook for the coming week: We are surprised that EUR FRA-OIS is tightening sharply, especially when (i) Greece still has no government, (ii) Spain has its banks (and corporates) effectively shut out of capital markets, with deeply entrenched

European Rates Weekly | 11 May 2012 Page 50

balance sheet problems. Spain is also struggling with high borrowing costs; current 10y SPGB is yielding 6.0%; and (iv) Moodys impending re-rating of European banks. Moodys re-rating exercise is the one to watch. Bank downgrades will widen FRAOIS. Depending on the magnitude of downgrades, victims may not be able to borrow from money-market funds (as they tend to have strict borrowing criteria), deepening the addicted bank problem. For choice, we still position for whites/reds, whites/greens steepeners. This is a tactical play. Long term, we expect further steam rolling of the Euribor strip.

UK: No QE extension; Short Sterling futures and Gilts underperform

Next stop is the Inflation Report for the medium-term outlook. House call is for no more QE, so price action is back to being at the mercy of (volatile) UK economic data and the EMU periphery. Short sterlingare we ranging trading? We think so, but with more downside bias. Front whites are nailed to 3m GBP LIBOR and yet GBP FRA-OIS is widening (the 2nd IMM dated contract is back to its Sep-11 summits. And this is before Moodys strikes. Have a look at the charts below:
GBP FRA-OIS widening and a stubborn 3m GBP LIBOR will continue to weigh on the Short Sterling. Sell upside
80 bp GBP FRA-OIS 3m GBP LIBOR 60 % 1.15 99.20 70 1.10 1.05 1.00 0.95 0.90 98.80 0.85 30 0.80 0.75 May-12
Source: Bloomberg, RBS

Sep-12 Short Sterling. Rising open interest and price dropping suggests overall short positioning
Open Interest L U2 price 350000 330000 310000 290000 270000 250000 230000 98.70 98.60 Jun-11 210000 190000 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12
Source: Bloomberg, RBS

99.10 99.00 98.90



20 May-11



Short Sterling reds have hit key supports. Positioning is net short and looks to be a range trade
99.15 99.05 98.95 200000 98.85 150000 98.75 100000 98.65 Open Interest L U3 price 250000 300000

Short Sterling greens are still above 3m lows; still room for downside high delta option plays
98.90 98.80 98.70 100000 98.60 98.50 98.40 98.30 40000 98.20 80000 60000 Open Interest L U3 price 140000 120000

98.55 98.45 Aug-11


0 Oct-11 Dec-11 Feb-12 Apr-12
Source: Bloomberg, RBS

20000 0 Oct-11 Dec-11 Feb-12 Apr-12

Source: Bloomberg, RBS S

98.00 Aug-11

European Rates Weekly | 11 May 2012 Page 51

Here is how we would trade short Sterling: Futures: The strip is heavily pre-disposed to a market sell-off high GBP FRA-OIS and fairly unchanging 3m GBP LIBOR limit upside potential. Also, market stresses are felt much more in GBP space relative to Europe. The likelihood and magnitude of downside moves increases from front to back contracts, hence our bias for tactical steepeners. Whites/reds spreads are OK, but reds/greens steepeners seem to have more juice. Options: There is more headroom for downside play in greens (1y2f) than whites (3-, 6- and 9m1yf) and reds (1y1f). Reds have sold off to key supports (see bottom left chart above). To break through these levels, we need decent economic data (in the UK or US) and/or magnified risks of inflation stickiness. Both are likely, in our opinion. For now, short positions in greens are more appealing. That said, positioning seems overwhelmingly short and that is indeed a worry. If UK data started to show significant deterioration, it could get squeezy soon. In line with our preference for reds/greens steepeners, we would buy upside in reds via call spreads. Strategies: (i) We like selling upside above 99.00 and use that to finance downside exposure, especially in reds and greens. You can cap your losses via selling call spreads, but above 99.125, we have a very strong conviction to sell naked calls to finance buying puts, especially in greens. Like many, we do not see the prospects of a BoE rate cut, and inflation is more likely than not to be a problem in the medium term; and (ii) the wide trading ranges means Short Sterling normalised vol remains rich, especially in reds and greens. In this backdrop cheap, low delta and expiry targeting structures will be largely a miss. We prefer high delta positions on the downside; capture the move as it happens. Of course you pay more, but you also get what you pay for.

Bundswhat does open interest say?

Market is limit long on bunds, but we have been grinding to these low yields on increasingly lighter volumes. We are structurally bullish bunds on continuing Eurozone woes, so our position does not change. Below, we show levels of open interest versus days to expiry and make some observations.
Schatz open interest is floating around recent averages despite record low yields. Safe haven bid
Open interest 1400000 1200000 1000000 800000 600000 400000 200000 0 80 70 60 50 40 30 20 10 0
Source: RBS

Bobl open interest has declined recently from record highs. It seems shorts were squeezed out
Open interest 900000 800000 700000 600000 500000 400000 300000


DUH2 DUU1 Days to expiry



200000 100000

Days to expiry 0 80 70 60 50 40 30 20 10 0
Source: RBS

Schatz: open interest is still at the levels seen during the Dec-11 contract roll. The ultra-low yields (current 7.5bp) have not deterred buying; unsurprising given the high structural demand for AAA collateral. If the crisis deepens, we expect negative Schatz yields.

European Rates Weekly | 11 May 2012 Page 52

Bobl: open interest has been steadily declining in the past 10 trading days in line with market flows. Investors have been switching out of DEM5y into 5y DSL, RAGB and OATs. The side chart also provides further evidence of the drop in interest, but with the price holding firm, suggesting shorts caught offside rather than initiation of new shorts. In line, DEM5y has not underperformed; stuck in an 8bp range (currently 53.6bp). Nonetheless, the risk of Bobl underperforming cannot be overlooked, especially as it is quite rich on the fly.
Bund open interest is still grinding higher. With Schatz and Bobl at ultra lows, Bunds are the new sweet spot
Open interest 1000000

Buxl open interest is at record highs. (25y) sector is flattening. Is this an extension of the yield grab?
Open interest 60000




400000 RXM2 RXZ1 RXH2 RXU1 Days to expiry 0 80 70 60 50 40 30 20 10 0

20000 UBM2 UBZ1 UBH2 UBU1 Days to expiry 0 80 70 60 50 40 30 20 10 0



Source: Bloomberg, RBS

Source: Bloomberg, RBS

Bund: Bund open interest is still grinding higher, almost touching on Sep-11 highs. With Schatz and Bobl floored in yields, Bunds are the next sweet spot for carry/ rolldown, especially for investors restricted to investing in EMU AAA government bonds. That open interest and price are both rising suggests the market is still getting long. This is further substantiated by the futures yield spread charts shown below. Buxl: This contract has seen a significant surge in open interest coupled with flattening in the 2s30s, 5s 30s and 10s30s slope. This suggests the market is getting long German long end as well in search of yield, given that the front end of the curve is well-bid and super flat. Another consideration is the Solvency II framework due to be implemented in Europe. Broadly, this is expected to reduce demand at the very long end as pensions funds shift from bonds to a swap discount curve (thus less structural demand for the long end). The Buxl CTD is a 25 yr, which is around the last liquid point on the swap discounting curve under Solvency II. This would stimulate some hedging demand, and consequently an increase in open interest.

Slope trades: Flattening is the overriding theme

Below we also show how the Buxl has recently outperformed Schatz, Bobls and Bunds. More importantly, with both 2s and 5s floored, 10s and 30s are attracting a much stronger bid on carry foraging. Have a look at the charts below. We show both the generic and futures CTD yield basis. The overall theme here isflattening; rolling yield curve compression.

European Rates Weekly | 11 May 2012 Page 53

Schatz-Bobl spread vs. DEM 2-5y slope; flattening aggressively

70 bp 65 60 55 50 45 3-Apr-12 DEM 2-5y generic OEM2-DUM2 21-Apr-12 65 60 55 50 45 40 35 30 9-May-12
Source: Bloomberg, RBS

Schatz-Bund spread vs. DEM 2-10y slope

170 165 160 155 150 145 140 135 3-Apr-12 DEM 2-10y generic RXM2-DUM2 21-Apr-12 bp 150 145 140 135 130 125 120 115 110 9-May-12
Source: Bloomberg, RBS

Schatz-Buxl spread vs. DEM 2-30y slope

240 235 230 225 220 215 210 205 3-Apr-12 UBM2-DUM2 DEM 2-30y generic 21-Apr-12 9-May-12
Source: Bloomberg, RBS


Bobl-Bund spread had been resistant to tightening for some time. Welcome
110 bp 105 85 100 95 90 DEM 5-10y generic 85 80 3-Apr-12 RXM2-OEM2 21-Apr-12 70 9-May-12
Source: Bloomberg, RBS

Bobl-Buxl spreadalso started tightening. We think theres more

190 bp 185 180 170 180

Bund-Buxl spread. Not attractive for flatteners just yet

105 100 95 160 90 85 UBM2-RXM2 DEM 10-30y generic bp 80 75 70 65


80 175 75 170 165 3-Apr-12 UBM2-OEM2 DEM 5-30y generic 21-Apr-12 150 9-May-12
Source: Bloomberg, RBS

60 55 50 9-May-12
Source: Bloomberg, RBS

80 3-Apr-12


We like DEM 2s10s and 5s30s flatteners. Schatz yields are floored; edging close to yield parity with 12m Bubills. The most popular trade would be a 2s10s flattener. TRADE IDEA: Buy June-12 Bund futures (RXM2) versus selling June-12 Schatz (DUM2) at current 117bp (in CTD yield terms; stop at 130bp) and target a 25bp compression in the spread. Hedge ratio is 1000 RXM2: 180 DUM2. Using generic bonds, the spread is currently at 142bp. On the 5s30s flattener, the current spread is 177bp, and we would also target a 25bp tightening in the spread at first, stop at 188bp (we like this trade very much). Note that the Buxl CTD is a 25yr bond. Therefore, strictly speaking, this is a DEM 5s25s spread. Also keep in mind the contract roll requirements. June-12 bund futures contracts expire on the 7th of June 2012.

Long Gilts: Does no more QE mean no CTD switch?

No. 10y Gilts lost 7bp after the BoE left the policy settings unchanged (including no QE) on Thursday. Overall, price action and open interest in Long Gilt futures suggests that the safe haven bid is now somewhat replacing QE. 10y Gilts are bouncing back, recouping all the losses from yesterday. Relative to previous contract rolls, current June-12 Long Gilt futures open interest is running a touch below the 4-contract cycle average. Is the CTD switch still coming? Our scenario analyses show that the NB differential between the CTD UKT 5% Mar-25 and the next competitor UKT 4% Mar-22 has widened to 24 pence (c. 2.4bp) versus the pre-MPC level of 10 pence (c. 1bp). The hurdle is slightly higher for 4% 22s to topple 5% Mar-25 as the next CTD. But if Gilts continue to rally on the safe haven bid, a CTD switch remains very possible, in our view.

European Rates Weekly | 11 May 2012 Page 54

June-12 Long Gilt futures open interest versus previous contract rolls; a tad below average
400000 350000 300000 250000 200000

June-12 Long Gilt futures open interest versus price. Trends suggests market went short before the MPC
118.50 118.00 320000 117.50 117.00 116.50 300000 116.00 150000 115.50 100000 115.00 280000 114.50 114.00 2-Apr 270000 9-Apr 16-Apr 23-Apr 30-Apr 7-May
Source: Bloomberg, RBS

G M2

Open interest




G M2 G U1

G H2 G M1

G Z1

50000 0

80 75 70 65 60 55 50 45 40 35 30 25 20 15 10

Source: Bloomberg, RBS

UKT 5% 25 auction and the CTD switch: As we mentioned last week, the UKT 5% Mar-25 bond gets auctioned on the 15th of May. If the bond were to concede into the auction, this will further raise the CTD switch hurdle. Our general view is that the bond is not too attractive on flies, and may need to see the some concession for strong results. By and large, the larger the concession, the higher the chances of a good takeup and strength of a post-auction rally, which would in turn support the CTD switch optionality (25s rally much more than 22s). Until then we wait. Below we show our usual customary scenario analysis charts for June-12 delivery.
Same-day net basis (NB) scenario analyses. For CTD, NB at delivery is zero. CTD switch to Mar-22s happens at point A, and to Sep-21s at point B
2.00 1.80 1.60 1.40 1.20 1.00 0.80 0.60 0.40 0.20 0.00 60 40 30 20 10 0 -10 -20 -30 -40 -60 B 114.5000 112.5000 110.5000 market sell-off market rally
Source: Bloomberg, RBS

Theo fut prices for June-12 deliverables. Lowest price = CTD at the yield level. CTD switch to Mar-22s happens at point A, and to Sep-1s at point B

net basis at delvry (GBP0.00) 124.5000 UKT 3.75% Sep-21 UKT 4% Mar-22 UKT 5% Mar-25 122.5000 120.5000 118.5000 A 116.5000 B Price UKT 3.75% Sep-21 UKT 4% Mar-22 UKT 5% Mar-25

market sell-off

market rally











Source: Bloomberg, RBS

Note that: (i) our scenario analyses show a CTD switch is still possible if outright yield levels in 10y Gilts drop by 10bp (to c. 1.85%; current 1.96%); (ii) a strong post-auction rally will help reduce the hurdle; and (iii) an even stronger rally brings UKT 3.75% Sep21 into the frame as yet another CTD competitor. In the event of a messy conclusion to the Greek saga, we can see 10y Gilts at 1.5%, 10y bunds at 1%, in which case, the UKT 3.75% Sep-21 bond should become CTD.

European Rates Weekly | 11 May 2012 Page 55

Technical Strategy
Dmytro Bondar
Bund RX1 daily chart with Fibonacci retracements, slow stochastic, volume and 9-day MA

Bund RX Bunds reached the 142.85 target, but displayed signals of a possible correction If so, the major support levels should provide buying opportunities, as we believe the long-term view remains bullish

Source: RBS, Bloomberg

Sweden 10-yr In the long term, the market is still bullish post key level breakout and positive momentum In the short term, it is overbought and a correction to 5-day MA looks possible

Bund RX1 met the 142.85 target (long-term target published in the previous weekly) and even rallied to 143.00; although in our view the trend looks like it has run ahead of itself and hence a correction/consolidation is needed. Among technical indicators pointing to this are momentum divergence with the price, a Harami cross candlestick pattern and a 3rd-time failure to break 143.00. If so, the key support levels would be 142.00 and 141.40. The bias is for a correction/consolidation in the short term to 142.00 (possibly 141.40), but a resumption of the uptrend to 143.00 and new highs thereafter. Once 143.00 is broken, our next long-term targets would be 143.70, 144.30, 144.70 and 145.10.

10-yr Sweden daily chart with Fibonacci retracements, 5-day MA and RSI

Source: RBS, Bloomberg

Sweden 10-yr generic yield a break of the 1.55% resistance (the 150% Fibonacci retracement from the Aug10-Feb11 extremes) in a strong trend suggests further potential for the yields to go lower to the next key resistance level 1.39%, although an RSI oscillator entering overbought region (on the yield chart) suggests a possible pause/correction to the 5-day moving average before trend resumption.

European Rates Weekly | 11 May 2012 Page 56

EMU Issuance Update

Claire Tucker

Gross Issuance
Our gross issuance forecasts for 2012 are adjusted to reflect the extra funding required for the ESM (a total of EUR 32bn shared across the euro area countries). The percentage contributions to the ESM are based on each countrys National Central Banks contribution to the ECB capital key. Please note that all issuance amounts are quoted on an auction date basis rather than a settlement date basis.
Gross Issuance 2012 (EUR bn)
RBS Forecast Germany France Italy* Spain Nether. Belgium Austria Finland 182.0 195.0 221.0 98.0 61.0 28.0 22.0 13.0 Year To Date 66.0 85.0 80.3 48.1 30.8 17.0 10.2 3.0 ESM contrb. (%of 32bn) 27.1% 20.3% 17.9% 11.9% 5.7% 3.5% 2.8% 1.8% RBS adj. for ESM 190.7 201.5 226.7 101.8 62.8 29.1 22.9 13.6 Remaining (inc. ESM) 124.7 116.5 146.4 53.7 32.0 12.1 12.7 10.6 % complete (inc. ESM) 34.6% 42.2% 35.4% 47.2% 49.1% 58.3% 44.6% 22.1%

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy, ECB

Chart 1 below shows the total amount issued by each country compared to the amount that remains to be issued in order to meet the countrys funding requirement for 2012 (according to our estimates, including ESM funding).

Chart 1: Gross Issuance 2012 YTD & Remaining (EUR bn)

225 200 175 150 125 100 75 50 25 0 Germany France Italy Spain Netherlands 66 85 80 48 54 32 31 12 17 Belgium 13 10 Austria 125 146 117 EUR billions Issued to date Remaining (2012, inc ESM funding)

11 3 Finland

Source: RBS Rates Strategy

Chart 2 shows a breakdown of the debt issued to date this year by maturity sector (as a percentage of the total amount issued to date).

European Rates Weekly | 11 May 2012 Page 57

Chart 2: Gross Issuance YTD by Bucket (as % of total YTD)

Finland Austria Belgium Netherlands Spain Italy France Germany 0% CTZs Floater 2Y 20% 3Y 5Y 10Y 40% 15Y 20Y 30Y 60% 50Y Linkers
Source: RBS Rates Strategy.



Monthly gross issuance in historical and expected context

The tables below compare monthly issuance for each country over the last eight years and the 8y averages against 2012 monthly issuance (YTD and forecast). The MayDecember and total 2012 figures (italics) are a combination of announced sizes where available and our own estimates, based on individual debt agencies indicative calendars and historical patterns. The figures include the additional funding required for the countries ESM contributions.

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 19 15 13 6 14 9 19 16 9 13 13 7 152 2005 20 6 14 7 12 18 9 5 13 12 12 7 136 2006 27 7 23 13 8 11 21 7 17 11 11 7 162 2007 20 6 14 9 12 12 16 6 13 15 12 7 142 2008 18 6 18 7 13 13 20 6 15 12 11 7 146 2009 13 6 20 7 21 20 6 6 24 13 17 5 158 2010 24 18 17 24 20 18 15 13 19 11 18 10 207 2011 20 16 17 22 18 16 10 13 16 12 18 10 188 Average 20 10 17 12 15 15 14 9 16 12 14 8 161 Avg % complete 12% 19% 29% 37% 46% 55% 64% 69% 79% 87% 95% 100% 100% 2012* 16 18 11 16 15 15 15 10 20 20 20 15 191 2012 % complete 8% 18 % 24 % 32 % 40 % 48 % 55 % 61 % 71 % 82 % 92 % 100 % 100 %

*estimates from publication date.

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

European Rates Weekly | 11 May 2012 Page 58

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 16 14 14 11 13 14 9 11 11 12 125 2005 14 20 10 10 10 13 14 11 9 11 123 2006 13 12 11 13 11 9 14 10 11 9 113 2007 13 12 9 11 11 11 9 8 7 8 97 2008 13 14 11 18 7 11 7 12 13 14 118 2009 15 15 18 16 17 23 16 18 18 17 6 179 2010 23 19 23 20 21 20 20 19 20 20 9 214 2011 22 21 19 22 23 21 20 20 18 17 5 208 Average 16 16 14 15 14 15 14 0 14 13 13 2 147 Avg % complete 11% 22% 32% 42% 51% 62% 71% 71% 80% 89% 98% 100% 100% 2012* 19 20 18 19 18 21 21 20 20 20 6 202 2012 % complete 9% 19 % 28 % 38 % 47 % 57 % 67 % 67 % 77 % 87 % 97 % 100 % 100 %

*estimates from publication date.

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 23 22 26 26 18 14 12 11 15 12 8 186 2005 23 17 16 18 16 17 13 9 17 16 2 8 171 2006 17 19 18 19 15 18 14 10 11 11 4 13 166 2007 15 17 18 19 16 17 14 11 13 18 3 9 167 2008 19 17 12 21 15 14 15 12 7 15 14 14 173 2009 20 24 25 30 23 27 29 18 28 21 10 13 268 2010 24 24 19 19 19 20 21 22 25 24 15 15 246 2011 21 17 19 24 18 18 15 10 20 18 15 11 206 Average 20 20 19 22 17 18 16 13 17 17 8 11 198 Avg % complete 10% 20% 30% 41% 49% 59% 67% 73% 82% 90% 94% 100% 100% 2012* 20 19 26 16 17 21 20 16 21 20 16 15 227 2012 % complete 9% 17 % 29 % 35 % 43 % 52 % 61 % 68 % 78 % 86 % 93 % 100 % 100 %

*estimates from publication date.

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 4 3 2 2 4 6 2 3 2 4 4 37 2005 10 3 2 4 3 2 1 5 1 3 1 34 2006 5 3 3 2 1 1 3 2 5 1 1 28 2007 5 2 3 4 6 2 3 2 1 27 2008 6 5 1 2 4 2 5 4 2 5 12 9 57 2009 9 16 7 10 14 3 10 4 12 8 9 5 107 2010 10 9 11 6 7 8 13 4 7 8 7 8 96 2011 9 7 8 8 7 8 6 4 8 9 9 12 94 Average 7 6 5 5 5 5 5 2 5 5 6 5 60 Avg % complete 12% 22% 30% 38% 46% 53% 62% 65% 74% 82% 91% 100% 100% 2012* 19 14 8 5 7 7 7 5 8 8 7 7 102 2012 % complete 19 % 32 % 40 % 45 % 52 % 59 % 66 % 71 % 78 % 86 % 93 % 100 % 100 %

*estimates from publication date.

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

European Rates Weekly | 11 May 2012 Page 59

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 3 2 7 2 2 2 2 3 7 2 31 2005 3 2 2 7 2 7 2 2 2 2 29 2006 2 2 2 2 2 1 5 2 3 2 21 2007 1 3 2 2 6 4 2 21 2008 3 7 3 3 2 16 5 2 40 2009 6 7 4 4 4 4 7 4 3 4 48 2010 6 10 4 5 9 5 3 4 2 3 1 53 2011 6 2 10 5 3 3 5 5 8 4 49 Average 4 4 4 3 3 3 4 0 5 3 3 0 37 Avg % complete 10% 21% 32% 41% 49% 58% 69% 69% 83% 91% 99% 100% 100% 2012* 6 10 7 6 6 6 8** 5 5 4 63 2012 % complete 10 % 25 % 37 % 46 % 56 % 65 % 78 % 78 % 86 % 94 % 100 % 100 % 100 %

*estimates from publication date

**includes DDA Est.4-5bn (3 July )

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 5 3 5 3 3 2 22 2005 5 5 3 3 4 2 21 2006 3 5 3 2 2 16 2007 5 3 5 3 3 3 23 2008 4 3 3 5 3 3 2 4 28 2009 7 3 5 4 2 5 3 3 3 35 2010 5 4 4 4 9 3 3 2 3 2 39 2011 3 6 5 3 4 4 3 3 4 2 2 38 Average 4 2 4 3 3 2 3 1 3 1 2 0 28 Avg % complete 15% 23% 38% 47% 57% 65% 76% 78% 89% 91% 100% 100% 100% 2012* 5 4 8 3 2 2 3 1 1 29 2012 % complete 17 % 31 % 59 % 59 % 69 % 76 % 83 % 83 % 93 % 97 % 100 % 100 % 100 %

*estimates from publication date.

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 3 1 1 2 1 1 1 1 1 1 14 2005 4 1 2 6 1 1 1 1 1 16 2006 4 1 1 5 2 2 2 1 1 18 2007 3 1 1 2 1 1 2 5 1 1 17 2008 4 1 1 1 1 1 1 1 1 1 1 11 2009 3 2 2 1 2 4 2 2 2 2 1 23 2010 4 2 2 2 2 2 1 1 2 2 1 1 22 2011 4 2 1 2 1 2 2 1 1 1 17 Average 4 1 1 3 1 2 1 0 2 1 0 0 17 Avg % complete 21% 28% 36% 51% 58% 68% 76% 78% 89% 95% 98% 100% 100% 2012* 6 1 1 2 2 2 2 2 2 2 1 23 2012 % complete 26 % 26 % 30 % 35 % 43 % 52 % 61 % 70 % 78 % 87 % 96 % 100 % 100 %

*estimates from publication date.

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

European Rates Weekly | 11 May 2012 Page 60

2004 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total 5 5 2005 2 5 7 2006 5 1 6 2007 4 1 5 2008 4 1 5 2009 6 1 3 10 2010 1 4 2 2 4 2 14 2011 2 4 2 2 3 2 13 Average 0 1 1 2 2 0 0 0 1 0 1 0 8 Avg % complete 4% 10% 26% 47% 70% 75% 75% 75% 86% 91% 100% 100% 100% 2012* 3 1 2 2 2 2 2 14 2012 % complete 21 % 21 % 21 % 21 % 29 % 43 % 57 % 57 % 71 % 86 % 100 % 100 % 100 %

*estimates from publication date.

Issuance amounts are quoted on an auction date basis

Source: RBS Rates Strategy

Q2 Gross Issuance by Maturity Sector

We look at April issuance by maturity sector and estimate the bucket distribution for May* and June. For Germany and the Netherlands the maturities and sizes have been announced already, whereas for France, Italy and Spain we have forecast the distribution based on historical patterns. We have omitted Belgium, Austria and Finland due to the small issuance amounts and the fact that auctions can often be moved or swapped for syndications. *The May estimates take into account what has been issued/announced already.
CTZs Germany France Italy Spain Nether. 1.1 2.8 Floater 2Y 5.0 1.3 4.3 3.6 2.2 3Y 5Y 4.0 2.8 3.2 1.0 3.5 10Y 4.0 4.7 5.1 1.9 1.1 1.7 15Y 20Y 30Y 3.0 1.2 2.5 1.0 50Y Linkers Total 16.0 18.5 15.7 5.1 5.8

MAY (forecast, EUR bn)

Germany France Italy Spain Nether. 3.0 5.0 2.5 2.5 3.5 1.1 2.2 3.5 5.0 4.1 3.5 1.7 5.0 5.9 5.2 2.0 2.5 1.9 0.6 1.2 1.5 15.0 18.1 17.3 7.0 6.0

JUNE (forecast, EUR bn)

Germany France Italy Spain Nether.
Issuance amounts are quoted on an auction date basis

5.0 1.5 5.0 3.0 2.5 1.0 4.0 1.0 1.5

5.0 5.0 4.0 3.0

5.0 5.0 5.0 1.5 3.0 2.5 1.5 1.5 1.5 1.5

15.0 21.0 21.0 7.0 5.5

Source: RBS Rates Strategy

European Rates Weekly | 11 May 2012 Page 61

Net Issuance
C+R refers to Coupons + Redemptions. See the Weekly Flows table on the following page for more detail over the next six weeks.

2012 Remaining (EUR bn)

160 140 120 100 80 60 40 20 0 GER FRN ITL ESP NLD BLG AUS FIN
Source: RBS

Net Issuance Remaining 2012 (EUR bn) - including ESM contributions



Gross (RBS forecast) Germany France Italy Spain Netherlands Belgium Austria Finland 124.7 116.5 146.4 53.7 32.0 12.1 12.7 10.6

Coupons 16.8 22.1 27.5 6.6 5.9 5.4 4.4 1.7

Redemptions 97.0 69.2 101.4 23.5 15.3 22.5 10.2 6.0

C+R 113.8 91.3 128.9 30.1 21.1 27.9 14.6 7.7

Net (GC) 107.9 94.4 118.9 47.1 26.1 6.8 8.3 8.9

Net (G-C-R) 10.9 25.2 17.5 23.7 10.9 -15.8 -1.9 2.9

Source: RBS Rates Strategy

Net YTD (EUR bn)

80 70 60 50 40 30 20 10 0 GER FRN ITL ESP NLD BLG AUS FIN
Source: RBS

Net Issuance YTD 2012 (EUR bn) - including ESM contributions

Issuance C&R

Gross Germany France Italy Spain Netherlands Belgium Austria Finland 66.0 85.0 80.3 48.1 30.8 17.0 10.2 3.0

Coupons 17.1 19.4 22.9 14.5 3.6 6.4 2.6 0.6

Redemptions 60.0 37.7 55.7 30.3 14.4 3.8 1.8 0.0

C+R 77.1 57.1 78.6 44.8 18.0 10.2 4.4 0.6

Net (GC) 48.9 65.6 57.4 33.6 27.2 10.6 7.7 2.4

Net (G-C-R) -11.1 27.9 1.7 3.3 12.9 6.8 5.9 2.4

Source: RBS Rates Strategy

2012 Total (EUR bn)

240 220 200 180 160 140 120 100 80 60 40 20 0 Issuance C&R

Net Issuance Total 2012 (EUR bn) - including ESM contributions

Gross (RBS forecast) Germany France Italy Spain Netherlands Belgium Austria Finland 190.7 201.5 226.7 101.8 62.8 29.1 22.9 13.6 Coupons 33.9 41.5 50.4 21.0 9.5 11.8 7.0 2.3 Redemptions 157.0 106.9 157.1 53.8 29.6 26.3 12.0 6.0 C+R 190.9 148.4 207.4 74.8 39.1 38.1 18.9 8.3 Net (GC) 156.8 160.0 176.3 80.8 53.3 17.3 15.9 11.3 Net (G-C-R) -0.2 53.1 19.3 27.0 23.7 -9.0 3.9 5.3


Source: RBS

Source: RBS Rates Strategy

European Rates Weekly | 11 May 2012 Page 62

Weekly Net Flows

Weekly Net Supply Flows (EUR bn)
Week cmnc'g Issuance 14-May Coupons Redemptions Net Flow (1) Net Flow (2) Issuance 21-May Coupons Redemptions Net Flow (1) Net Flow (2) Issuance 28-May Coupons Redemptions Net Flow (1) Net Flow (2) Issuance 04-Jun Coupons Redemptions Net Flow (1) Net Flow (2) Issuance 11-Jun Coupons Redemptions Net Flow (1) Net Flow (2) Issuance 18-Jun Coupons Redemptions Net Flow (1) Net Flow (2)

Germany 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 0.39 19.00 4.61 14.39 5.00 0.23 4.78 4.78

France 9.20 9.20 9.20 10.00 10.00 10.00 11.00 11.00 11.00

Italy 5.30 5.30 5.30 12.00 0.55 0.57 11.45 10.89 8.50 0.97 3.00 7.53 4.53 -

Spain 4.00 4.00 4.00 3.50 3.50 3.50 0.07 0.07 0.07 3.50 3.50 3.50

Nether. 3.50 3.50 3.50 2.50 2.50 2.50 -

Belgium - - 2.00 2.00 2.00 0.20 0.20 0.20 - - -

Austria 0.07 0.07 0.07 2.00 2.00 2.00 0.01 0.01 0.01

Finland 1.00 1.00 1.00 - - -

Ireland n/a n/a n/a n/a n/a -

Portugal n/a - - n/a - - n/a n/a n/a 1.85 10.16 1.85 12.01 n/a - - -

Greece n/a 0.65 3.33 0.65 3.98 n/a 0.06 0.06 0.06 n/a n/a n/a n/a 0.09 0.09 0.09

Total 24.50 0.71 3.33 23.79 20.45 10.50 0.06 10.44 10.44 12.00 0.55 0.57 11.45 10.89 18.70 18.70 18.70 18.00 3.29 32.16 14.71 17.45 19.50 0.66 18.84 18.84

- - n/a 0.34 0.34 0.34

*Issuance numbers contain some estimates

Source: Bloomberg, RBS

European Rates Weekly | 11 May 2012 Page 63

European Auction Calendar

European Auction Calendar 2012
Time (GMT)
10:00 10:00 10:00 10:00 11:00 11:00 10:10 10:30 09:50 09:50 09:50 09:50 09:50 09:50 09:50 09:30 09:30 09:30 11:00 11:30 09:00 10:30 10:00 10:00 10:10 10:30 09:30 09:50 11:30 09:00 10:00 11:00 10:10 10:30 11:00 10:00 10:30 09:30 09:50 09:50 11:00 11:30 09:00 11:00 10:00 10:00 09:00 10:00 11:00 11:00 09:30 09:50 09:00

14-May-12 14-May-12 14-May-12 14-May-12 14-May-12 15-May-12 15-May-12 16-May-12 16-May-12 16-May-12 16-May-12 16-May-12 16-May-12 16-May-12 16-May-12 17-May-12 17-May-12 17-May-12 17-May-12 21-May-12 22-May-12 23-May-12 w/c 28 May 28-May-12 30-May-12 30-May-12 04-Jun-12 06-Jun-12 07-Jun-12 07-Jun-12 08-Jun-12 12-Jun-12 12-Jun-12 12-Jun-12 13-Jun-12 13-Jun-12 14-Jun-12 14-Jun-12 20-Jun-12 21-Jun-12 21-Jun-12 21-Jun-12 21-Jun-12 25-Jun-12 26-Jun-12 26-Jun-12 26-Jun-12 28-Jun-12 03-Jul-12 03-Jul-12 03-Jul-12 04-Jul-12 05-Jul-12 05-Jul-12 10-Jul-12

Italy Italy Italy Italy Finland UK Sweden Germany France France France France France France France Spain Spain Spain UK Belgium Netherlands Germany UK Italy Italy Sweden Belgium Germany Spain France Belgium Netherlands Austria UK Sweden Germany UK Italy Germany Spain France France UK Belgium Netherlands UK Italy Italy Netherlands Austria UK UK Spain France Netherlands

3y 10y 10y 15y 5y 15y 10y 2y 3y 5y 5y Linker Linker Linker 3y 3y 5y 2y 3y 2y Linker

BTPS 2 1/2 03/01/15 BTPS 4 1/4 03/01/20 BTPS 5 03/01/22 BTPS 5 03/01/25 RFGB 1 7/8 04/15/17 UKT 5 03/07/25 DBR 1 3/4 07/04/22 BTNS 0 3/4 09/25/14 FRTR 3 1/2 04/25/15 FRTR 3 1/4 04/25/16 BTNS 1 3/4 02/25/17 FRTR 1.1 07/25/22 FRTR 2.1 07/25/23 FRTR 1.85 07/25/27 SPGB 4.4 01/31/15 SPGB 4 07/30/15 SPGB 3 1/4 04/30/16 UKT 5 09/07/14 OLO Auctions NETHER 0 3/4 04/15/15 13-Jun-14 UKTI 0 3/8 03/22/62 CTZ / BTPei auction Med-long term auction Conventional auction

IT0004805070 IT0004536949 IT0004759673 IT0004513641 FI4000029715 GB0030880693 SE0003784461 DE0001135473 FR0120634490 FR0010163543 FR0010288357 FR0120473253 FR0010899765 FR0010585901 FR0011008705 ES0000012916 ES00000123L8 ES00000122X5 GB0031829509 NL0010055703 GB00B4PTCY75

3.50 0.60 0.60 0.60 1.00 2.75 2.50 5.00 2.50 2.50 1.50 1.50 0.40 0.40 0.40 1.25 1.25 1.50 1.50 2.00 3.50 5.00 4.50 7.50 2.50 2.00 5.00 3.50 10.00 0.20

Amt outst.
8.8 22.8 17.2 20.9 4.0 28.6 72.1 5.0 3.5 23.3 28.0 11.0 14.2 9.3 4.5 20.4 12.0 17.4 37.4 6.4

10Y future equiv.(K)*

8 3 4 5 4 30 42 5 7 5 6 2 2 3 3 3 5 3 9

E2.5-3.5bn Total size E1.0-1.75bn " "

10y SGB 3 1/2 06/01/22#1054

Re-opening Total size E7-8bn " " " Total size E0.8-1.2bn " " RBS Size Estimate RBS Size Estimate RBS Size Estimate Mini-tender sale RBS Size Estimate Re-opening New issue Syndicated RBS Size Est., TBA 24 May RBS Size Est., TBA 25 May

RBS Size Est., TBA 23 May RBS Size Estimate Re-opening RBS Size Estimate RBS Size Est., TBA 1 June RBS Size Est., ORI

5y, 8y 5y

Retail bonds 07-Apr-17 Bono auctions OAT auctions ORI Auctions

20y 5y 10y 50y 2y

NETHER 2 1/2 01/15/33 RAGB Auctions UKT 1 09/07/17 Conventional auction 04-Jul-22 UKT 4 01/22/60 Med-long term auction 13-Jun-14 Obligaciones auctions BTAN Auction

NL0010071189 GB00B7F9S958

2.50 2.00

4.2 8.5


Re-opening RBS Size Estimate TBA 6 Jun

2.50 5.00 GB00B54QLM75 8.50 5.00 3.50 9.50 1.50 tba 2.00 NL0010060257 GB00B3Y1JG82 4.50 8.00 5.00 3.00 8.5 6.2 16.9

RBS Size Est.,TBA 5 Jun Re-opening TBA 6 Jun RBS Size Est., TBA 11 Jun Re-opening RBS Size Estimate RBS Size Est., TBA 15 Jun RBS Size Est., TBA 15 Jun TBA 12 Jun RBS Size Estimate

Linker 10y 10y Linker

OATei Auction New conventional 7/9/22 OLO Auctions NETHER 2 1/4 07/15/22 UKTI 0 1/8 03/22/29 CTZ / BTPei auction Med-long term auction


Re-opening TBA 19 Jun RBS Size Est., TBA 22 Jun RBS Size Est., TBA 25 Jun DDA, size probably EUR 4-5bn


New 5y benchmark DSL RAGB Auctions Conventional auction Conventional auction Bono auctions OAT auctions DSL auctions

TBA 29 Jun
Source: Respective DMOs, Bloomberg, RBS

European Rates Weekly | 11 May 2012 Page 64

Coupons & Redemptions Calendar

Coupons & Redemptions Calendar

ATS 12-May-12 15-May-12 18-May-12 19-May-12 20-May-12 21-May-12 24-May-12 26-May-12 29-May-12 01-Jun-12 03-Jun-12 10-Jun-12 12-Jun-12 14-Jun-12 15-Jun-12 16-Jun-12 17-Jun-12 18-Jun-12 19-Jun-12 20-Jun-12 23-Jun-12 25-Jun-12 28-Jun-12 30-Jun-12 01-Jul-12 02-Jul-12 03-Jul-12 04-Jul-12 06-Jul-12 12-Jul-12 15-Jul-12 17-Jul-12 19-Jul-12 20-Jul-12 21-Jul-12 23-Jul-12 25-Jul-12 26-Jul-12 30-Jul-12 31-Jul-12 01-Aug-12 04-Aug-12 08-Aug-12 10-Aug-12 16-Aug-12 20-Aug-12 3.51 2.33 0.99 3.22 12.72 0.01 0.10 0.27 0.23 0.30 0.10 BEF FIM FRF DEM GRD IEP ITL NLG PTE ESP Othr SUM

ATS BEF FIM FRF DEM GRD IEP ITL NLG PTE ESP Othr SUM Total C&R 0.07 0.04 3.51 0.07 0.52 0.06 0.09 0.00 0.60 0.51 0.06 0.00 0.01 0.66 34.45 0.26 0.07 0.34 0.09 0.23 0.01 0.10 0.27 0.00 17.57 0.01 0.00 40.71 0.01 19.37 33.44 0.08 0.58 0.09 0.03 16.88 0.04 20.21 0.33 9.32 0.09 0.01 0.11 0.00 3.68

0.07 -

0.18 0.47 0.06 0.09 0.00 0.00 0.08 0.58 0.03 0.00 0.11 0.55

0.07 0.04 0.00 0.05

0.07 0.04 0.18 0.07 0.52 0.06

3.33 -

3.33 -


0.03 0.51 0.97 -

0.36 1.23 0.26 -

0.07 -

0.01 0.00 0.06 0.00 0.00 -

0.01 0.00 0.03 0.51 0.06 0.00 0.00 0.66 2.29 0.26 0.07 0.34 0.09

19.00 -

0.57 3.00 -

0.08 0.01 -

0.08 0.57 0.01 -

- 10.1 -

- 32.16 -

0.51 -

0.01 0.00 0.01

0.23 0.01 0.10 0.27 0.00 0.51 0.01 0.00

17.05 -

- 17.05 -

5.88 -

0.01 0.03 -

13.7 0.01 3.22 8.25 0.08 0.58

10.1 -

16.1 -

27.00 -

15.0 -

- 27.00 -

- 16.15 - 25.19 -


0.09 0.03

0.17 0.04 0.33 9.32 0.09 -

7.34 -


3.69 0.04 7.34 0.33 9.32 0.09 0.01 0.11

13.1 -

12.8 -

- 13.19 -

- 12.87 -


0.00 0.55



Source: Bloomberg, RBS

European Rates Weekly | 11 May 2012 Page 65

Portfolio of Trade Ideas

Trade Performance
*Trades that have hit targets/stop this wk have P&L shown green (red); or blue if contract has expired / taken off for another reason Exposure Rationale Details Delta Vega EUR
Sell 3y1y ATM payer Roll-down makes 60% return in first year Sell 1.87 strike 3y1y payer Sep Euribor risk reversal: long 99 put short 99.5 call Buy 5y German CDS Receive the 2s5s10s fly, 1year forward starting. Buy 2y2y FRA/OIS 10s30s 10y forward steepener EUR 20s30s steepener EUR 10s30s 2y forward steepener 5y CDS 2:1 (beta) weighted 0.0k 187 bp 130 bp 125 bp 225 bp 62 bp -38 bp 29,150 Volatility Weekly 23Jan


Levels Now* Target



Cash Stop



Bearish Sep Euribor Germany 5y CDS

Correlation to FRA/OIS widening risk Failure to resolve crisis pushes EMU CDS higher. Attractive levels and rolls down to -16.3bp in spot. Aided by 5s10s flattening view Long lived funding stress means FRA/OIS continues to remain wide We expect ALM paying in long rates and long slopes to push aggressively higher Alternative to 10s30s 10y forward. Levels driven more inverted by year end REC flows

-2.0k 10.0k

0.0 ticks 98 bp

0.0 ticks 87 bp

10 ticks 200 bp

-7 ticks 65 bp

10 ticks 102 bp

-7 ticks -33 bp

5,000 -110,000

Weekly: April-5 Year End: Trade 3

2s5s10s fly FRA/OIS widener EUR 10s30s 10y forward


16.3 bp

3.5 bp

-16 bp

32 bp

32 bp

-16 bp


Year End: Trade 4 Year End: Trade 7 Year End: Trade 8 Year End: Trade 10 Year End: Trade 9 Year End: Trade 12


34 bp

53 bp

75 bp

20 bp

42 bp

-14 bp



-54 bp

-49 bp

-30 bp

-70 bp

24 bp

-16 bp


EUR 20s30s EUR 10s30s 2y forward Long Denmark vs Finland 5y CDS


-19 bp

-9 bp

10 bp

-43 bp

29 bp

-24 bp


Favourable carry and fits with our long-end steepening theme Euro 'outs' should outperform euro 'ins'. Denmark should be considered a safe haven. The Euribor curve is steep, and greens and blues are yet to catch the bid that reflects deteriorating Euribor flattener Euro economy Jun-12 Euribor Front euribors rich, interbank bearish options stress to stay high. Rec EUR 6y Richening of the belly should Pay 2f 1y mean levels normalise Long end of the SPGB curve not showing any price differentiation, SPGB 2037 vs. which is likely to change over 2032 2012 If economic improvement and Buy USD 2y2y near-term inflation pressures take payers against hold, the front end of the US EUR should come under pressure first.


-29 bp

0 bp

10 bp

-43 bp

39 bp

-14 bp



-20 bp

-30 bp

-80 bp

40 bp

60 bp

-60 bp


Sell the ERM3ERM4 Spread Buy 98.875 / sell 98.625 Rec 6y Pay 2f 1y Long SPGB 37s versus 32s on price differential Buy USD 2y2y payers against EUR Buy 1y20y receivers ATM25bp and sell 1y30y receivers ATM-27.5bp Buy 1y5y ATM receivers and sell 1y30y receivers 15bp OTM, DV01 neutral at expiry Buy 1y singlelook 2y/30y capfloors vs 1y30y swaption straddles Pay the belly in the German 2s5s10s Receive Dec-12 ECB OIS

10.0k 0.0k 10.3k

49 bp 6.0 ticks 54 bp

25 bp 0.5 ticks 54 bp

20 bp 25 ticks 40 bp

55 bp 0 ticks 62 bp

29 bp 19 ticks 14 bp

-6 bp


-6 ticks - 55,000 -8 bp 1,695

Year End: Trade 23 Year End: Trade 24 Early 2012 thoughts


-2.4 bp

-4.4 bp

-40 bp

5 bp

38 bp

-7 bp

- 9,734

Early 2012 thoughts


53 bp

30 bp

50 bp

-25 bp


Vol Weekly 06 Jan-12

Bull steepening long EUR

Solvency II to steepen long end. Risk is bear flattening.



-24 bp

-12 bp

15 bp

-40 bp

39 bp

-16 bp


Year End: Trade 34

Bull steepening broad curve EUR

Solvency II to steepen long end. QE to depress out to 10 years. Convergence to US curve dynamics. Front end pinned and FRA/OIS may be negatively correlated with long end. 5y is still the sweet spot but we expect a yield grab for 10y Expect long term ECB liquidity to bring down Eonia-deposit rate spread 3m carry and roll is worth 17bp and is the highest on the 1Y forward curve 50y REC flow done. Long-end cheapening in response to Dutch pensions sector & Solvency II. Roll-down makes 52bp over 1 year.



35 bp

84 bp

95 bp

5 bp

60 bp

-30 bp


Year End: Trade 35

Sell correlation in EUR German 2s5s10s fly Long Dec ECB OIS



0 vols

-6 vols

15 vols

-10 vols

- 63,088

Year End: Trade 36 Weekly 27 Jan-12 Weekly 27 Jan-12 Weekly 27 Jan-12


-43 bp

-47 bp

-25 bp

-50 bp

18 bp

-7 bp

- 63,167


37 bp

27 bp

20 bp

45 bp

17 bp

-8 bp


Rec EUR 3F1Y Long-end steepener, 40F10Y vs 30F10Y Long belly in EUR 2s5s30s 1Y forward

Rec EUR 3F1Y Long-end steepener, 40F10Y vs 30F10Y Long belly in EUR 2s5s30s 1Y forward


186 bp

149 bp

128 bp

210 bp

58 bp

-24 bp



-12.0 bp

-26.4 bp

-45 bp

0 bp

33 bp

-12 bp


Weekly 3 Feb-12 Weekly 3 Feb-12


-3.2 bp

-27.8 bp

-53 bp

-12 bp

50 bp

-9 bp


European Rates Weekly | 11 May 2012 Page 66

Buy ATM payers 6m2y vs sell 6m5y ATM payers Eurodollar vs. Euribor H4/H5 box June-12 expiry mid-curve 2y Euro$ option on EDM4 (98.75/99.5 put spread) Buy Jun-12 Euribor 99.375/99.5 1x2 Call spread Sell the 133/131 RXM2 put spread; buy the TYM2 126/124 put spread

Sell 83 RXM2 and buy EUR10m DBR 3.25% 2021 Buy the 2RM2 98.875/99.00 Call spread for 1 tick Buy the Jun13Jun14 Euribor flattener vs. the Short Sterling steepener Buy the June 12 Bobl (OEM2) 122.75/122.00 1 x 2 put spread and receive 1 tick credit (ref OEM2 price = 123.50) Buy the June12 Bund (RXM2) 138/139/140 call ladder and receive 7 ticks (ref RXM2 price = 137.16). 2F2Y and 4F5Y vs 2F7Y ATM straddle triangle, rec 172bp upfront

Sell 6m30y ATM receivers

BTPs 2s10s flattener Sell SPGB 3.15% 2016, carry is -7.6bp over 3m Buy the ERM2 99.375 Call; Sell the ERM2 99.25 Put Buy the 0RM2 99.25/99.375 1x2 Call spread; sell the 0RM2 98.875 Put

Buy ATM payers 6m2y vs sell 6m5y ATM 2s5s bearish flatttening payers Current box spread too small a Buy EDH4, sell premium if the recovery is for real. EDH5, sell Bearish Euribor Blues - we expect ERH4, buy EMU problems to dominate. ERH5 June-12 expiry mid-curve 2y Euro$ option on To hedge our view of the EDM4 European lower-for-longer being (98.75/99.5 put only curtailed by a US recovery spread) Too much liquidity in the system Buy Jun-12 to be ignored, so 3m Euribor Euribor fixings should continue to drift 99.375/99.5 1x2 lower. Call spread If there is going to be an upside Sell the 133/131 surprise in growth it will come RXM2 put from the US not Europe. This spread; buy the trade offers bear protection at the TYM2 126/124 long end. put spread The DBR 3.25% 2021 will become CTD for RXM2 in a 20bp Sell 83 RXM2 steepening sell-off at 10y. The bond is likely to richen vs. RXM2; and buy a cheap insurance trade against EUR10m DBR further sell-off. 3.25% 2021 Fade the richness in Euribor vol. Buy the 2RM2 Look for low yields in green 98.875/99.00 Euribors while staying short vol Call spread for via cheap options. 1 tick Buy the Jun13Jun14 Euribor Short sterling seems prone to a flattener vs. the market sell-off. Box trade less Short Sterling volatile. steepener Buy the June 12 Bobl (OEM2) 122.75/122.00 1 Expect Bobl futures vol to fall x 2 put spread further. A cheap insurance trade; and receive 1 DEM5y remains quite rich vs. 2y tick credit (ref and 10y and could be vulnerable OEM2 price = in the event of a correction. 123.50) Buy the June12 Bund Expect Bund futures vol to fall (RXM2) further. We anticipate less noise 138/139/140 in EGBs for the short term, while call ladder and overall weakness will likely receive 7 ticks support a slow grind to lower bund (ref RXM2 price yields. = 137.16). Buy 2y7y vs sell 2y2y and 4y5y This triangle is extreme and ATM straddles, normally trades cheap at low equal notional levels of volatility. for net 10k vega Solvency II use of 20y as last liquid point and extrapolation to UFR is on track and should Sell 6m30y reduce long end hedging needs 2.595% strike receivers dramatically. Re-entering at full risk. The remaining firepower from the Sell 2.25% LTRO is likely to be lower than we 2013 Buy 5% expected. 2022 BTPs End of the carry trade; the belly of the curve should be the early loser.


-0.2 bp

0.1 bp

30 bp

-15 bp


Weekly 10 Feb 12


3 bp

10 bp

23 bp

-6 bp

20 bp

-20 bp


Weekly 17 Feb 12


2.0 ticks

0.1 ticks

- 19,328

Weekly 9 Mar-12


-1.0 ticks

0 ticks


Weekly 16 Mar-12


-1.6 bp

-0.6 bp


Weekly 16 Mar-12


4 bp

7 bp

16 bp

-1 bp

12 bp

-5 bp


Weekly 16 Mar-12


-1.0 ticks

-4.5 ticks

- 35,000

Weekly 23 Mar-12


8 bp

1 bp

-10 bp

18 bp

18 bp

-17 bp


Weekly 23 Mar-12


1.0 ticks

1.4 ticks


Special 27 Mar-12

7.0 ticks

-64.6 ticks


Special 27 Mar-12



0 bp

-7 bp

- 65,423

Volatility Weekly 23 Mar



0 bp

-11 bp


Volatility Weekly 23 Mar


256 bp

286 bp

150 bp

350 bp

106 bp

-94 bp


Weekly 30 Mar-12

Sell SPGB 3.15% 2016 Buy ERM2C 99.375, Sell ERM2P 99.25 Buy 1x2 0RM2C 99.25/375 sell 0RM2P 99.25


371 bp

444 bp

700 bp

340 bp

329 bp

-31 bp


Weekly 30 Mar-12

Fade the recent sell-off in Jun-12 Euribor


0.0 ticks

-2.3 ticks

- 22,500

Weekly 30 Mar-12

Reds and greens in Euribor are still very cheap, and vol is rich. Euribor reds and greens have Dec-14 Euribor strongly underperformed vs. the Buy 1000 vs. Jun-12 Bobl DEM 2y and 5y sectors, which are ERZ4, sell 450 futures almost at record low yield levels OeM2 Buy DBR 2.25% Net carry and Sep 2021 vs. Extension trade; DBR 2.25% Sep rolldown is DBR 2.5% Jan 2021 is cheap on the curve. neutral


0.0 ticks

1.0 ticks


Weekly 30 Mar-12


65 bp

65 bp

40 bp

74 bp

25 bp

-9 bp


Weekly: April-5 Weekly 13 Apr-12


14 bp

13 bp

8 bp

18 bp

6 bp

-3 bp


European Rates Weekly | 11 May 2012 Page 67

2021 DUN2 110.8/111.0 1x2 call spread, cost 1 tick Sell BTP 4.5% 2026, buy SPGB 5.9% 2026 Buy NETHER 3.25% 2015, sell RFGB 4.25% 2015 TECHNICAL TRADE: Sell 5y Spain Sell 1y midcurve ATM straddle on Dec13 Euribor; buy the 2y on Dec14 Euribor Trading the negative yield view in 2y Germany; expect tensions to build more seriously around midyear. Weaker Italian budget targets will see more speculation on eventual bailout risk; also trade to catch index shifts Budget consolidation effort and continued domestic support + demand from intl investors looking for core Euro risk with a pick-up. Pullback level 4.53% seen in generic yield 18 Apr. A possible short-term relief to the 200d moving average should be faded. July option expiry on Schatz Sep-12 future


-1.0 ticks

-0.4 ticks


Weekly 13 Apr-12

ASW spread 65bp at entry


48 bp

58 bp

10 bp

85 bp

38 bp

-37 bp

- 88,777

Special 19 Apr-12

Yield pick-up 5.1bp


5 bp

6 bp

-5 bp

10 bp

10 bp

5 bp

- 5,117

Special 19 Apr-12

Sell the SPGB 5.5% 2017


471 bp

509 bp

538 bp

425 bp

67 bp

-46 bp


Weekly 13 Apr-12

Play the relative movement between the two contracts and volatility within the calendar spread. Net cost 15 ticks ECB risk premium rising vs. USD. Buy Sep-13 ECB easing will be a strong lowerIMM dated EUR for-longer message - failure to OIS vs. USD ease will fwd risk premium fall; US OIS data is better than EMU Non-directional fly trade Rec 2F2Y Pay opportunity; 4y is cheap and 4F2Y 4F2Y (2s4s6s too low given the level of the fly) 2F2Y. Buy OAT 3.75% 2021 on fly vs. Correlation between the fly and 4.25% 2018 the French 5s10s suggests the and 4.25% OAT 3.75% 2021 is too cheap on 2023 the fly vs the 2018 and the 2023 Bund ASW widener boxed with OBL ASW tightening, using futures

Buy 0RZ2C & 0RZ2P 99.125; Sell 2RZ2C & 2RZ2P 98.625


15 bp

10 bp

- 4,400

Weekly 20 Apr-12

Roll on 3m is favourable by 1.7bp


29 bp

19 bp

10 bp

34 bp

19 bp

5 bp


Weekly 20 Apr-12

5s10s steepener in the Netherlands vs. France flattener

Buy RFGB 2.75% 2028 vs. DSL 5.5% 2028 Short 10y France vs. Germany

Rec EUR 5F5Y, Pay USD 5F5Y

Rec EUR 5F5Y, Pay CHF 5F5Y Buy Jun13/14 Euribor steepener

Buy the RXM2 142.00 straddle for 155 ticks

Roll is 0.7bpover 3m Duration weighted (0.64: 1.0: 0.4); 3m carry is around +1.5bp Buy RXM2, sell Regime shift based on collateral OEM2, rec 5y, value and non-resident buying pay 10y means the German curve should (maturity to continue to richen in ASW on a matched rolling basis. swaps) Higher duration supply in the Netherlands is expected to weigh Sell Nether on the Dutch long end while the 2.25% 2022 vs. French curve is too steep in 5s10s 4.5% 2017; Buy owing to overseas buying of the FRTR 3% 2022 5y sector, which we expect to vs. BTNS dissipate. 1.75% 2017 Finland rated higher in our EGB risk index & RFGB 28s are highest pick up to DSLs, where Finland typically trades tighter. Insurer liability discounting curve changes / Solvency II negative for Dutch long end. Carry is neutral Re-entering after taking profit before the French election. Our more aggressive targets simply Sell 10y FRTR reflect our view on the Euro crisis. vs. 10y Bunds 3m carry and Term premium in EMU still too roll is 2bp in high. EMU growth likely to favour of the underperform US. trade EUR 5y5y is trading at the cheap end of its long term relationship with CHF. Higher vol in EUR means best risk-reward is through Beta of 1.2 on the CHF leg a beta-weighted spread. Z-score is -2.2, indicating the spread is cheap and offers a good Buy ERM3 Sell buying opportunity in our view. ERM4 Vol is cheap. We are targeting a sharp break-out from current tight ranges. 25th May expiry should Buy RXM2C 142.00 & capture the 'hot' aftermath of the RXM2P 142.00 Greek and French elections. Solvency II requires different discount curve assumptions in EUR and GBP Increasingly likelihood that the current 50bn of QE will be the last. The steepening pressure on the announcement may just be the start. Receive GBP 20F10Y, Pay EUR 20F10Y


87 bp

83 bp

105 bp

80 bp

18 bp

-7 bp

- 44,546

Weekly 20 Apr-12


37.2 bp

29.4 bp

12 bp

45 bp

25 bp

-8 bp


Weekly 27 Apr-12


15.1 bp

18.9 bp

0 bp

21 bp

15 bp

-6 bp


Weekly 27 Apr-12


34.3 bp

27.7 bp

20 bp

40 bp

14 bp

-6 bp


Weekly 27 Apr-12


6 bp

6 bp

-5 bp

11 bp

11 bp

-5 bp


Weekly 27 Apr-12


135 bp

136 bp

200 bp

100 bp

65 bp

-35 bp


Weekly 4 May-12


-17 bp

-25 bp

-50 bp

0 bp

33 bp

-17 bp


Weekly 4 May-12


92 bp

84 bp

60 bp

110 bp

32 bp

-18 bp


Weekly 4 May-12 Weekly 4 May-12


26 bp

25 bp

40 bp

18 bp

-14 bp

8 bp

- 5,000


-155.0 ticks

-156.6 ticks

- 16,000

Weekly 4 May-12

Receive GBP 20F10Y, Pay EUR 20F10Y 12.0k 115 bp 164 bp 60 bp 170 bp 55 bp -55 bp 23,120 Solvency II Trades

10s30s bullish steepening in ATM receivers

10s30s bullish steepening in ATM receivers



67 bp

81 bp

25 bp

-15 bp


Weekly 10 Feb 12

European Rates Weekly | 11 May 2012 Page 68

Inverted front end SS curve does not fit BoE rate expectations. We favour richening in L M3 and LM4. UK budget to provide further Sell the FRTR reassurance - and election risks in 4.5% 2041, buy France mean non-negligible UKT 4.5% 2042 probability of French downgrade Alternative to ASW, to take Long UKT advantage of the steepness of the 4.75% 2030 vs. Gilt curve. Spread between the 2 UKT 3.75% bonds is the statistically widest on 2020 the curve. Rec GBP 3F6Y A cheap hedge against rate hike vs. Pay GBP premium. Spread close to 5F1y historical highs. Buy GBP 2y5y vs 5y5y and Bearish vol trade (flat parallel 2y2y vega) Buy the 2RM2 98.875/99.00 Call spread; sell the 2LM2 Vol is high and Short Sterling 98.75/98.875 remains vulnerable to a sell-off, Call spread for while Euribor is predisposed to rally even more. 1 tick Sell the basis Short basis position. 22s become on the UKT 4% CTD in a 15-20bp market rally; 2022 (sell bond, should also cheapen when the buy future) new 10y Gilt is launched. Short Sterling Condor

Sell LM2-LM3LM4-LM5 Condor Sell the FRTR 4.5% 2041, buy UKT 4.5% 2042


44 bp

17 bp

10 bp

60 bp

34 bp

-16 bp


Weekly 13 Jan-12


-28 bp

-29 bp

-60 bp

0 bp

32 bp

-28 bp


Morning Call 13 Mar 12

Long UKT 4.75% 2030 vs. UKT 3.75% 2020 Rec GBP 3F6Y vs. Pay GBP 5F1y Buy GBP 2y5y vs 5y5y and 2y2y Buy the 2RM2 98.875/99.00 Call spread; sell the 2LM2 98.75/98.875 Call spread for 1 tick Sell the UKT 4% 2022, buy the Jun-12 Long Gilt future Buy UKT 4% Volatility protection - buy the basis 2022, buy UKT Synthetic on the UKT 4% 2022 and the 5% 5% 2025, Sell straddle; long 2025 by buying the bonds and Jun-12 Long basis selling the Jun-12 Long Gilt future Gilt Buy 5y10y Bearish vol exposure. Regression against 5y5y residual is at high and standard and 10y5y ATM triangle is equivalent to regression Receive 208bp premium straddles weighting. Buy GBP 3y10y EUR vol looks high compared to Buy GBP 3y10y payers against GBP. GBP rates are more likely to payers against EUR be in play at this horizon. EUR With the long end very steep and QE surely priced out completely Buy 6m10y ATM payers sell for now, further upward pressure 10s30s bearish on yields must be a traditional 6m30y ATM flattening bearish flattener. payers Sell GBP 30y Sell GBP 30y ASW have traced a clearly benchmk, ASW on a yield- defined range since QE restarted receive 30y yield basis in October, in middle now swap Offers good risk-reward as any further less dovish/more hawkish Pay Feb-12 BoE rhetoric drives up rate Pay Feb-12 MPC Sonia expectations. MPC Sonia Buy 10y Australia is yet to adjust to the Buy Jun-12 10y Australia vs. UK new low growth/low bond yields Australia in futures normal and if UK QE is off the (XMM2); sell (hedge ratio table we expect 10y Austrlia to Jun-12 Long 518:1000) continue outperforming the UK Gilt


107 bp

114 bp

90 bp

120 bp

17 bp

-13 bp

- 69,741

Weekly 16 Mar-12 Weekly 16 Mar-12 Weekly 30 Mar-12


14 bp

16 bp

5 bp

20 bp

9 bp

-6 bp

- 20,351



0 bp

-1 bp

100 bp

-40 bp

- 1,478


-1.0 ticks

3.4 ticks


Weekly 30 Mar-12


41 bp

39 bp


Weekly 13 Apr-12



197 bp

194 bp


Weekly 13 Apr-12



208 bp

218 bp

30 bp

-10 bp


Weekly 20 Apr-12 Weekly 20 Apr-12


0.0 bp

20.0 bp

20 bp

10 bp



-8.0 bp

-10.8 bp

30 bp

-10 bp

- 27,575

Weekly 20 Apr-12


12 bp

10 bp

22 bp

5 bp

10 bp

-7 bp

- 13,016

Weekly 20 Apr-12


56 bp

51 bp

75 bp

50 bp

19 bp

-6 bp

- 47,000

Weekly 20 Apr-12


107 bp

87 bp

75 bp

120 bp

32 bp

-13 bp


Weekly 27 Apr-12

2y4y SEK steepener vs. USD flattener Post-Riksbank decision the spread in relative steepeness is 23bp, time to get onboard again. Hard to see continued surge in Swedish yields without also affecting UK yields. Limited downside, good risk-reward. Cheap hedge against a big delta move. Flatteners between front to 3rd contracts look attractive as the Riksbank regards the economy as improving and is unlikely to cut in April. Rec SEK 2y, pay SEK 4y, pay USD 2y, rec USD 4y Weekly 17 Feb 12


23 bp

26 bp

10 bp

40 bp

13 bp

-17 bp

- 29,921

Buy SGB 1041 vs. UKT Mar 2014

Buy SGB 1041 vs. UKT Mar 2014


70.5 bp

56.7 bp

50 bp

90 bp

20 bp

-20 bp


Weekly 16 Mar-12

Sell (Rec) Dec12 RIBA vs. Jun-12 RIBA

Sell (Rec) Dec12 RIBA vs. Jun-12 RIBA Pay 10y HICPx, receive 5y HICPx swaps Buy Jul-13 TIPS vs 3.375 Jul-13 Treasuries Buy Feb-42s vs Jan-22s on breakeven


-13.0 bp

-34.7 bp

-40 bp

5 bp

27 bp

-18 bp


Weekly 30 Mar-12

Pay 10y HICPx, receive 5y HICPx swaps Long 2y TIPS breakeven inflation 5y5y HICPx looks too high both fundamentally and historically. TIPS look good value compared to our forecasts after a big pullback. Carry is positive. Too little risk premium. Should do well if breakevens fall. 10y supply this week and in May before 30y supply. -10.1k 248 bp 232 bp 210 bp 260 bp 38 bp -12 bp 45,750 Weekly 24 Feb 12 Linked-Up 21 Mar 12


269 bp

188 bp

80 bp

-40 bp


10s30s TIPS b/e steepening IL42s/IL62s

-10.5k -10.7k

10 bp -2 bp

13 bp 5 bp

36 bp 8 bp

4 bp -7 bp

26 bp 10 bp

-6 bp -5 bp

- 23,759 74,954

Linked-Up 21 Mar 12 Linked-Up

IL42s look expensive on b/e curve Long IL62s b/e

European Rates Weekly | 11 May 2012 Page 69

breakeven steepening

Long 3y in 7y Italy real yield Long French vs European inflation in 5y bonds Buy OATei20s out of 15s breakevens for equal cash amounts. Entry spread 60bp in forwards. 5s10s30s TIPS breakeven butterfly, short middle. Buy Jan-17 TIPS, sell Jul-21 TIPS, Buy Feb42s

and against swaps. Syndication risk lull in ultra-long now. 6% real yield looks very attractive when nominal yields are close to this level and Italian fundamentals are improving. French inflation has cheapened a long way. Hollande proposes to double Livret-A allowance.

vs IL42 b/e

21 Mar 12

Buy BTPei23 vs BTPei19s cashfor-cash





6.303 %

150 bp

-50 bp


Morning Call 22 Mar 12

Long BTANi16 vs OATei15 Pay inflation in 10y and receive in 5y for equal notionals. Duration neutral package,


71 bp

61 bp

30 bp

-15 bp

- 15,686

Weekly: April-5

Adding to short 5y5y HICPx swaps outright recommendation by doing it as a spread against a cash-for-cash extension in bond breakevens.


60 bp

75 bp

30 bp

75 bp

30 bp

-15 bp


Weekly 20 Apr-12

Buy BTPei 19s on breakeven

Long end is too flat and we are now in the lead up to 10y supply. As we near the target on this trade, conviction is reduced, but SMP restart risk and Italy downgrade risk both appear somewhat remote and I expect shorts to find the negative carry painful in the meantime.

vs standard comparator nominals, duration weighted, 50-50 wings


21 bp

17 bp

36 bp

14 bp

15 bp

-7 bp


Linked-Up 28 Mar 12

Buy BTPei 2.35% 2019 vs. BTPS 4.25% 2019


-90 bp

-103 bp

-125 bp

-70 bp

35 bp

-20 bp


Weekly 27 Apr-12

Sell IRZ2, buy Dec-12/13 Markets are pricing in too much IRZ3. Carry/roll flattener in RBA easing. Dec-12 is the richest is in your favour Australia 3m bill part of the curve; z-score is 1.78, by 17bp over Weekly 27 futures a sell signal. 3m 9.9k 28 bp 31 bp 12 bp 34 bp 16 bp -6 bp - 29,788 Apr-12 *Current level is yield for bonds. For swaps, the current level is starting rate adjusted for P&L in bp running. **Year End refers to European Rates Year Ahead, published 12-12-11

Trade Performance YTD 2012

10,000,000 Total P&L (EUR): 2012 ytd





- 2,000,000 13-Jan-12 27-Jan-12 10-Feb-12 24-Feb-12 9-Mar-12 23-Mar-12 6-Apr-12 20-Apr-12 4-May-12
Source: RBS, Bloomberg, GDS

European Rates Weekly | 11 May 2012 Page 70

Macro Forecasts
Official rate forecasts
Latest US BoJ ECB UKMPC Sweden Norway Denmark China India Korea CzechRep Hungary Poland 0.07 0.10 1.00 0.50 1.50 1.50 0.70 6.6 8.50 3.25 0.75 7.00 4.50 Q2(12) Q4(12) 0-0.25 0-0.10 0.75 0.50 1.50 1.50 0.50 6.6 8.25 3.25 0.75 6.50 4.50 0-0.25 0-0.10 0.50 0.50 0.50 1.00 0.25 6.8 7.75 3.25 0.75 6.00 4.50 GDP US Eurozone Germany France Italy Spain UK Japan Latest Rates per US dollar JPY GBP* CHF AUD* CAD ZAR SGD KRW CNY BRL USD JPY GBP CHF SEK NOK PLN CZK HUF 80.0 1.61 0.93 1.00 1.00 8.11 1.25 1147 6.31 1.95 1.29 103.4 0.80 1.20 9.0 7.59 4.25 25.2 290 82.0 1.58 0.95 1.02 0.96 7.20 1.24 1130 6.25 1.85 1.26 103.3 0.80 1.20 8.9 7.55 4.00 24.2 310 82.0 1.62 0.91 1.08 0.98 7.00 1.22 1110
Source: RBS Economics, Consensus Economics Inc. Survey (10-04-12)

Changes this week: None.

GDP and Inflation forecasts

----------2012--------RBS 2.5 -0.2 0.5 0.6 -1.2 -0.9 0.6 1.5 2.2 2.5 2.1 2.5 3.5 1.6 2.9 0.0 Cons 2.3 -0.4 0.7 0.3 -1.5 -1.6 0.7 2.0 2.3 2.3 1.9 2.1 3.0 1.8 2.8 -0.2 -------------2013-----------RBS 2.5 0.8 1.1 1.0 0.3 0.1 1.8 1.5 2.2 1.5 1.3 1.8 2.6 1.1 1.6 0.0 Cons 2.5 0.9 1.6 1.0 0.2 -0.1 1.8 1.5 2.1 1.7 1.8 1.8 2.4 1.6 2.0 0.0

Source: RBS Economics

FX forecasts
Q2(12) Q4(12)

Inflation US Euro area Germany France Italy Spain UK Japan

6.15 1.85 1.33 109.1 0.82 1.21 8.9 7.50 4.00 24.0 300 Germany US 2y 5y 10y 30y 2y 5y 10y 30y Japan UK 2y 10y 2y 5y 10y 30y

Rates per euro

Government bond yield forecasts

Latest 0.26 0.75 1.85 3.03 0.08 0.53 1.51 2.21 0.11 0.85 0.40 0.96 1.94 3.24 Q2(12) 0.30 0.75 2.00 2.85 0.10 0.60 1.50 2.35 0.10 0.75 0.50 1.15 1.85 3.05 Q4(12) 0.30 0.75 2.00 2.85 0.10 0.50 1.25 2.50 0.10 1.20 0.80 1.55 1.75 2.85

Commodity forecasts
Unit Latest Platinum Palladium Copper Zinc Nickel Lead US$/t US$/t US$/t US$/oz 1463 605 8105 1969 2100 Q2(12) 1595 675 8275 2000 18330 2100 Q4(12) 1750 800 8600 2150 20000 2250

US$/t 17170

Source: Bloomberg, RBS Commodities

*US Dollar per currency unit Source: Bloomberg, RBS FX Desk Strategy

Source: Bloomberg, RBS (forecasts from respective teams)

European Rates Weekly | 11 May 2012 Page 71

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European Rates Weekly | 11 May 2012 Page 72