2008 DB Fixed Income Outlook (12!14!07)

Global
14 December 2007
Fixed Income Outlook 2008

Deutsche Bank Securities Inc.
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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1
Compendium

Table of Contents
Bond Market Strategy ...................................... Page 05
US..................................................................... Page 09
Euroland............................................................ Page 29
UK..................................................................... Page 56
EMEA ............................................................... Page 63
Japan ................................................................ Page 72
Asia................................................................... Page 76
Dollar Bloc Strategy.......................................... Page 77
Linkers .............................................................. Page 84

Global Views
Level Slope Volatility
USD Short Steeper Neutral
EUR Neutral Steeper Long
JPY Neutral Neutral Neutral
GBP Neutral Steeper Long
AUD Neutral Neutral Neutral
CAD Neutral Steeper Neutral
NZD Neutral Flatter Neutral

Research Team
Mustafa Chowdhury
Research Analyst
( ) 212 250-7540
mustafa.chowdhury@db.com

Ralf Preusser
Strategist
(+44) 20 754-52469
ralf.preusser@db.com

Francis Yared
Strategist
(+44) 020 754-54017
francis.yared@db.com

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The end of easy leverage:
2008, a year of rising risk premia
14 December 2007 Fixed Income Weekly
Deutsche Bank Securities Inc. Page 3
EXECUTIVE SUMMARY

Reduced financial leverage, lower credit availability and negative wealth effects
should weigh on the consumer and growth, especially in the US

The good shape of the corporate sector, an aggressive Fed, a depreciating dollar
and reasonable equity valuations should help steer the US economy away from a
recession

Downside risks to this view remain, especially in light of the scale of the credit
contraction but the current process of recognizing and writing-down impaired
assets is a very positive step in ensuring that the current slow-down does not
translate into a deflationary recession

Despite the uncertain economic outlook, the pricing inconsistencies between the
US and EUR markets, the vulnerability of the UK economy and the strength of the
factors supporting rising risk premia have helped us develop high conviction
investment strategies for 2008

We like to enter the year positioned for higher risk premia globally, which will be
driven by higher long term rates in the US, but lower policy rates in Euroland and
the UK

We recommend curve steepeners in USD, GBP and EUR. We are underweight
duration in the US (target 4.50% on 10Y UST), and are long the front-end in EUR
and GBP. We are long EUR 5Yx5Y against USD 5Yx5Y

In USD we are buyers of tail volatility and like 2Y-10Y ASW disinversion trades

In EUR we are buyers of forward volatility and like payer flies on 1Yx2Y

For US Agencies, we do not expect the crucial OFHEO 30% capital surplus
requirement to be relaxed in the first half of the year. If the 30% requirement is
lifted in the second half, increased supply could put pressure on spreads

The EUR Jumbo covered bond market has started differentiating according to
issuer specific (cover pool credit quality, issue structure, bank credit quality) and
market specific topics (housing market risk, country risk). We expect that
differentiation to continue in 2008

Three key global factors will drive rates returns in EMEA in 2008: high non-core
inflation, the global growth slowdown and the continued effects of the credit
crunch. We are bearish on the outlook for Poland and Hungary and bullish on
Turkey and Israel. Over the course of 2008 we expect most rates curves in EMEA
to steepen with the ZAR curve likely to disinvert by 100bp

In Japan, we recommend cutting remaining outright shorts. We like defensive
butterfly positions, paying the belly in 5Y-7Y-10Y

We agree with market pricing for the RBA and RBNZ, while that for the BoC looks
out of step with the strength of the economy. We find 10Y CAN expensive versus
the US. We look for 10Y ACGB/UST spreads to compress

Inflation markets remain stuck between near-term price pressures from
commodities and prospects of slowing growth, with the focus being skewed
towards the former in Europe and the latter in the US. We see headline inflation
moderating next year in both, but continue to believe that given differences in
monetary policy and FX trends, current US/Europe spreads offer attractive
opportunities in real rate and inflation space
The next regular Fixed Income Weekly will be published 11 January 2008.
We wish all our clients and readers very Happy Holidays!
Page 4 Deutsche Bank Securities Inc.
Global Trades
EUR
Expressed with
bond/swap
Entry date Closing Date Entry level
Target level at
inception
Current/Closing
Level
EUR - 5/10 steepener Bond 21-Aug-07 14bp 20bp
EUR - Long 2Y Bond 25-Sep-07 4.00% 4.03%
EUR - Receive 3M March Eonia Swap 25-Sep-07 4.02% 3.77% 4.16%

USD
Expressed with
bond/swap
Target level at
inception
Current/Closing
Level
USD -2Y-10Y steepener Bonds 14-Sep-07 96bp 150bp 96bp
USD - Short 10Y Swap 14-Sep-07 5.07% 5.50% 4.85%
USD - 2/10 Swap spread Steepener Swap 21-Sep-07 2.5bp -22bp

GBP
Expressed with
bond/swap
Target level at
inception
Current/Closing
Level
GBP - 2Y-10Y steepener Swap 26-Jul-07 -41bp -30bp -26bp
GBP - Long 2Y GIlts Bond 7-Dec-07 4.49% 4.62%

JPY
Expressed with
bond/swap
Target level at
inception
Current/Closing
Level
JPY - YEH8- YEH9 Steepener 26-Oct-07 25bp 9.5bp
JPY - Long 10Y B/E Bond 25-May-07
JPY - Bull Steepener 3m fwd 4Y-20Y Swap 9-Nov-07 1.07% 1.13%

Cross market
Expressed with
bond/swap
Target level at
inception
Current/Closing
Level
Buy Tips VsOATei(Tips 32 and OATei 32) Bond 10-Nov-06 -34bp -45bp -13bp
Receive EUR 5Yx5Y, pay USD 5Yx5Y Swap 14 Dec 07 54 bp 85 bp 54 bp

Asia
Expressed with
bond/swap
Target level at
inception
Current/Closing
Level
INR - Rec 5Y Outright Swap 3-Aug-07 7.54% 7.25% 7.10%
HKD-2/10 Steepener Swap 23-Aug-07 44.5bp 80bp 56bp
SGD-2/10 Steepener Swap 23-Aug-07 39bp 120bp 69bp

$-Bloc
Expressed with
bond/swap
Target level at
inception
Current/Closing
Level
NZD - 6M fwd 1Y/2Y flattener Swap 10-Aug-07 -21bp -40bp -20bp
AUD - Receive 2020 BE Inflation Bond 17-Oct-07 360bp 330bp 365bp
AUD - 2Y/10Y AUD/USD basis Swap spread
steepener Swap 14-Nov-07 -2bp 2bp -1bp
Receive 3Y Vs March 08 futures Swap 7-Dec-07 91bp 70bp 91bp
Receive body of AUD 2Y/5Y/10Y Butterfly Swap 29-Nov-07 36bp 10bp 31bp

EMEA
Expressed with
bond/swap
Target level at
inception
Current/Closing
Level
PLN - sell 3X6 FRA FRAs 14-Dec-07 6.10% 5.60% 6.10%
PLN - long CPI-linked Aug-16, pay PLN 10Y bond/swap 14-Dec-07 300bp 350bp 300bp
HUF - 2Y-10Y steepener swap 14-Dec-07 -60bp -20bp -60bp
CZK - pay CZK 5Y, receive EUR 5Y swap 23-Nov-07 -15bp 30bp -26bp
SKK - pay SKK 2Y, receive EUR 2Y swap 26-Feb-07 -10bp 20bp -18bp
ZAR - pay ZAR 5Y swap 23-Nov-07 9.64% 10.00% 9.67%
TRY - long CPI-linked Feb-12 bond 2-Nov-07 109 113 112
Source: Deutsche Bank

Bond Market Strategy 2008

Reduced financial leverage, lower credit
availability and negative wealth effects will weigh
on the consumer and growth, especially in the US

The good shape of the corporate sector, an
aggressive Fed, a depreciating dollar and
reasonable equity valuations should help steer the
US economy away from a recession

Downside risks to this view remain, especially in
light of the scale of the credit contraction but the
current process of recognizing and writing-down
impaired assets is a very positive step in ensuring
that the current slow-down does not translate into
a deflationary recession

Despite the uncertain economic outlook, the
pricing inconsistencies between the US and EUR
markets, the vulnerability of the UK economy and
the strength of the factors supporting rising risk
premia have helped us develop high conviction
investment strategies for 2008

We like to enter the year positioned for higher risk
premia globally, which will be driven by higher
long term rates in the US, but lower policy rates in
Euroland and the UK
A year of rising risk premia
Tighter credit conditions will lead to higher risk
premia and steeper curves
The US economy is entering uncharted territory of credit
rationing, reduction of financial leverage and falling house
prices. The combination of lower credit availability and
negative wealth effects will weigh on the US consumer
and US growth. The good shape of the corporate sector,
an aggressive Fed, a depreciating dollar and reasonable
equity valuations should help steer the US economy away
from a recession. However downside risks to this view
remain, especially in light of the scale of the credit
contraction.
Despite the uncertain economic outlook, the pricing
inconsistencies between the US and EUR markets, the
vulnerability of the UK economy and the strength of the
factors supporting rising risk premia have helped us
develop high conviction investment strategies for 2008.
We like to enter the year positioned for higher risk premia
globally which will be driven by higher long term rates in
the US but lower policy rates in Euroland and the UK.
Painful deleveraging under way
The second half of 2007 has turned-out to be the period
when the excess leverage in the financial system finally
began unwinding. Years of low real rates, recycling of
large savings from emerging markets, loose lending
standards and low economic volatility had compressed
risk premia and led investors to increase leverage.
As corporate leverage was actually declining during most
of the period, the appetite for debt and yield pick up had
to be satisfied by other forms of debt creation: financial
innovation (ABCP, CDO squared, SIVs etc. ) and increased
consumer leverage (subprime in the US and mortgage
markets in general).
The bursting of the US housing market bubble triggered
the liquidity put implicit or explicit in several of the ABCP
and SIV structures. The competition for banks balance
sheet increased as previously off balance-sheet vehicles,
warehoused loans (leveraged loans, new mortgage
originations, CMBS etc.), and provision for losses started
crowding out other lending activities. As a result lending
standards in the US have started to tighten rapidly.
The tightening of credit standards has not been limited to
the US market. Indeed, as evidenced by the latest ECB
lending survey, credit standards tightened in Europe for
both mortgage and corporate loans. In the UK, the
tightening of lending criteria is also apparent through the
sharp drop in mortgage approvals and is further
exacerbated by the combination of an overextended
mortgage market and the dependence of some
institutions on wholesale funding. We believe that the
credit rationing initiated in 2007 is likely to continue well
into 2008.
Asset absorption more than half way through
While a great deal of progress has been made in terms of
absorbing assets on banks balance sheets (and in the
case of Northern Rock, IKB etc.. public balance sheets),
we estimate that around one-third of the SIV and ABCP
conduits which included some form of credit term
structure arbitrage still need to be absorbed by the
system. Beyond year-end effects, liquidity is likely to
remain strained until a solution for these assets has been
engineered. In that respect, Wednesdays coordinated
effort from the worlds central banks is an important first
step in the right direction. While the amounts involved
remain modest relative to the size of the problem, one
can be hopeful that the revamped discount rate window
will alleviate some of the funding concerns in the US and
the UK.
Even if banks manage to find the short term liquidity to
absorb the assets on balance sheet, they have yet to
permanently resolve their funding issues. Indeed the
maturity mismatch between the assets (average of 4.5
years for SIV for instance) and liabilities (mostly short term
borrowing from central banks), will eventually need to be
resolved through either longer term funding (long term
debt issuance or increase in the deposit base) or a sale of
the assets. While the asset/liability mismatch persists (i.e.
until the market for these assets starts functioning again,
or banks are able to issue long term debt in size), it is
likely that the liquidity situation will not fully normalize.
But repairing of the capital bases will constrain
lending
Beyond the current liquidity crisis, there is little doubt that
the capital for financial institutions is in need of serious
repair. The combination of large losses (estimated
anywhere between $200 and $400bn) and the
accumulation of assets on balance sheet (leveraged loans,
SIV, ABCP etc..) will require a considerable increase in
capital. We note that several successful capital injections
have been completed so far. However, the price at which
these transactions have been completed is a reflection of
the high insurance premium that financial institutions had
to pay for emergency capital. These capital injections are
therefore most likely only one part of a wider strategy to
shore up capital and are likely to be supplemented by
other means including a scaling down of lending activities.
The process of rebuilding the capital base, recognizing the
losses, funding the assets and restoring confidence is
likely to curb lending activity in 2008.
For instance, the capital base of monoline insurers would
be seriously eroded if rating agencies were to revise
upward their assumptions for cumulative losses for 2005-
2007 subprime vintages towards current analysts
estimates. As highlighted by our securitization team,
rating agencies have so far been relatively slow in
adjusting their assumptions (and in downgrading
subprime related securities). Thus, we should expect the
pressures on the capital of monoline insurers to stay in
place until the process of convergence between rating
agencies assumptions and actual expected losses is
completed. In the meantime, and as some of the
monolines suggested, we should expect them to reduce
their activities in order to improve their capital positions.
This will erode one of the key elements in the creation of
leverage in the structured finance market.
Similarly Spanish and UK banks are finding it increasingly
difficult to fund new mortgage originations as the covered
bond, securitisation and wholesale funding markets are all
under stress. As a results, these institutions have had to
increase the price/reduce the availability of mortgage
loans which is likely to negatively impact frothy markets.
However, it is obvious that the current, though painful,
process of recognizing and writing-down impaired assets
is actually a very positive step in ensuring that the current
slow-down does not translate into a Japanese-style
deflationary recession.
Slowdown is (over)priced in the US:
short duration
Neutral the front end
Our analysis of the credit rationing outlook suggests that
the current environment is more about availability of credit
than price. As a result, the effectiveness of rate cuts will
be reduced, in the same way as the aggressive lending
practices in 2004-2006 delayed the effectiveness of the
rate hikes.
This suggests that from a central bank perspective the
solution to the current crisis should, together with rate
cuts, involve providing more long term liquidity to the
market, for instance by further expanding the TAF
initiative. The remaining inflation risk in the US (see the
discussion below), raises question marks over excessive
Fed easing to cure the liquidity problem.
On the other hand, the macroeconomic impact of credit
rationing and the downside risks to growth that it poses,
justify further rate cuts. However, given that the corporate
sector and equity market valuations enter the crisis in
reasonable shape, and given the 10% depreciation of the
USD trade weighted index year to date, it is difficult to
argue at this point that there is scope for a much more
aggressive Fed than what is already reflected in the
forwards.
Thus, given the volatility of the front end of the curve and
the uncertainty around the path that the Fed will choose
to cure the liquidity crisis, we prefer to remain neutral
on US front end pricing and assume for the rest of our
analysis that the forwards will get realised.
But short the long end
Assuming that the forwards in the front-end get realised,
we recommend maintaining short duration position in
the US for the following reasons.
The current level of bond risk premia does not reflect the
current upside risks to inflation. Indeed, when the Fed
initiated its rate cut process, it itself acknowledged
inflationary pressures. This was in marked contrast to
previous rate cut cycles, when the FOMC described
inflation as being contained. Rising inflation risks are also
reflected in Consensus Forecasts long term inflation
forecasts, which rose following the first rate cut (unlike
previous rate cut cycles). In fact, the 10% depreciation of
the trade weighted dollar over the last 12 month is already
being reflected in higher import prices and should impact
inflation in 2008. Finally, we note that in recent history, the
only time when 10Y rates remained below 4% for a
sustained period (with a minimum of about 3.1%) was in
late 2002, early 2003 when the Fed Funds target rate was
at 1% and the market was concerned about deflation
risks. As mentioned above, we view the risks of a
deflationary recession as limited, given the current
process of loss recognition and bank recapitalization. In
fact the current level of 10Y yields can only be explained
by a sizable flight to quality premium which is evidenced
by the widening spread between same maturity OIS and
government bonds.
As highlighted in the US overview section, mortgage
technicals are likely to add to steepening pressure on the
long end of the curve. The duration of the mortgage
universe will extend as the weaker housing market and
tighter lending criteria lead to lower mortgage prepayment
speeds and increased fixed rate originations.
Thus the combined force of rising inflation risk premia,
mortgage technicals and a shift in asset allocation from
sovereign wealth funds away from sovereign credit and
towards equities (discussed below) should contribute to
support long term rates.
Decoupling is (over)priced in Euroland:
long the front end
Long the front end
While the market is pricing another 100bp of cuts from
the Fed and 50bp from the BoE, hawkish rhetoric from the
ECB is leading the front end of the EUR curve to price a
40% chance of a hike. While Eurolands economy is likely
to be less impacted by the credit rationing than the US or
UK economies, its growth outlook will nonetheless suffer
both directly and indirectly from the credit crisis. We
remain receivers of EONIA.
First, and as mentioned in the discussion above, the
competition for balance sheet usage and tightening of
lending criteria impacts financial institutions not only in the
US but in Euroland and the UK as well. Second, as our
economists have highlighted, it is unlikely that
consumption growth in Asia will compensate for a
slowdown of consumption in the US. Third, given the
more proactive approach from the BoE and the Fed, the
EUR is likely to face continued upside pressures. Further
appreciation of the currency (or even consolidation at
current levels), will both help contain inflation which we
expect to start falling in Q1 of next year (see Global
Linkers update for more details), and also reduce the
competitiveness of the Euro area. We note for instance
that the good performance of the US economy in Q3 has
been driven by exports, which is more than likely to occur
at the expense of the Euroland economy given that global
growth will be constant at best. Third, most of the key
forward looking indicators in Euroland have started to turn
indicating that the peak of the cycle has been reached
already.
In fact, we would expect the ECB to become more explicit
about rate cuts in Q1 of next year once (a) the important
annual wage negotiations are completed, (b) inflation
starts to subside as we expect and (c) the impact of the
credit rationing becomes more obvious and the
downward trend in the forward looking indicators gets
confirmed by the data.
But neutral the long end
The long end of the EUR curve will face conflicting forces
that lead us to be neutral. On one hand, if we are right
about the front end of the EUR curve, we would expect
the 10Y rate to rally. This rally could be further supported
by some potential shift in international reserve allocations
towards Europe as currency pressures lead reserve fund
managers to hedge their USD exposure. On the other
hand, EUR rates are highly correlated to their US
counterparts and react with a high beta to movements in
USD rates. We therefore prefer to maintain a neutral
duration view in Euroland.
Short USD 5Y5Y v. EUR 5Y5Y
Being short the USD 5Y5Y vs. EUR 5Y5Y naturally falls
out from our analysis. The analysis of the inflation and
real rate components is also supportive of the trade. First,
looking at the inflation component, we concur with the
view reflected in Consensus Forecasts expectation of
higher inflation risks in the US relative to Europe. This
should support higher breakevens and steeper breakeven
curves in the US. Second, looking at the real rate
component, we note that long term forward real rates in
the US have materially outperformed their EUR
counterpart, so that the spread between the two is now
negative (see Global Linkers for more details).
Risks in the UK skewed to the downside
High leverage
Analysing current events through the lens of an unwind of
leverage highlights the vulnerability of the UK economy.
Indeed, rising house prices towards unsustainable levels
and low savings rates have pushed the UK consumer
leverage to all time highs. Moreover, the UK economy
itself is heavily dependent on the service sector (75% of
GDP) and especially the financial sector (10% of GDP).
The financial and service sectors are clearly the most
exposed to the current credit crisis as evidenced by the
rapid fall of the services PMI.
an over-extended housing market
The UK has benefited from an extremely rapid house price
appreciation, even relative to the US. As a result, most
house price models would tend to highlight the fact that
UK houses are overvalued. This view would be confirmed
by standard affordability measures such as house prices
to earnings. The high level of house prices is often
justified by supply/demand imbalances in the UK. We
would tend to disagree with this view as a rental yield on
buy-to-let properties below the mortgage rate is more
likely a reflection of speculative behaviour and over-supply
of rental properties.
and tighter credit conditions will require aggressive
rate cuts
High libor fixings, dysfunctional covered bond and
securitization markets have increased the funding
pressures on UK mortgage originators. Mortgage lenders
have naturally reacted by pulling back their lending criteria
and/or increasing the cost of credit especially for buy-to-
let and subprime mortgages. At this stage, only
aggressive easing by the BoE could prevent a more brutal
adjustment to house prices. We still see value in the UK
front-end.
Risk premia set-to continue to rise:
maintain steepeners
Our highest conviction trade for 2008 is that risk
premia will continue to increase for several reasons.
First, the continued contraction in credit availability and
the forced deleveraging of the system will naturally result
in rising risk premia as asset prices adjust to lower levels
of financial leverage and as risk is priced more
conservatively when retained on balance sheet.
Second, central banks benefited from an exceptional
macroeconomic environment during the last tightening
cycle. The cycle started from an extremely low level of
real rates while with the benefit of globalization, inflation
levels remained subdued. Thus central banks had the
opportunity to gradually normalize interest rates and the
luxury to be exceptionally transparent in their forward
looking statements. This very benign macro environment
enabled central banks to be more predictable which
reduced volatility in the front end of the curve and risk
premia more generally. However, now that inflation is
close to, or above central banks comfort zones and that
the trade-off between growth and inflation is more acute,
central banks are bound to be more agnostic themselves
about the direction of interest rates and therefore become
less predictable. This will reintroduce volatility in the front
end of the curve and support rising risk premia.
Third, unless a more permanent funding solution is found
for the assets that moved back on banks balance sheet,
we see still some risk of potentially disorderly liquidation
of the assets underlying the SIV and ABCP structures.
Finally, and as we have argued in The Unwind of the
Bond Market Conundrum (Fixed Income Special Report
20 June 2007) and the latest edition of Global Economic
Perspectives, we believe that there are compelling
opportunity costs, currency hedging and asset/liability
management arguments for shifting SWF asset allocation
to equities relative to fixed income. The rapid increase in
reserves and the simultaneous improvement in the Equity
Risk Premium have resulted in an increasing opportunity
cost for holding fixed income securities rather than
equities.
One can also make the argument that the increased
allocation towards equities makes sense from an ALM
perspective. As oil exporters have used early windfalls to
significantly repair their balance sheets (as can be seen in
the evolution of Russias external debt and Saudis
domestic debt ratios) there are less ALM arguments to
maintain a high asset allocation into debt. Finally, relative
to Treasuries, investment in the equity of large US
multinationals offers a good hedge against potential USD
depreciation, since these will benefit at the margin from
an improvement in US competitiveness.
We can already witness this trend in the behaviour of
SWF money. Such a shift away from sovereign credit to
equities should also contribute to an unwind of the bond
market conundrum and a bear steepening of the curves
especially in the US.
We therefore recommend maintaining steepeners in
the US, UK and EUR and also selective long volatility
positions (see the US and EUR derivatives sections).

Ralf Preusser (44) 20 7545 2469
Francis Yared (44) 20 7545 4017

US
US Overview

Repairing the breach

We view there are two aspects of the current
crisis that need to be addressed: a capital crisis
and a funding crisis. Government support and
disclosure of losses are helping with the funding
crisis, while the bank recapitalization is gradually
resolving the capital crisis.

We also look at 4 drivers of the twin crises:
mortgage supply, past Fed tightening, the fall in
housing prices, and the hidden leverage of the
securitization markets.

Our base scenario is for moderate GDP growth
and 10% housing price declines. But the risk
scenarios of recession or inflation raise the issue
of increased systemic risks and high volatility.

We recommend being underweight duration for
the base case, but across the scenarios, the
constant theme is for implementing yield curve
steepeners, entering swap spread curve
disinversion trades, and buying out-of-the-money
put and call volatility.
Capital vs. funding crisis
In the current financial crisis, we see two distinct aspects
of the crisis that need to be addressed in the coming year.
The first is the bank capital crisis, rooted in anxiety about
the effect of losses on bank (and other financial
institutions) balance sheets and their solvency. The
second is the funding crisis, which is based on the lack of
trust among banks due to the lack of transparency
regarding losses. Each aspect has had some distinct
origins as well as some overlapping ones, and will be
solved with different tools, with the solutions occurring at
different paces. For example, at one extreme there are
the GSEs, which are funding at extremely good levels,
while they are forced to raise capital to cover credit
losses. On the other side of the coin are institutions such
as Northern Rock that are on the verge of bankruptcy
because they cant find funding, while they have had little
in the way of US subprime exposures and related losses.
Most other financial institutions are somewhere in the
middle of that spectrum.
LIBOR-OIS spread a measure of the funding crisis
0
20
40
60
80
100
120
Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07
Libor-OIS spread
Four underlying drivers
There have been 4 fundamental factors that have
interacted in various ways to cause these two crisis
aspects. The first was the Fed tightening monetary policy
beyond a likely neutral rate. The steady increase in the fed
funds rate by 425 bp from 2004 through 2006 changed
the economics of strategies that banks and consumers
had adopted in the lower-rate environment. The second
was the decline in housing prices and expectations of
further declines. The Case-Shiller indices have already
reported a 5% fall in home prices on a nationwide basis
since mid-2006, and the housing-price futures market is
pricing in another 8% drop over the next year. The third
factor was hidden leverage caused by the creation of
ABCP-financed SIVs, which were vulnerable due to an
asset-liability mismatch. Total outstanding ABCP issuance
had been nearly $1.2 trillion at the peak, but there is little
likelihood that the ABCP-financed SIV business model will
survive in its current form, given the exposure to
correlated risks. The last, but not the least, was the pickup
in volume of ARM resets and the resulting increase in
fixed-rate mortgage supply. ARM resets and prepayments
are likely to amount to $400 bn per quarter in 2008,
adding substantially to both the mortgage duration supply
and credit losses.
How did these drivers create the capital and funding
crises?
The sharp increase in mortgage supply kept consistent
widening pressure on the mortgage market, forcing
spreads wider. At the same time, this occurred against a
background of weak demand, as banks, which had been
the primary buyers of mortgages since 2003, stopped
buying. Low net interest margins, a result of the Fed
tightening, led to no bid for the mortgage assets that
were coming to the market. The resulting markdowns in
mortgage prices started the capital crisis and contributed
substantially to it.
Declining housing prices also contributed to the capital
crisis, by leading to subprime CDO losses, first brought to
light by the Bear Stearns hedge fund losses in June, and
requirements to mark down the value of positions. The
CDO losses were exacerbated by the increased market
anticipation of forced selling or hedging of positions. The
CDO losses brought rating agencies into the limelight,
with the market questioning the models, correlation
assumptions etc that the agencies have used to arrive at
their rating decisions. These CDO losses, and anticipation
of ratings downgrades, also created transparency issues,
and a lack of trust among market participants, as CDO
holders resisted marking their positions to market and
disclosing the losses. This in turn led to a general
unwillingness to lend, contributing to the funding crisis.
ABX price history
0
20
40
60
80
100
120
AAA (06-2)
BBB (06-2)
Finally, the recent structural innovations in the financial
sector, particularly SIVs, and the hidden leverage that they
represented, created a strong need to borrow when the
traditional means of funding through ABCP was cut off. as
first happened to IKB and Countrywide in August. The
existence of such massive hidden leverage and ALM
mismatches came as a surprise to the broader markets.
So the reaction was equally massive, especially in LIBOR
resets and swap spreads. As it became clear that there
would be need for bank financial support or the shift of
SIV assets to bank balance sheets, the spiraling bank
funding crisis ensued.
Asset backed commercial paper outstanding
700
800
900
1000
1100
1200
1300
ABCP outstanding
Source: Federal Reserve
The methods of addressing these two aspects of the
crisis have differed somewhat. For the capital crisis,
recapitalization of banks (or other financial institutions
such as GSEs or monoline insurers) was facilitated by the
investments of sovereign wealth funds, or the public
issuance of preferred stock in the public or private
markets. However, the recapitalization activities were
made possible first by a decline in bank equity prices,
which enabled equity risk capital to enter the picture. So
far, the interest in buying capital securities has been very
strong as shown by the magnitude of oversubscription of
GSE preferred issuances. In addition, Fed rate cuts
lowered the anxiety level somewhat, kept the economy
from sinking into a recession that would have further hurt
the capital positions, and made it easier for banks to hold
securities on their balance sheets.
In addition, the monoline insurers have began to enter into
large reinsurance contracts, albeit at a high price,
mitigating some of their risk.
For the funding crisis, government or quasi-government
substitution for private funding went a good way toward
restoring confidence. The Fed cut the fed funds target
rate by 100 bp so far, and has added funds aggressively
whenever shortages developed. In addition, the launch of
the Term Auction Facility sought to overcome the stigma
of the discount window and lend funds on a collateralized
basis to a wide variety of banks. Another significant
source of funding has been the Federal Home Loan Bank
System, which has lent the banking system nearly an
additional $200 bn in home loan advances during the
crisis. At the same time the FHLBs themselves are
funding at a very favorable rate. So, in a way, the FHLB
advances served as a complement to the Fed discount
window, which many banks are reluctant to use. Finally,
the increase in transparency, through pre-announcing
losses based on an actual mark-to-market value against
indicators such as the ABX, might have caused substantial
pain and event risk in the short term, but in the longer
term has been crucial in restoring confidence in the
funding markets.
Scenarios for 2008
Going forward, our views for 2008 depend substantially
on how the 4 factors evolve. Especially significant is the
housing market and its effect on the economy. There are
3 possible scenarios. Our base scenario is one where real
GDP grows at a modest, but below trend, pace of 2%,
and housing prices fall by about 5% over the course of
the year (adding up to 10% from the peak). The Fed
continues to cut the fed funds rate to 3.75%, and ARM
resets continue at a strong pace. This scenario would give
plenty of room for the continuation of trends in
deleveraging and capital replenishment for the coming
year. The working out of the market crisis would involve
the repricing of risk assets, but constrained by the relative
scarcity of liquidity. The repricing of risk assets will occur
as investors, primarily banks, seek to deleverage and
reduce the balance sheet overhang by selling these
assets, particularly in the mortgage sector, and recognize
losses.
There will also be continued prospects of event risk early
in the new year. We see two sources of event risk: Q4
earnings announcements that will force the laggards to
recognize further losses on subprime portfolios, and rating
agency downgrades that might force portfolio
restructuring. As this process proceeds, we should see an
improvement in transparency and market confidence, but
at the same time, risk premia will widen given the amount
of risk transfer that will have to take place. This sets the
foundation for a recovery in the fixed income sector.
In this scenario, we would expect a mild bearish move to
4.50% on 10Y Treasuries, and curve steepening to 150 bp
in 2/10Y Treasuries, as assets that had previously been
financed through short-term funding such as ABCP or
bank deposits instead are shifted to investors who fund
through long-term debt or equity capital. This would put
upward pressure on yield levels on the long end of the
curve.
The next scenario is one with an especially bad outcome.
The economy falls into recession, and housing prices fall
steeply, approaching Depression-era levels. The credit
crunch moves from the banks to consumers, causing a
sharp drop in consumption, as both the capital and
funding crises transition into the real economy. Global
growth is also threatened with a slowdown or outright
recession, with commodity prices falling and sovereign
wealth investors becoming more conservative and
restricting the equity investments into banks. In this case,
we could see very low rate levels, with 3.50% on 10Y
Treasuries, 1% fed funds, and substantial curve
steepening.
The third scenario is one where housing prices bottom out
during 2008, perhaps falling 5% in the first half of the
year, then rising 5% to end up unchanged for the year.
GDP growth in this scenario returns to or moves above
the long-term trend. In this scenario, inflation becomes a
concern, with the Fed possibly starting to withdraw its
recent rate cuts. However, this doesnt mean a return to
pre-crisis markets. The conundrum of low long-term rates
does not return, nor does mortgage equity withdrawal
revive. In this scenario, bearish steepening of the yield
curve occurs on the back of higher inflation fears, with
10Y Treasury yields north of 5%.
Trade recommendations
Pursuant to our base case, moderate growth scenario, we
would implement a duration underweight. But across our
scenarios, one consistent theme is the increasing
steepness of the yield curve, either through rising risk
premia, aggressive Fed rate cuts, or rising inflation
premia. We thus favor 2/10Y curve steepeners.
We also favor buying out-of-the-money volatility, in both
calls and puts, across the various scenarios. In our base
case, the extension trade in mortgages, via the credit
impact on slower refis, should be supportive for volatility.
Lower rates in a recession, if prolonged, and accompanied
by substantial mortgage origination in new coupons, could
set up the market for another convexity hedging episode.
Finally, a steepening sell-off and higher inflation in the
third scenario could expose the market to substantial
shocks in adjusting to the new market environment. Thus,
we favor buying volatility on the tails of the distribution.
We also think that the present inversion of swap spreads
curve has been primarily driven by the funding crisis and
consequent LIBOR resets. The funding crisis, in our view,
will eventually dissipate because of central bank actions
and more transparency. The transparency will improve,
either because of more disclosure of mark to market
losses by financial institutions or more data on actual
subprime defaults. Thus we target disinversion of the
spread curve. With regard to spread level, we see 10Y
swap spreads narrowing only modestly, to 60 bp, as
narrower spreads in the short end and increased Treasury
supply, are offset by poorly-performing mortgage
markets, and wider risk premia among spread product.
Mustafa Chowdhury (1) 212 250-7540
Marcus Huie (1) 212 250-8356

1
4

D
e
c
e
m
b
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r

2
0
0
7

F
i
x
e
d

I
n
c
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W
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y

P
a
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1
2

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c
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B
a
n
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S
e
c
u
r
i
t
i
e
s

I
n
c
.
The flow-through effects of the credit crisis
ARM resets and
mortgage supply
Fed tightening beyond
neutral rate
Declining housing
market and
expectations
Hidden leverage
created thru SIVs
Markdown
Balance sheet anxiety
and capital crisis
Transparency issue
and lack of trust
Unwillingness
to lend
Funding crisis
Supply
Low NIM and no bid
for assets
Leveraged loan and
CDO losses,
markdowns
Strong need
to borrow
More transparency
and disclosures
Fed cuts and
TAF program
FHLB
advances
Fed cuts
SWFs
Cheap
equity

Cross Rates Strategy

2008 - Mortgage Extension & ARM
Resets Bear steepening Swap spread
slope disinverting and bullish for vol

We expect prepayment related mortgage
extension to provide a bear steepening pressure on
rates, widening pressure on swap spreads with a
steeper swap spread slope and structural support
for vol in 2008.

Lending standards are likely to tighten and the
housing market, worsen further. Mortgage
extension due to lower prepays in 2008 could add
about $450bn in 10Y equivalents with most of the
increase focused on the long end of the curve. The
10Y swap spread is likely to widen by 4bp due to
these effects

ARM resets are likely to add to the same
exposures as well. We estimate $ 100bn in 10Y eqv.
added mostly on the long end with the 10Y swap
spread likely to be another 2-3 bp wider due to this
issue.

Call risk should continue to trend lower, and
extension risk higher. Structural preference for
payer skew over receiver skew should thus
continue.

The initial part of the year could see high spread
volatility of mortgages, as views on the basis
remain varied (valuation vs supply/demand
technicals). Mortgage options should thus reflect
higher vol.
2007 saw considerable turmoil in the mortgage markets
that eventually led to a broader credit and liquidity crisis,
forcing the Fed to cut rates to forestall slowing of the
overall economy. Volatility came back after being initially
range bound, with a structural bid re-emerging from
mortgage players, due to ARM to fixed refinancing and
mortgage extension. In 2008, we expect the constriction
in mortgage credit and available products and its interplay
with the housing market to further extend mortgages due
to lower prepays, aid ARM to fixed refinancing, as well as
influence the general economic volatility.
Duration and Vega: Turnover vs Refinancing effects
We have previously discussed the impact of slower
prepayments on duration (partial and total) and vega of
mortgages, and the resulting effects on rates and vol. We
now examine the effects of turnover and refinancing
separately.
If turnover slows without any change in refinancebility,
then effectively you are extending the expiry of the call
option held by the borrower due to longer duration of the
mortgage, while the sensitivity of that option to rates
remains about the same, increasing the vega. In the case
of refinancing however, there are two competing
pressures. If refinancing reduces, the sensitivity to rates
reduces, but the expiry of the option increases as duration
extends. As we show below, while the duration is
affected by both factors, vega is a function of turnover, as
the competing pressures in the case of refinancing net
each other out.
Duration Exposure: Refi and Turnover both contribute
Base
Duration
-20% Refi &
Turnover -20% Refi -20% Turnover
5 4.97 0.35 0.08 0.26
5.5 4.04 0.37 0.12 0.24
6 2.95 0.44 0.21 0.22
6.5 1.81 0.54 0.30 0.23
Changes
Source: Deutsche Bankg
Vega Exposure: Turnover dominates Refi
Base Vega
-20% Refi &
Turnover -20% Refi -20% Turnover
5 (23.1) (2.9) 0.6 (3.6)
5.5 (24.8) (2.8) 0.4 (3.3)
6 (24.3) (2.7) 0.2 (2.9)
6.5 (17.3) (2.5) (0.1) (2.3)
Changes
Cash-out refinancing is a function of home equity buildup,
which is closely related to turnover as well as lending
standards, which are currently influencing premium
prepayments considerably.
Turnover continues to worsen: The Pending Home
Sales figure was much worse than it looks
While the market focused on the stronger seasonally
adjusted Pending Home Sales figure, in reality, the
weakness of the report lay in the non seasonally adjusted
figure, which increased 7%. In 2007, October had 22.5
business days, while September 19. Ignoring the seasonal
decrease in turnover, day count in isolation should have
caused an 18.5% increase in home sales. Last year, on a
day count adjusted basis, the index fell about 5%, while in
2005 it was unchanged, adjusted for day count. Even after
using a 5% decline based on 2006 numbers, the net
shortfall in the index amounts to: 18.5-7-5 = 6.5%. YOY
this figure has fallen 21%., daycount adjusted
and as does the Refi atmosphere
The Refi index has consistently overestimated the extent
of premium coupon prepayments due to increasing ARM
resets, multiple applications from borrowers and lower
approval rate due to tighter lending standards. Moreover
actual refi index prints continue to increase in a benign
fashion. For a 14 bp rally in mortgage rates, the Dec 7th
print of the Refi index showed only a 4.3% increase.
Premium prepayment response to decreasing rates is
thus quite muted.
2008 Outlook
In our view, lending standards should continue to tighten,
despite better liquidity as delinquencies continue to rise
and also due to political initiatives. Lenders also continue
to scale back or discontinue their subprime origination
business. The housing market is also likely to worsen.
Moreover, the tightening in lending standards and
constriction in mortgage products also impact turnover
indirectly by considerably shrinking the buyer pool for a
particular home.
During 2008, a 20% reduction in turnover and refinancing
speeds from current levels (where we already dial the
models -20%) is a reasonable base case scenario. In a
rally, the disparity between expected duration (and vega)
and actual is likely to widen substantially as prepays
surprise on the lower side. Note that indices may not have
fully adjusted to current lower prepayments and thus the
index managed community could be longer duration.
Changes in duration (total and partial) and vega of
FRMs and ARMs
OAD Vega
2Y 5Y 10Y 20Y
5 0.54 (0.05) (0.03) 0.08 0.55 (2.1)
5.5 0.53 (0.04) 0.01 0.11 0.47 (2.6)
6 0.53 (0.01) 0.04 0.13 0.40 (3.2)
6.5 0.55 0.02 0.09 0.17 0.30 (3.2)
ARM 0.15 0.03 0.07 0.04 0.04 (0.7)
Partial Durations
Assuming a 60/40 split between fixed and ARMs, with
$10 trillion mortgage debt outstanding, we expect the
duration extension in 2008 due to prepayments to be of
the order of $450 bn 10Y equivalents, if rates remain at
current levels. A selloff could intensify the housing market
downturn and further exacerbate the prepay related
extension. As can be seen in the above figure, the
extension is a considerable curve steepener. The
extension is likely to influence swap spreads wider as
well, with an additional 4 bps or so in 10Y swap spread,
based on the relationship between the agency MBS DV01
and swap spreads. While the vega increase in absolute
terms for ARMs is not that high, in percentage terms the
vega exposure increases about 21% versus 11% for fixed
rates. From a servicer perspective, the effects are even
larger as the duration of the IO becomes less negative
and vega higher (more negative).
As we discuss in the section on ARM resets, these
effects are compounded by the ARM to fixed refinancing.
If turnover and refinancing deviate to some extent, the
effects can be determined from the discussion in the
beginning of the article. One can also use the elbow shifts
in models to change the refi incentive to obtain a dynamic
extension picture in rallies.
Call risk should thus continue to be benign and extension
risk significant in 2008. We continue to look for violent
selloffs, due to convexity related flows in backups. In the
first half of the year, as the market focus shifts away from
immediate liquidity and P&L concerns, we could see full
adjustment of MBS durations across the investor
spectrum. Already, models have begun to release new
versions, particularly due to the enormous variation in
expected vs model prepays following the breach of the
5.5% threshold in the current coupon rates in early
December. Buying of MBS in rallies to make up duration
should continue to be muted, as prepays do not increase
as much. Structural bid for low strike receivers is thus
likely to be benign as well.
We also like the long vol optionality offered by PACs
versus MBS as the vega becomes longer as prepays slow
further. Investors can sell this volatility through swaption
straddles or low strike receivers for example, to monetize
some of this exposure. We favor curve steepeners and
recommend bear steepeners as a support hedge. Other
instruments such as VADM/Supports and Reference
Remics are an excellent asset/liability management
vehicle.
ARM Resets:
In the figures below, we show the history and schedule of
ARM resets by quarter.
ARM resets by quarter
Resets with prepayment projections
0
50
100
150
200
250
300
350
400
450
07Q4 08Q4 09Q4 10Q4 11Q4 12Q4
$
b
n
Prepayment
First Reset
Source: Deutsche Bank, eMBS, Loan Performance
ARMs as a percentage of total applications continue to
reduce, both in $ and numerical terms. Moreover the
White House proposal to aid subprime borrowers points
to the increasing channeling into fixed rate mortgages.
ARMs as a percentage of total applications back to
pre mortgage product expansion levels
0
5
10
15
20
25
30
35
40
J
a
n
-
0
2
J
u
l
-
0
2
J
a
n
-
0
3
J
u
l
-
0
3
J
a
n
-
0
4
J
u
l
-
0
4
J
a
n
-
0
5
J
u
l
-
0
5
J
a
n
-
0
6
J
u
l
-
0
6
J
a
n
-
0
7
J
u
l
-
0
7
Source: Bloomberg
Risk premium on ARMs continues to increase. The fixed
to ARM spread has continued to shrink despite
steepening of the yield curve and this spread could lag
further steepening of the yield curve in 2008. Borrower
demand for this product is also likely to be lower, due to
increased aversion of related risks.
ARM to fixed net duration and vega effects (dialing
20% lower prepays for both products)
OAD Vega
2Y 5Y 10Y 20Y
ARM 1.96 1.03 0.59 0.08 0.03 (0.03)
Fixed (6%) 3.48 0.62 0.75 0.71 1.17 (0.27)
Net 1.51 (0.41) 0.16 0.63 1.14 (0.24)
Partial Durations
Assuming a 30% conversion from ARM to fixed, the net
duration added to the 30Y universe in 2008 is about $100
bn in 10Y equivalents, most of it on the long end of the
curve. This has the effect of about 2-3 bp widening in 10Y
swap spreads as well.
As can be seen in the figure, considerable vega is added
through the transaction. A similar trend occurs in the IO
space as well, relevant to the vol needs of servicers. Vega
exposure of the total market may increase about 7-10%
because of this effect.
We expect mortgages to provide a bear steepening
pressure on rates, widening pressure on swap spreads
with a steeper swap spread slope and structural support
for vol in 2008.
Mortgage Options:
The hedge ratio implied by mortgage options continues to
remain high as compared to that implied by the pass-
throughs, indicating high MBS spread volatility.
Hedge ratio comparison between TBA and mortgage
options for the 6% cpn
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
6
/
7
6
/
2
1
7
/
5
7
/
1
9
8
/
2
8
/
1
6
8
/
3
0
9
/
1
3
9
/
2
7
1
0
/
1
1
1
0
/
2
5
1
1
/
8
1
1
/
2
2
1
2
/
6
Option HR TBA HR
Moreover, views on the mortgage basis remain diverse as
seen in the Mellon survey of money managers. Essentially
the carry of mortgages is quite attractive but supply
continues to overwhelm demand. Money managers are
considerably overweight mortgages, and banks have been
buying whole loans in favor of MBS.
25
th
vs 75
th
percentile money manager MBS
overweight
5
7
9
11
13
15
17
19
21
23
25
May-
03
Nov-
03
May-
04
Nov-
04
May-
05
Nov-
05
May-
06
Nov-
06
May-
07
Nov-
07
25th vs 75th
Source: Mellon Survey
We thus recommend against selling mortgage vol vs
swaption vol until these views are reconciled, which may
happen by mid-2008.
Anish Lohokare (1) 212 250 2147

Treasuries

Increase in deficit and issuance expected

2008 is likely to be the end of the 3 year trend
toward narrower deficits, as reduced fiscal
discipline, greater willingness to engage in fiscal
stimulus, and the slower economy pressure the
budget deficit wider.

We think the additional Treasury issuance will be
primarily done through the Treasury bill market.
Thus we are likely to see the bill share of total
issuance rise.

As the Treasury repo market normalizes, we
should see Treasury futures richen relative to the
CTD, and on-the-run spreads start to narrow back.
The federal budget deficit is likely to exceed the estimates
of the Congressional Budget Office due to higher-than-
assumed cost of the operations in Iraq and Afghanistan,
the AMT provision, and possibly higher non-discretionary
spending and lower revenue. These point to increased
Treasury issuance in 2008. Our forecast for the deficit for
FY 2008 is $250 bn, which is likely to be skewed upwards
as the economy weakens.
Recent improvement in federal deficit likely to reverse
in 2008
-500
-400
-300
-200
-100
0
100
200
300
400
500
97 99 01 03 05 07
-500
-400
-300
-200
-100
0
100
200
300
400
500
Deficit - LHS
Net marketable coupon issuance - RHS
Our 2008
projection
The AMT fix adds about $50 bn in additional deficit for FY
2008. On the war funding front, the Administrations
revised request was $43 bn higher than the original
estimate. Moreover, there is also a chance of additional
funding requests on this front later in 2008. The early
months of FY 2008 give some indication of this: Both the
October and November 2007 outlays for defense, social
security, Medicare/Medicaid, Social Security and net
interest on public debt increased considerably over the
previous year (adjusted for business days and
seasonality). The total spending was up 6% from Nov 06
to Nov 07, with net interest on public debt soaring 12.6%
YOY. Overall, the Nov deficit widened slightly beyond
economist expectations.
Also, fiscal discipline is under threat, given the political
dynamics in Congress. The recent passage of the AMT
provision in the US Senate, in absence of an offset under
the Pay-as-you-go principle advocated by the
Democratic leadership earlier this year, is perhaps an
indication of the continued impasse between the
opposing parties. Once this principle is abandoned, the
likelihood of additional populist legislation increases,
particularly due to the proximity of the US presidential
elections.
The revenues side of the equation could also fall lower
than the CBO estimates. While early FY 2008 data
indicates healthy individual income tax receipts, the year-
end bonus payments for individuals are likely to be on the
weaker side. Moreover, overall individual tax receipts for
the year could decline, particularly if the weaker economy
exerts pressure on wages and/or employment.
Employment taxes could decrease in proportion to
income taxes, further exacerbating the deficit situation.
The CBO reported a drop in corporate income tax receipts
for the first two months of FY 2008. While the first two
months may not set the course for the entire year, in the
face of weak retail sales, poor financial company earnings
and also general weaker economic and credit conditions,
we find it hard for corporate income taxes to be stellar,
despite the weakening of the dollar. Corporate spreads
have widened considerably and stocks have declined and
served as an expectation of lower earnings, at least in the
near future, until the Fed cuts take effect. This also
bolsters the possibility of wage and employment
pressures.
The net note and bond issuance for the first half of the
year is negative and points to increased issuance sizes.
Given the considerable increase in the debt burden, the
Treasury is likely to increase issuance that minimizes the
net interest cost and thus T-bill issuance should show a
considerable increase, followed by modest increases in
the 2Y and 5Y .auction sizes.
Net Note and Bond issuance expectations for Jan-Jun
2008
Treasury Notes and Bonds Gross Issuance Maturing Net Issuance Coupon Net Supply
2Y 124 132 -8 10 -18
3Y 0 44 -44 4 -48
5Y 82 57 25 15 10
10Y 46 35 11 17 -6
20Y 0 0 0 0 0
30Y 15 0 15 17 -2
Callables 0 0 0 2 -2
TIPS 29 16 13 6 7
Notes/Bonds 296 284 12 71 -59
Source: Wrightson

Share of bills as pctage of total debt is likely to
increase
18%
20%
22%
24%
26%
28%
30%
01 02 03 04 05 06 07
The breakdown in the financing markets have contributed
to a widening of on-the-run spreads. With the recent
reduction in the financing crisis, the liquidity premium for
on-the-runs could start to decline, compressing spline
spreads and also lead to narrower quoted swap spreads.
In addition, the cheapness of the back Treasury futures
contracts should correct in the improving environment,
leading a long futures position to outperform cash.

Spline spread of on-the-run 10Y Treasury
-20
-18
-16
-14
-12
-10
-8
-6
-4
-2
0
Apr-07 Jun-07 Aug-07 Oct-07 Dec-07

10Y futures CTD net basis
-4
-2
0
2
4
6
8
10
12
14
16
Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
H8 Z8
Marcus Huie (1) 212 250-2147
Anish Lohokare (1) 212 250-8356

Derivatives

We see developments in 2008 as the conundrum
in reverse with a sticky reaction to the Fed cuts.

Our base case scenario is a moderate economic
slowdown with at least a partial resolution of
liquidity problems in the first two quarters of the
year.

We are structurally bullish on vol due to mortgage
related factors and would look to take advantage
of the liquidity induced dislocations in an RV
context.

The conditions of forced capitalization which are
behind the recent trust preferred issuance are
likely to reduce the swapping activity and supply
of vega to the market.
2008: The conundrum in reverse?
2007 saw a big comeback of volatility after several years
of continued decline. In the second half of the year we
saw the unraveling of the housing bubble and what could
be a beginning of a log U-turn in rates and credit markets.
The year started with one of the largest drops in implied
volatilities with both indices hitting their 10Y lows after a
supply shock at the end of 2006. This was followed by a
relatively quiet period with occasional episodes of
convexity hedging, but without major excitements
pushing vol even lower in May until the first indications of
sub prime crises showed up during the summer. The
figure shows the recent history of the two indices.
Volatility indices reach 3-year highs
17-May
12-Sep
11-Dec
15-Feb
50
60
70
80
90
100
110
120
130
140
04 05 06 07
60
70
80
90
100
110
120
DGX (left)
DVX (right)
As the housing market slowdown began to take its toll,
we saw a gradual return of mortgage related demand,
while high realized volatility provided support for gamma.
Although liquidity problems never disappeared, the
immediate reaction and positioning which emerged after a
long period of low volatility and complacent markets soon
began to reflect concerns abut he long term impact of the
housing market on the economy. As rates trended lower
in a flight to quality mode, different trades kicked in at the
same time across all sectors of the curve leading to
fragmentation and breakdown of long-term relationships
across different market and curve sectors which further
impaired already fragile liquidity.
The big picture
We believe that the first two quarters of the next year will
revolve around the resolution of liquidity and the direction
of the economy. Although the two issues had the same
origin, each gained life of its own. We see the economic
drivers as the long-term agenda and liquidity as transient.
Our base case scenario is a moderate economic
slowdown with gradual improvements of liquidity.
How we got here?
The last tightening cycle was in many respects different
than any previous episode in recent history. In order to
match increasing future liabilities, investors took higher
and higher risks across different products leading to
compression of the risk premia together with its
manifestations through curve flattening and spread
tightening across all market sectors. With the entire
economy riding the real estate boom, creative mortgage
lending resulted in proliferation of instruments which
pushed the effect of rate hikes further into the future.
Although the Fed funds target rate continued to rise, the
relevant rate levels (e.g. 10Y, swaps, mortgages, ) did
not follow in the same manner. As a result, effectively the
Fed had not tightened to the consumer despite 425bp of
rate hikes. The 10Y rate, for example, remained near its
levels in the middle of the cycle, Figure below. At the end
of the tightening cycle, there was about 150-200 bp of
rate cuts missing from the long end of the curve.
10-year swaps vs Fed funds target rate
3
4
5
6
7
8
9
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
0
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FFT
10Y
Similar effect propagated across different sectors of the
interest rates market. Most notably, the expansion of the
real estate market brought in buyers at the long end
pushing spreads tighter and reducing the carry across the
board as risk premia compressed. The Figure below
shows the mortgage carry (CC mortgage vs. 5Y swaps
rate) across different Fed cycles. The decline in the spread
during 2004-2006 hikes was largely triggered by the low
levels of Fed funds which catalyzed subsequent growth of
the real estate market.
Mortgage carry across Fed cycles
50
100
150
200
250
300
99 00 01 02 03 04 05 06 07
0
1
2
3
4
5
6
7
Carry (Primary Mtg - 5Y Swap Rate)
FFTR
Despite continued hikes, mortgages remained in demand
keeping the spreads and carry low. Although vol declined,
it remained out of sight for the hedgers both due to
structural as well as carry reasons.
What to expect in 2008?
During the conundrum days, reaction of the market to the
Fed remained sticky and delayed. We believe that the
next year would be a replay of the conundrum in reverse
with the same type of reaction function likely due to
eroded trust and confidence. The ability of the Fed to
control rates relevant for the consumer by easing is
questionable in these market conditions. As Treasury
rates follow the Fed, the actual lending rates, e.g.
mortgage, swaps etc., could remain largely unaffected by
this maneuver with spreads wide due to the same
stickiness as during the conundrum. Lack of transparency
regarding the banks balance sheets would affect their
ability to lend, while credit availability would continue to
contract. With high cost of capital, the lending rates
should remain high which, in turn, would make it difficult
for people to borrow. Fed would cut rates substantially,
but the 10Y rate, for example, could remain high. This is
the high risk premium environment. As economy is
deleveraging, the consumption could gradually slow
down.
During that time, we would see periods of high realized
volatility due to substantial repricing as the market digests
new information. In that environment, there would be little
consensus and wide divergence in terms of positioning.
Generally, such markets are very volatile with substantial
reaction to information shocks and large swings in rates
due to repricing. Together with higher risk premia next
year should be supportive for gamma. Even a favorable
resolution of the liquidity problems in the economy with
moderate slowdown is likely to lead to high volatility. An
improvement in liquidity, if it happens, would be followed
by a period of large swings in rates like those seen in
November and December as the cumulative effect of
monetary policy kicks all at once after a prolonged delay.
Risk scenarios
We see the following two departures from the base case
as the likely risk scenarios.
1) Sub prime fallout has a deeper impact on the economy
which would enter into a recession with consumer credit
crunch together with a further escalation of capital and
funding crisis. Fed would continue to cut with the curve
bull steepening while the long end remains sticky. As
rates decline, there is a new production of low-coupon
mortgages (5s and 4.5s), which would increase the
convexity. The deterioration of the credit and liquidity
would make it only a partial replay of the early years of the
decade without a massive participation of the US
consumers in the real estate growth. This environment
would be highly bullish for vol both fundamentally and
structurally, although we would not see a return of the
golden days of convexity hedging.
2) On the other side of the spectrum, we have possibility
of a less substantial impact on the economy, but
continued rate cuts forced by liquidity issues, which could
produce higher inflation as a side effect. As the curve
prices out the Fed cuts, we might see initial flattening,
followed by the long-term steepening pressures. This type
of market would be close to neutral on vol, although we
do not expect vol to decline substantially due to
accumulation of various risks in the market.
Structural demand for vol
We are long-term bullish on vol as the current structural
changes in the market point out to return of demand. The
housing market slowdown has changed the convexity
exposure of mortgages considerably. As it became
increasingly more difficult to refinance, gamma has been
pushed towards lower rates, while optionality extended
leading to more negative vega. The figure below shows
the snapshot of convexity profile of the mortgage
universe at the end of 2007.
Dec-11 snapshot of convexity profile of the mortgage
universe
-0.3
-0.25
-0.2
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0
0.5
Vega OAC - RHS

We are currently about 60bp above the peak convexity.
Although gamma has declined since the beginning of the
year, vega increased as the optionality extended with the
peak moving towards higher rates.
The main effect of the housing slowdown is coming from
decline in turnover. This is going to cause a long-lasting
effect on servicers and mortgage hedgers in general. The
extension of the mortgage portfolios both in terms of
vega as well as duration is making hedgers longer than
initially anticipated. In the next year, this trend will
continue and we expect to see a continued need to shed
duration in a sell off which would make the corresponding
episodes more volatile than we are used to seeing. On the
other side, the call risk remains benign. In that
environment we would prefer payers to receivers as rate
protection instruments.
The transition from ARMs to fixed rate mortgages is also
supportive of both steepeners and higher vol, as we move
from less to more convex instruments. In terms of
duration hedging, this transition would cause an increase
in paying beyond 10Y and unwind of hedges at the short
end (receiving in 5s and 2s). Keeping away from the
liquidity contaminated short end, the best bet in this
context are 5s/10s steepeners, both outright and
conditional over 1Y or longer horizon.
As mortgages widened in the second half of the year,
their carry increased. Generally, hedging decisions are
made in relationship to the carry. The Figure below shows
the mortgage carry (adjusted for the scale) against 1Y10Y
vol. Their long term relationship is a result of an RV twists
introduced by mortgage hedgers in the hedging process
they are constantly arbing between the curve and vol. For
a given return they decide how much of carry they can
give up in order to reduce the variations of their portfolio
by hedging their convexity exposure. Whenever carry is
high, potentially high hedging costs can be justified. This
brings in the hedgers to the vol market and maintains a
bid for vega. Conversely, when carry is low, hedging
becomes too costly and demand for vol declines. Clearly,
return of carry is supportive for vol as it is likely to
intensify convexity hedging which had been reduced to a
minimum during the conundrum days.
Comparing the mortgage carry with vol
60
70
80
90
100
110
120
130
140
150
160
02 03 04 05 06 07
Nominal Spd vs Swaps
1y10y

We expect servicers to be the main players in this
process, while the rest of the hedging community might
be less active in the fist half of 2008. Due to its focus on
capital issues they might stay away from the MTM
exposure of derivatives with more attention on accounting
than actual hedging. So, while vol levels might remain
high due to buildup of risk in the market, we might see
somewhat lower vol of vol.
Supply
While demand for vol continues to grow, we had, in
general a declining trend in vol supply both in term of
callable as well as the trust preferred issuance. In the
past, most of the callable structures were matched by the
10Y intermediate vol. As the log end of the curve flattened
FHLB, which has been one of the main suppliers of vol in
this sector, switched to shorter tenors and expiries with
vol exposure corresponding to the upper left corner. As a
consequence, vega dropped considerably since than. In
the fist three quarters of 2007, we have the callable
supply below 2005 and 2006 levels as we saw a large
wave of redemptions with declining rates and the curve
inversion at the short end. Due to declining optionality,
there has been a dramatic drop in issuance of the same
structures as the inverted curve makes optionality less
valuable and the corresponding coupon less attractive for
the investors. In 2008 we could see a continuation of this
trend if the curve does not steepen materially at the short
end, although persistence of these conditions and further
steepening of the swaps curve at the long end might
create an environment where issuing 10NC1-type
structures would amount to a pickup of the vega supply.
We believe that in this environment where investors are
not yield-hungry, this transition might take some time to
kick in.
Due to their longer maturity trust preferreds have had a
much bigger impact on the vega supply. However, in the
current market environment created by the sub-prime
crisis, they are also likely to have less of an impact on the
vol supply in the next year. Recent issuance of preferred
securities has been driven by forced capitalization with
pressure to raise tier 1 capital. Most of the banks maxed
out on their tier 1 capital (limit to 15%). Currently, there is
a room for about $5bn of new trust preferreds among the
top 10 banks. Given their typical structure of 60NC5, their
vega is matched roughly by 10Y20Y, around 4mn/$1bn)
which would result in 10-20mn of potential vega supply, if
swapped. As balance sheets grow and capital ratios
improve, banks might issue more to repair their capital.
Because of the conditions under which they were issued,
these securities have had high coupons and less favorable
structure for the issuer than is generally seen in the times
of opportunistic issuance. The embedded optionlity (call
feature) in this case contains both a call on rate as well as
a put on credit. Given this, it is less likely that the
optionality of these issues would be swapped with the
street, as they have a substantial value once the market
conditions normalize, the credit ratings improve and
especially if the Fed continues to cut rates. Because of
this, we see this wave of issuance having less of an effect
on the vol market in terms of supply pressure at the long
end of the surface.
Who will be the vol sellers?
In the last year we have seen an increasing participation of
the real money in the options market which came in
mostly as vol sellers with different variants of short
strangle strategies as a way to play the range bound
markets, or improve carry on short mortgage positions.
Although, they might continue their presence in this
market, the change of the dynamics is likely to reduce
their impact through these types of trades. However, they
could come in as vol sellers in a different way. As the
credit related losses are making investors look for yield in
alternative products, as replacement for their high yield
exposure convexity is arising as an alternative. If this trend
picks up and various structured notes replace the
conventional credit products, real money would emerge
as vol sellers in this context. Although this is still a
possibility, the effect of such a transition would not
materialize in the near term.
Between 2004 and 2007 specs have emerged as the
largest suppliers of vol in the market. As they grew in size
and number, their impact overpowered the declining
demand since they became core sellers of vol during the
conundrum years. In the current environment it is difficult
to see RV players coming in with similar strategies while
realized volatility remains at such levels with continued
prospects of large swings and structural breaks. It is likely
that they will look for carry away from short gamma and in
different sectors of the surface. Supply outlook might
bring in vol sellers at the long end while intermediates
remain well bid due to mortgage related demand and
higher realized vol. RV players are likely to be a regulating
factor in this sector. As the gap between the regions of
the surface widens, they are likely to take advantage of
the favorable vol rollup and sponsor the long dated sector.
Dislocations
As the first wave of sub-prime shocks hit the market, the
defensive strategies and focus on the first order risk left
behind a number of the dislocations across different
market sectors, which persisted through the last quarter
of the year awaiting the resolution of liquidity before the
RV players come in and take advantage of these
inconsistencies. Part of the reason for the delayed
reaction of the market has been the compromised
integrity of the curve triggered by the market
segmentation. As a consequence of the breakdown of the
long-term relationships between various market sectors,
risk management became difficult increasing the friction
and causing the dealers to further withdraw liquidity from
the market. The persistent spread widening at the short
end has lead to an increased widening of the condor
spreads along the swaps curve. Typically, 2s/5s/10s/30s
condor spreads show high degree of stability as the
number of legs allows an optimization procedure which
accounts for the bulk of the risks contained in the curve
with standard deviation of only a few bp. Currently, the
condor spread has widened by more that 13 bp, a
magnitude seen only a few times in recent history. As
liquidity issues get resolved and the 2s/5s sector of the
swaps curve undergoes an appropriate correction, the
convergence of the condors should follow.
Disconnect between vol and curve. Although vol
continued to move higher in November, it did not appear
excessive to mortgages as their cheapening drove the
mortgage spreads to swaps higher in a way which was
commensurate with the bid for vol. Currently, vol appears
in tune with mortgage carry, but is consistent with a
steeper curve. The figure below shows the history of the
1Y5Y against the levels implied by the levels of rates and
curve slope together with projections across different
rates scenarios. Current levels of vol are consistent with
50bp steeper curve and higher rates.
Current vol levels are consistent with a steeper curve
112
111
90
79
60
70
80
90
100
110
120
130
140
150
160
01 02 03 04 04 05 06 07 08
1Y5Y
TREND*
50bp sell off & 25bp steepening
50bp rally & 50bp flattening
The positioning in this context would be a short vol
against the curve steepener which would most likely
converge due to steepening of the curve as the pressures
at the short end fade away.
As rates move in and out of the flight to quality mode,
they create an environment of declining correlation across
different sectors of the curve as well as across different
curves. With the persistence of this mode and continued
spread volatility we would look to take advantage of the
inconsistencies across Swaps and Treasury vol markets,
especially since we believe that relative lack of liquidity
and related problems might keep a large fraction of RV
players away from these trades. Similarly, we see a
growing fundamental widening between the value of caps
and swaptions in this context, but the markets focus and
degraded liquidity might prevent a favorable execution.
We would look for attractive entry levels to the wedge
trade, preferably at the short end of the curve.
We still see a disconnect between vol and carry in the
context of conditional trades with vol differential between
short and long tenors still wide relative to the carry of the
curve. While the dip at the front end of the curve is
keeping carry players away from steepeners, given our
rates and vol outlook, we still see good value in 5s/10s
conditional bear steepeners 1Y forward.

Aleksandar Kocic (1) (212) 250 0376

Agencies

The crucial OFHEO 30% capital surplus
requirement is not expected to be relaxed in the
first half of the year. This will be the main
constraint for portfolio growth and debt supply
for 2008. If the 30% requirement is lifted in the
second half, increased supply could put pressure
on spreads. We see no risk to the senior
unsubordinated credit outlook.

A moderate relaxation of portfolio caps may occur
by H208, in the range of 5-10%. Conforming loan
limits are less likely to be changed in 2008.

There is scope for outperformance of callables
relative to bullets in the base case scenario of
unchanged to moderately higher rates for 2008,
especially given the current high levels of implied
volatility.

Subordinated Agency debt will remain vulnerable
to headline risks, but the GSEs are expected to
adequately manage their capital requirements.
We recommend adding subdebt in periods of
heightened capital adequacy concerns.

FHLB advance growth is expected to remain in
the $30bn per month range for the next one or
two quarters. The $200bn increase in FHLB
discount notes seen in Q407 may not be termed
out if liquidity and credit conditions begin to
improve in the first half of 2008.
Credit portfolio growth instead of
retained portfolio growth for 2008
When year-to-date declines of $2bn and $1.5bn in capital
surpluses were reported by Freddie Mac and Fannie Mae,
respectively, in their November Q3 10Q reports, the
market became focused on whether the GSEs were at
risk of falling below capital adequacy, what measures
could be taken to restore capital, and whether OFHEO
would soon drop the 30% additional capital requirement.
OFHEO introduced the 30% buffers in January 2004 for
Freddie Mac and in May 2006 for Fannie Mae. Before the
credit events began this summer, there had been a
general expectation that the additional capital
requirements would be dropped when the GSEs updated
their internal accounting and resolved material
weaknesses, which included timely quarterly financial
reporting. Although Freddie expects to be timely by the
end of 2007 and Fannie is currently timely, the probability
of dropping the 30% buffer in the first half of 2008 has
been reduced by the worsening housing market outlook
and the enormous impact it has had on credit markets.
Although OFHEO has indicated that it will enter into more
discussions regarding the 30% rule after the Q407
financials are released in February, it is likely to remain
very conservative in its approach to fostering safety and
soundness at the GSEs. If the 30% rule is lifted, we
would expect it to happen in the second half.
Credit portfolio growth will be the focus for 2008
Change in credit portfolios: 3-mo rolling avg
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$
FNMA
FHLMC
Both Agencies successfully recapitalized via preferred
stock transactions of $6bn to $7bn late in November. But
because retained portfolio growth is so capital intensive
(3.25% capital required), the growth path for 2008 will be
the guarantee portfolios (0.585% capital required). Growth
in the GSEs guarantee business is more in line with the
core purpose of the Enterprises which is the packaging of
mortgage loans into passthrough securities backed by the
credit of the Agencies, which are in turn implicitly backed
by the credit of the US Government. This is the
mechanism by which investors channel funds to
borrowers yet face the uniform credit of the GSEs, and it
is considered the core purpose of the GSEs.
Fannie and Freddie will increase their guarantee fees for
2008 to reflect the higher level of credit risk. Fannie
averaged fees of 22.8bp and Freddie averaged 18bp in
Q307. Initial indications are for a fee increase of around
6bp. Although given the high rates of the recent preferred
stock issues (8.25%-8.375%) even with the higher
guarantee fees it will be challenging to achieve desired
levels of profitability in 2008. Year-to-date, the GSEs have
grown the credit portfolios by $488bn, or 13% annualized,
Given the ARM resets expected for 2008, we expect
about a 25% increase in the net supply of conforming
loans available for GSEs to securitize. This would allow
portfolio growth closer to $580bn in 2008. We do not
expect the Agencies to significantly reduce the size of
their retained portfolios but this will be an important
option for them in their capital management process in
2008. A decrease of $100bn in the retained portfolio frees
up $3.25bn of core capital. This amount of capital could
support an increase of $550bn in the credit portfolio.
Because of the limited increase, or possibly decrease, in
the retained portfolios for 2008, the net supply of Agency
debt is expected to remain unchanged or decline
modestly. As a result, the focus on credit portfolio growth
in 2008 will be a positive for Agency debt spreads. The
GSEs will tactically replenish retained portfolio runoff
when valuations of mortgage-backed securities are
relatively favorable versus GSE funding levels. We believe
that the GSEs will manage their capital constraints
adequately throughout the year and would look to add
subdebt exposure in periods of heightened concern.
Caps and conforming loan limits unlikely
to experience significant modifications
in 2008
The portfolio caps were established by OFHEO to limit
growth in the retained portfolios of mortgage-backed
securities, which consist of whole loans, Agency MBS
and private label MBS. OFHEO considers these portfolios
more risky than the credit portfolios because of the
significant interest rate and implied volatility risks that
must be actively managed. The initial caps set in 2006
were 2% annualized growth for Freddie Mac, and 0%
growth for Fannie Mae. But in response to the initial
phases of the credit crisis, in mid-September 2007
OFHEO adjusted the caps upward, allowing both
portfolios to grow to as large as $742bn by the end of
2007. The caps were effectively increased to 5.5% for
Freddie Mac and 2% for Fannie Mae. For 2008, the
current allowable rate of increase is 2% for both, or a
$757bn maximum (measured as outstanding average
unpaid principal balance in the month). Yet despite the
moderate increase in caps in 2007, portfolio growth was
hindered by capital constraints. Both portfolios declined in
September. In October, Freddies portfolio again declined,
(to $704bn) while Fannies increased $8.5bn to $732bn
due to a single transaction involving the purchase of
whole loans. An increase in portfolios to the maximum
allowable size in 2008 would require capital of about
$1.7bn for Freddie and $1bn for Fannie. If caps were
raised to 5% above the current year-end $742 maximum,
capital required would be $3bn for Freddie and $2bn for
Fannie. This may be too large of a capital drain. As a
result, although it is possible that OFHEO raises the caps
in 2008, we believe that 1) the rate would not exceed a
5% maximum growth limit, and 2) the portfolios would
not grow more than 2% because of the capital
constraints. If OFHEO were to drop the 30% additional
capital requirements, however, then caps of 5-10% would
make more sense.
The conforming loan limits are a more difficult restriction
to modify because they are codified in law and would
require an act of Congress to change. It is difficult to
justify the need to increase conforming loan limits given
the expected large supply of conforming loans in 2008.
Furthermore, increasing conforming loan limits would
introduce additional risk that stretches the GSEs beyond
their core business strengths. In light of the heightened
need for safety and soundness in the current market
environment, together with the political focus on
presidential elections for 2008, we think that conforming
limits are unlikely to be modified in 2008.
2008 supply limited at FNMA and
FHLMC, while FHLB continues funding
advance growth with discount notes
Debt growth at Fannie and Freddie will ultimately be a
function of housing market conditions.
Flat or declining portfolios should lead to declining
debt outstanding at Freddie and Fannie in 2008
700
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760
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840
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FHLMC debt
outstanding
FHLMC Retained
Portfolio (right)
If the housing market remains as weak as expected in
2008 (another 5% decline on average), net debt supply
could be close to zero. In the event that housing is worse
and defaults higher than expected, capital will be
threatened and the portfolios will likely shrink. A historical
precedent is Fannies reduction of its retained portfolio by
$177bn for capital purposes in 2005. Debt outstanding
declined $189bn from $955bn to $766bn that year. The
best case housing scenario could lead to a combined
Fannie/Freddie net supply of $100bn on the year, most
likely in the second half. Callable issuance versus bullets
will largely be a function of the attractiveness of par
callable coupon levels versus bullet yields. This depends
on implied volatility levels and curve slope (forwards
versus spot). A better than expected housing market
should lead to lower implied volatilities but a less inverted
front-end, which have offsetting effects on callable
coupons. In a worsening economic environment with high
implied vols, the demand for callables could potentially be
strong as long as the front end of the curve doesnt invert
too much with Fed easing expectations. Our base case
scenario is one in which volatility remains high, and the
front end prices moderate eases an environment which
is mildly supportive for callable issuance. Among the
outstanding Fannie and Freddie callables that can be
called in 2008, most have their first call dates in the first
quarter. In the event of a large rally early next year,
approximately $120bn could be called in Q1.
2008 call dates for FNMA and FHLMC outstanding
callables are heavily weighted in Q1
Outstanding callable notionals ($bn)
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40
60
80
100
120
140
Q407 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Q409
Issuance at FHLB in 2008 depends on the growth in
advances to its 8100 member institutions. Advances
growth was spectacular in the fourth quarter as FHLB
became a major source of funding for financial institutions
during the onset of the credit crisis. Although the base
case outlook for 2008 will be for improving credit
conditions, advances should continue to grow at least for
the first quarter or two, depending on how the credit
situation evolves. The first large jump in advances
(+110bn) occurred in August when ABCP outstanding fell
the most (-205bn). We expect advances to continue
partially filling in the funding holes left by ABCP. The
ABCP market has averaged a decline in outstanding of
about $50bn per month since the first large drop in
August. FHLB advances growth has averaged $30bn per
month in the same period. We expect the $30bn per
month rate to persist for the next quarter, if not the first
half of 2008. This advance funding has been achieved
almost exclusively via discount notes. Since July, total
debt at FHLB is up $207bn while discount notes are up
$197 and bonds are up $10bn. Discount notes have the
advantage that they can be expired whenever normal
credit conditions return. But if it becomes clear that credit
conditions will not improve materially in 2008, a portion of
the discount notes would likely be rolled into one-year or
longer maturities. This would probably have comparatively
little effect on spreads in the front end given the overall
flight-to-quality conditions that would prevail in this
environment.
FHLB advance growth has been keeping pace with the
decline in ABCP outstanding
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ABCP
Outstanding
FHLB
Advances

Ralph Axel (1) 212-250-7104


BMA Swaps

Ratios widened massively in the second half of
the year as the BMA market absorbed several
rounds of sub-prime shocks following relatively
calm first two quarters.

We see a downgrade of major guarantors as
unlikely although the credit rating issue may
persist for a while. As a major risk scenario for the
muni market in 2008, should such a downgrade
occur, TOB dealers may have to sell assets and
unwind BMA hedge.

The initial signs of reestablishing directionality of
the ratios were interrupted by the credit crisis.
We see continuation of this trend in the first
quarter of 2008 and discuss a possibility of the
restoration as a function of relative carry between
the two curves.

The long-term municipal bond issuance in 2008
could pick up further to $450 bn while liquidity for
the short-term securities may dry out temporarily
in early 2008 due to soft issuance and strong
demand from tax-exempt money market funds.
BMA market in 2007
The BMA swaps experienced two dramatically different
regimes in 2007. In the first half of the year, ratios
remained stable with RV players continuing to take
advantage of the carry trade on the ratios curve. In the
second half the market saw a substantial re-pricing of
credit premia of the muni products. The first episode of
the re-pricing is the widening credit spreads in July, and
the BMA market was hit by the herding behavior of BMA
hedging which drove ratios wider. Although the ratios
recovered quickly at end of August, the market got caught
again by the monoline insurers credit rating stories in
early November. Since then, the possible downgrade of
AAA guarantors has been the dominant challenging risk
factor causing another wave of widening at the long-end.
Market conditions were gradually improving after the
Thanksgiving, although the long-end ratios remain still
much higher relative to their pre-crisis level. The front-end
ratios also saw massive widening as dealers were clearing
their floater inventories at the year end. As a consequence
the 2s/10s ratios slope almost inverted, which are under
quick correction right now.
BMA ratios widened due to credit premia re-pricing
66
68
70
72
74
76
78
Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07 Dec-07
2Y
10Y
30Y
2008 outlook
Pressure on guarantors is likely to persist for awhile
The threat of monolines downgrade is still evolving and is
likely to persist in the next few months. In our view, it is
unlikely for major guarantors to get downgraded because
AAA rating is crucial for their business model and the
options for keeping their credit ratings, although costly,
seem substantial. The fact that CIFG and MBIA
successfully raised new capital demonstrated that cash is
available from private equity firms and other types of
investors. Besides, insurers may also seek to add
reinsurance to their relatively low risk business lines, or as
a last resort, they could even sell their lucrative municipal
bond guarantee business to a healthier insurance
company to separate that business from sub prime risks.
Given that, we still think the market sentiment would
prevent the back-end ratios from tightening further in a
significant way and would like to keep the monolines
downgrade as the major risk scenario for BMA market in
2008.
Directionality
In the first half of 2007, ratios curve flattened while swap
curve steepened. This could be an initial sign of return of
directionality between BMA and swaps markets, although
the directionality was broken down in the second half of
2007. Historically the ratios curve flattens when the
swaps curve steepens, and vice versa, as shown in the
chart below. Such negative correlations exist because the
Muni curve tends to be less reactive than the swaps in
either direction. Substantial deviations from this pattern
had been observed since April 2005. This was catalyzed
by an increasing interest of the carry players. They were
driven to the Muni market as the foreign buying continued
to flatten the yield curve, while the absence of foreign
participation in the Muni market kept the BMA curve
steep. Given the likely steepening swap curves in 2008,
will the directionality be reestablished, especially if the
credit issues get resolved?
The historical directionality between ratios and rates
reappeared in 1
st
half of 2007, but broke down again.
y = -0.0426x + 8.2202
R
2
= 0.7185
-10
-8
-6
-4
-2
0
2
4
6
8
10
-10 40 90 140 190 240 290
swap 2s/10s slope
B
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A

r
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2
s
/
1
0
s

s
l
o
p
e
1998-2005
1st half of 2007
2nd half of 2007
We believe when directionality will be reestablished in a
large part depends on the way RV players migrate back to
the swap curve. As shown in the figure below, RV players
came into BMA market attracted by superior carry in early
2005. Carry in ratios curve has been trending down since
the proliferation of RV players in BMA market, while carry
on swap curve has been improving in 2007. The
diminishing difference has made BMA markets less
attractive than it was in 2005 and 2006. Yet the carry in
the swap curve currently is still way off from the level of
pre-2005, and seems not providing enough incentive for
carry players. Moreover, although we maintain a
steepening bias on the swap curve, a reversal of
conundrum may appear in this steepening process in
the sense that the swap curve may fail to steepen as
much as expected while fed keeps cutting rates. In such
scenarios, a sticky flatter curve may delay a return of the
RV players, and hence postpone the reestablishment of
directionality.
RV players migrated to ratios curve since early 2005
for superior carry. Are they ready to return?
-1
1
3
5
7
9
11
13
15
17
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
Jan-
07
Jul-
07
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
carry - swap curve 10s/30s (lhs)
carry - ratio curve 10s/30s (rhs)
Proliferation of RV
palyers in BMA market
Ample issuance, yet possible liquidity dry out in early
2008
The long-term municipal bond Issuance in 2007 has
peaked at $420 bn, and it may pick up even further in
2008 as the low rate environment after Fed cuts provides
more incentive for the issuers. We estimate that 2008 will
see around $450 bn supply, based on the historical
issuance and 5Y5Y rates.
Issuance follows 5Y5Y very well historically.
0
5
10
15
20
25
30
35
40
45
50
99 00 01 02 03 04 05 06 07
Long-Term Issuance ($bn)
Issuance forecasted by 5Y5Y
Source: Deutsche Bank, Bond Buyer
However, the primary market will most probably be quiet
in the first quarter due to seasonal effects and, more
importantly, cheapening of the municipal bonds and
ongoing credit concerns. The issuance pattern in 2007
already showed that issuers withheld new borrowing
during credit crunch, as shown by the severely reduced
issuance in July, August, November, and December in
2007 in the chart below.
Issuance severely reduced in months of cheapening
munis in 2007. The bars show the difference between
the actual issuance and the projected issuance
amount according to seasonality.
-20
-15
-10
-5
0
5
10
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
$
b
n
Source: Deutsche Bank, Bond Buyer
If a prolonged credit crunch keeps issuance at a slow
pace in 2008, the liquidity of the short-term securities may
dry out as demand from the tax-exempt money market
funds is usually strong when muni cheapens, as shown by
the quick growth of the asset size of MMF in the second
half of 2007. Such liquidity dry out may put some bear
steepening pressure on the front-end. A prolonged credit
crunch may also create a crowded primary market after
the situation crystallizes, and the concentrated issuance
could shift the steepening pressure to the back-end.
Asset size of tax-exempt money market funds grew
fast in second half of 2007 due to cheapening muni.
250
300
350
400
450
500
Jan-
03
Jul-
03
Jan-
04
Jul-
04
Jan-
05
Jul-
05
Jan-
06
Jul-
06
Jan-
07
Jul-
07
Source: Bloomberg
Risk scenarios
The credit downgrade of guarantors presents one of the
major risks for the BMA market in 2008. Although we
think the downgrade to a major insurer is less likely, it
could cause a serious liquidity crunch in the muni market
via Tender Option Bond (TOB) programs should such a
downgrade occur. TOB sponsors buy fixed rate, long term
municipal bonds and finance them to create short term tax
exempt floating rate securities. The major portions of such
floaters are bought by money market funds, which require
the underlying bonds rated AA or better. Many lower
rating muni bonds become TOB eligible after credit
enhancement using credit line of banks or being insured
by an AAA wrapper. Should monolines get downgraded,
money market funds may have to tender the tainted
floaters back to the TOB remarketing agents. In such a
scenario, remarketing would involve applying new credit
enhancement to the underlying bonds. Or dealers may be
forced to sell such lower-rated assets, which could be
accompanied by massive unwinding of the BMA hedging
position, pushing ratios at the long-end lower. Meanwhile,
due to the reduced supply of short-term instruments from
TOB, the BMA index could reset lower.
Lei Chen (1) 212 250 9830
Aleksandar Kocic (1) 212 250 2131

Euroland
Overview

Growth in the Eurozone will also be affected by
the deleveraging we are seeing in financial
markets as well as the tightening in credit
conditions

Negative wealth effects from housing may also
manifest themselves for some European countries

Unlike the US and the UK, Euroland is also having
to cope with an extremely strong currency which
is helping to contain price pressures on the one
hand, but also squeezing exporters

Unlike in the US and the UK, however, the front-
end is not pricing any chance of a rate cut from
the ECB, thanks to continued hawkish rhetoric

We believe this offers an extremely attractive
opportunity to enter long positions in EONIA,
which will start to perform as headline inflation
recedes and ECB talk softens

We also see considerable value in 2Y-10Y
steepeners which should benefit from a softening
economic outlook in Euroland, as well as a likely
repricing of the US markets

We enter a USD-EUR 5Yx5Y widening position, as
the most attractive way of expressing the view
that the risks to global growth are
disproportionately reflected in US pricing
Credit to be rationed in Euroland, too
European banks are likely to be as affected as US banks
by an unwinding of off-balance sheet vehicles such as
SIVs and ABCP conduits, not least since many European
names seem to have been even more heavily involved in
securitizing and refinancing US mortgage assets than their
US counterparts. The on-going discussions about the
future of IKB and Sachsen LB, as well as the second
round of write-downs at UBS serve as timely reminders of
the global nature of the current liquidity crunch.
Consequently European banks are tightening credit
standards almost as aggressively as their US
counterparts, since the refinancing of former off-balance
sheet vehicles requires significant balance sheet
commitment from these financial institutions too, to the
detriment of existing lending activities.
Credit standards are expected to tighten further
-20
-10
0
10
20
30
40
50
Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07
House purchases
Corporate
Consumer credit and other lending
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We have argued in Bond Market Strategy that the
appearing cracks in the US housing market have been
instrumental in kicking off the unwind of the excess
leverage built up since 2004. On many measures, the
European housing markets look as overvalued as the US
market. While financial engineering and increasing
household leverage was key in pushing housing valuations
to the extreme in the US, lending standards were not
relaxed to the same extent in the Eurozone, However the
fundamental concerns about a normalization of house
prices and its effects on the consumer are clearly mirrored
to some extent also in Europe.
European housing may be as overvalued as in the US
-20
-15
-10
-5
0
5
10
15
20
25
30
35
71 74 77 80 83 86 89 92 95 98 01 04 07
Euroland
US
% deviation from trend
ECB needs to do more to combat
liquidity strains
Even though Wednesdays announcement from the
Federal Reserve, the ECB and the BoE amongst others
will likely improve conditions in USD and GBP money
markets, it effectively only brings US and UK central bank
tools to European standards. The Term Auction Facility
resembles the regular term auctions held by the ECB,
while the widened collateral pools now accepted by the
Fed and the BoE mirror the ECBs existing definitions. This
represents in our view a significant enough departure
from current policy to improve the situation in USD and
GBP money markets, however, we do not expect any
such mechanical relief in the Eurozone.
Euribor bases are still far from normal
0
10
20
30
40
50
60
70
80
90
100
Mar-07 May-07 Jul-07 Sep-07 Nov-07
3M Eonia - Euribor spot basis
3M Eonia - Euribor Mar basis
Making USD funds available to European institutions
through a swap line with the Federal Reserve against ECB
eligible collateral does not alter the fact that European
banks need to fund US assets rather than ECB eligible
assets. We therefore expect the basis between interbank
and overnight rates in EUR to remain wide and to improve
only slowly going into next-year, in line with current
forward pricing. This implies continued funding difficulties
for all Euribor based borrowers, including financials,
homeowners and corporates.
Currency reduces chance of de-
coupling
Given the still very hawkish rhetoric by the ECB, as well as
the more aggressive accommodation on display in the US
and the UK, the currency remains at extremely elevated
levels. Not only does this put significant pressure on
exporters, it considerably increases the risk that the
Eurozone fails to decouple from the US.
The currency raises the risk that US weakness spills-
over into the Eurozone
115
120
125
130
135
140
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08
EURTWI
calendar year averages
and mitigates inflationary concerns
The combination of weakening economic indicators and a
strong currency make us relatively sanguine about the
inflationary outlook. We do believe that we are likely to
receive confirmation that the current high headline
numbers are transitory and that base effects will result in
a sharp improvement in inflation figures early next year.
Also, the weakening in growth that we expect to take hold
suggests that companies will have very little opportunity
of passing on increased costs of production, be they
through higher input prices, or rising wage bills. Second
round effects should therefore remain limited.
Inflation is expected to fall back sharply
0.8
1.3
1.8
2.3
2.8
3.3
Jan-01 Jan-03 Jan-05 Jan-07
HICP
core (total excl energy, food, alc, tob)
% y/y
forecast
base effect from
German VAT
Forward-looking indicators point to
trouble
Not surprisingly, given the tightening in credit and financial
market conditions, as well as the strength in the currency,
the forward looking components of the main confidence
indicators, especially for the service and financial sectors
are pointing to a weakening in the economic outlook.
Forward looking indicators point to weakness
50
52
54
56
58
60
62
M
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N
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90
92
94
96
98
100
102
104
106
108
PMI Composite
PMI Services
PMI Manufacturing
IFO - Expectations
Hawkish ECB supports front-end
The market is now pricing in the chance of ECB rate hikes,
and no downside risk to the Eurozone economy is
reflected in current market pricing at all. We think that a
long position in the EUR front-end is one of the most
compelling trades for 2008. This is especially true when
comparing the current EUR pricing with that in USD and
GBP. If those relative rate paths were to be realized the
currency is likely to come under further upward pressure,
in itself raising the probability of the ECB cutting rates.
Hawkish front-end pricing does not reflect
distribution of risks, in our view
ECB
-25%
0%
25%
50%
Jan Feb Mar Apr May Jun Jul Aug
It is important to remember that the Eurozone is the only
market experiencing the higher Libor resets, the credit
tightening and deleveraging in combination with a
strengthening currency. This need for rate cuts can also
be backed up by a simple arithmetic around monetary
conditions in Euroland. Our economists estimate that 2%
appreciation in the EUR trade weighted index accounts for
about 25bp of tightening. Thus, the 7% appreciation of
the EUR TWI in 2007 (5.5% if we compare 2007 vs. 2006
average) accounts for 60-90 bp of tightening. Currently,
the average Euribor-Eonia bases spread for the March08
to Dec 08 contracts averages about 30bp, which means
that Euribors are pricing another 25bp of tightening even
beyond the year end effect. Thus at current market pricing
monetary conditions are arguably 85bp above the
(generous) neutral rate of 4% (2% real growth and 2%
inflation) which happens to be the current ECB refi rate.
Thus unless the liquidity situation improves faster than
what is priced in the forward bases and the EUR
depreciates somewhat, the combined impact the credit
rationing and the EUR appreciation should start to be
reflected in the macroeconomic data. Waiting for the
economic data to confirm the ECBs working assumption
of growth remaining close to trend is therefore the
equivalent of judging by your rear view mirror whether the
road you have just come down on was indeed straight.
We believe that once inflation figures start moderating,
and key wage negotiations are behind us, we are likely to
see a noteworthy change in ECB rhetoric.
Long-end at risk from US correlation
So, although we are bullish European fixed income, in
particular relative to current market pricing, the long-end
of the curve obviously remains exposed to the likely
bearish dynamic of the US market. We therefore see little
value in the long-end of the EUR curve on an outright
basis, due to the correlation risk and instead would
instigate a long position in EUR 5Yx5Y against a short
position in USD 5Yx5Y (see Bond Market Strategy section
for more details).
Enter EUR-USD 5Yx5Y widening trades
EUR-USD 5Yx5Y spd (bp)
-25
0
25
50
75
100
125
150
175
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

ALM impulses uncertain
The excess flatness of the long-end of the curve has
corrected with respect to the short-end in EUR. In our
view this reinforces the directionality of 10Y-30Y and
makes positioning on the curve guess-work. Solvency
ratios in the Netherlands have continued to improve to
such an extent, that pension fund hedging can remain
extremely opportunistic. Sharp falls in general yield levels
and a severe underperformance of equity markets may
change that picture, but for the time being we remain
neutral on the long-end.
Solvency ratios
100%
110%
120%
130%
140%
150%
160%
2004 2005 2006 2007
ABP
PGGM
The fact that equity valuations are not expensive (as
measured by the equity risk premia see Bond Market
Strategy for details) also suggests that it will be very
difficult to predict appetite for further ALM hedging.
10Y swap spreads fair, 2Y swap spreads
driven by the basis
Although we are less optimistic than the market, or
indeed governments on budget deficits for next year, net
issuance will continue to fall, thanks to very large
redemptions. This should provide some support for swap
spreads, even if total issuance is likely to come in slightly
higher than currently expected.
Tightening of credit standards
-50
-45
-40
-35
-30
-25
-20
-15
-10
-5
0
Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07
DEM 10Y ASW
Long term forecasts
Relative to current budget deficit expectations 10Y swap
spreads are fair. Should growth weaken more materially
than we expect, than swap spreads could come under
tightening pressure.
Front-end swap spreads on the other hand will remain
completely driven by the basis. Rolling into the new year,
should mechanically tighten front-end swap spreads
somewhat by removing the turn of the year, however, we
remain cautious and see the risk that the Euribor bases do
not tighten as quickly as currently priced in by the
forwards.

Ralf Preusser (44) 20 7545 2469
Francis Yared (44) 20 7545 4017

EUR Derivatives: 2008 Outlook

The second half of 2007 has turned-out to be the
period when the excess leverage in the financial
system finally began unwinding, and risk premia
in general and volatility in particular started rising

For 2008, we expect:

risk premia and volatility to remain elevated

the directionality of volatility with rates to
persist

CMS issuance to increase but the supply of
volatility through range accruals to decrease

Limited ALM driven demand for long tenor
Vega

We present a series of trades that are attractive in
that context
What to expect in 2008?
when the excess leverage in the financial system finally
began unwinding, and risk premia in general and volatility
in particular started rising.
European volatility followed the trend with Gamma and
Vega reverting back to levels more consistent with
historical averages. Volatility bottomed out in April and
bounced in May as US mortgage market convexity sell-off
and the repricing of Fed rate cut expectations drove the
bear steepening of the curve. Since then, the ongoing
credit and liquidity crisis and the reduction of financial
leverage in the system supported volatility.

2007: Volatility finally bounced back
40
45
50
55
60
65
70
75
Nov-04 Nov-05 Nov-06 Nov-07
DGXEUR Index
DVXEUR Index


In the mortgage-lead bear steepening, Gamma on the
belly of the curve led the spike in volatility as the EUR
front-end was still anchored by a predictable ECB and the
long end sold-off in sympathy with the USD curve. Then,
as the credit and liquidity crisis unfolded, volatility moved
back to the front end of the curve as the ECBs (and other
central banks) monetary policy path got repriced.

As we highlighted back in June, central banks benefited
from an exceptional macroeconomic environment during
the last tightening cycle. The cycle started from an
extremely low level of real rates while, with the benefit of
globalization, inflation levels remained subdued. Thus
central banks had the opportunity to gradually normalize
interest rates and the luxury to be exceptionally
transparent in their forward looking statements. This very
benign macro environment enabled central banks to be
more predictable, which reduced volatility in the front end
of the curve and risk premia generally.
However, now that inflation is close to, or above central
banks comfort zones and that the trade-off between
growth and inflation is becoming more acute, central
banks are bound to be more agnostic about the direction
of interest rates and will therefore be less predictable.
This will support elevated volatility in the front end of
the curve.

Given the strong performance of the upper left corner
(short expiry/short tenor) of the volatility surface, we are
entering 2008 with a volatility surface which is strongly
inverted along both the tenor and expiry axis.

Volatility surface is strongly inverted along both the
tenor and expiry axis
-15
-10
-5
0
5
10
15
20
Dec-06 Apr-07 Aug-07 Dec-07
-4
-2
0
2
4
6
8
3m2y-3m10y
3m5y-6m5y

The other salient feature of the recent crisis has been the
reestablishment of a strong negative correlation between
short term rates and short dated volatility. Given the
current environment, we expect this directionality of
volatility with interest rates to persist at least until we
see a normalisation of the liquidity situation and the
EURIBOR-EONIA bases.

Volatility is expected to remain negatively correlated
with rates (6M rolling correlation)
-1.2
-0.7
-0.2
0.3
0.8
Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
3M2Y 3M5Y
3M10Y 3M30Y

From a flow perspective, 2007 started with extremely
strong volatility supply through range accruals and
callables, which drove volatility well below historical
ranges. The effect of the range accruals can be seen in
the cheapness of cap-floor volatility relative to swaptions
and the cheapness of bottom left corner (long expiry/short
tenor). Given the more uncertain macro outlook, we
expect the supply of volatility through range accruals
to remain low in 2008, although we could see the usual
seasonal pattern of volatility selling in the early months of
the year as risk appetite returns.

Later in the spring, the unwind of some range accruals
and some ALM related activity provided support to Vega.
Finally, following the crisis, financial institutions have
increasingly been resorting to CMS issuance to satisfy
their funding needs. We expect the issuance of CMS to
continue as financial institutions seek permanent funding
solutions for the SIV and longer maturity ABCP conduit
assets that are back on their balance sheets.

CMS Issuance expected to continue in 2008
0
500
1000
1500
2000
2500
3000
3500
4000
4500
Feb-02 Jun-03 Oct-04 Feb-06 Jun-07
CMS (Plain)
EUR mln


Finally, ALM activity has been relatively subdued with
volatility buying broadly in line with seasonal patterns. The
impact of ALM flows is observable in the richness of low
strike receivers.
5y30y Payer-Receiver skew
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07
Given the good performance of equity markets over the
last few years, the funding ratios for major ALM players
have considerably improved. For instance the funding
ratio of ABP (a Dutch pension fund) has spiked up and is
now close to 150%.
Funding ratio for ABP
1.00
1.10
1.20
1.30
1.40
1.50
1.60
04Q1 04Q3 05Q1 05Q3 06Q1 06Q3 07H1

Given the high funding ratios, we expect ALM players to
remain more focused on equities and alternative
investments such as commodities. The hedging both in
volatility and in delta space should remain opportunistic
and at this point, we do not expect large ALM driven
vega demand in 2008. Actually, in rates space the focus
is more likely to be on inflation linked bonds as the high
funding ratios are triggering the indexation of liabilities to
inflation. Of course, should the equity market crash and
yields rally the hedging needs may change. However,
given the still high equity risk premia, we see the risk of
an outright crash of equity markets remote, even though
the outlook for corporate earnings may be challenging.
High equity risk premium limits the risks of a crash
-3
-2
-1
0
1
2
3
4
5
6
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
EUR Equity Risk Premium
EUR ERP average =
1.9%
%
Stock
market
bubble

The trades for 2008
Long EONIA vs. sell calls on Euribor
As highlighted in Bond Market Strategy and Euroland
Strategy, we find long positions in the front end of the
EUR curve attractive from a risk reward perspective.
Currently the EONIA curve is pricing 40% chance of a hike
in Europe which is in stark contrast with the additional
100bp and 50bp priced in the front end of the US and UK
curve respectively. While Eurolands economy is likely to
be less impacted by the credit rationing than the US or UK
economies, its growth outlook will nonetheless suffer
both directly (tighter lending criteria) and indirectly (rising
exchange rate) from the credit crisis.
We see asymmetric risks around our central scenario of
one rate cut by June of next year. Given the downside risk
to growth and the still present event risk, it is possible for
the ECB to cut rates more aggressively than we expect.
On the other hand, given the regime shift in the repricing
of risk and the reduction in credit availability due to
balance sheet constraints, the liquidity situation is unlikely
to normalize quickly enough for the ECB to hike rates
more than once in the worse case scenario. Therefore, we
seek to construct trades that offer protection against one
rate hike, but remain profitable if the ECB cuts rates more
aggressively than expected.
An attractive way of expressing our view is to .go long the
June 3M EONIA, and sell OTM calls on the corresponding
3M Euribor struck at 95.75 (4.25%) for a premium of 8
cents. The trade performs in a rally, but also offers
protection for small sell-offs through the premium
received on the short call position. The table below shows
the performance of this trade for different EONIA and
basis scenarios.
Scenario analysis (P&L of the trade in bp)

We see that this trade performs well if EONIA rallies and
the basis remains elevated. We do however give up some
upside if the basis normalises in a rally, to protect against
a sell-off in EONIA, with a breakeven EONIA rate of
4.23%.
Long Front End: Payer fly on 1Y2Y swaption
In our central scenario, the ECB would cut rate to 3.75%.
Assuming that the basis does not fully normalise and a
50bp spread between 2Y swap rates and the terminal ECB
rate, we expect the 2Y swap rate to be around 4.25% in
one years time. Although this is the most likely scenario
we believe the risks are skewed towards lower rates.
Hence, we look to create a portfolio which has a positive
payoff around a rate of 4.25%, remains profitable for big
rallies in rates and offers protection in case the ECB
remains on hold or hikes once if the basis normalises.
We express this view by buying payers with 4% strike on
1Y2Y and selling 4.25% and 4.5% strike payers for an 8bp
take out. The payoff of the trade including the initial take
out is given in the chart below. The breakeven for the
trade is 4.83% which is above the maximum level in 2Y
swap rates achieved during this tightening cycle.
Payoff Profile
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
40
3.60% 4.10% 4.60% 5.10%
Instant P&L
Decayed P&L

Long Forward Vol
Given our positive volatility bias and the extreme inversion
in the volatility surface we like to take exposure to forward
volatility. Indeed, our models suggest that spot Gamma is
expensive relative to the curve even after adjusting for the
impact of the basis. However, forward volatility 3M or 6M
out is closer to fair value.
DGX forward and yield curve slope
y = 0.2344x + 56.54
R
2
= 0.6417
y = 0.178x + 51.292
R
2
= 0.438
40
50
60
70
80
90
100
-20 0 20 40 60 80 100
DGX Dec DGX Mar
DGX Jun DGX Sep

The trade could be implemented either by entering a
DGXEUR March IMM contract (at 60.5bp at the time of
writing), or by entering a calendar spread on a specific
tenor.
Given the current shape of the Gamma surface, we find
the 6M5Y -1Y5Y calendar spread attractive. The trade
would be structured so that it is Gamma neutral and with
strangles rather than straddles to ensure a more stable
Gamma profile over time (see FIW 23 November 2007).
6M forward 6M5Y is attractive

45
55
65
75
85
95
105
Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
6m5y vol
6m fwd 6m5y vol


5y2y-5y30y Bull steepener
Combining our macro views with our understanding of the
flows, we find entering a 5Y2Y-5Y30Y bull steepener
attractive. The trade fits our core view for a steepening of
the EUR curve. It also benefits from the cheapness of the
5Y2Y point (on the back of range accruals) and the
richness of the 5Y30Y point (on the back of ALM flows).
As mentioned above, we do not expect strong ALM flows
in 2008 whilst we expect the supply of vol through range
accruals to recede. Also by striking both options 100bp
out, we take advantage of the richness of the 5Y30Y skew
relative to the 5Y2Y skew. The trade details are
summarised in the following table.
Trade details
EUR 5Y2Y Rcr EUR 5Y30Y Rcr Net
Notional 810 -100
ATMS 4.59% 4.86%
ATMF 4.72% 4.93%
Strike 3.72% 3.93%
Delta -28,541 26,031 -2,510
Gamma 309 -346 -37
Vega 1bp 97,052 -91,670 5,382
1y Carry -130,366 338,204 207,838
Take Out -2,532,220 1,996,838 -535,381


Aditya Challa (44) (020) 7547 5966
Alessandro Cipollini (44) (020) 7547 4458
Gopi Suvanam (44) (020) 7547 5966
Francis Yared (44) (020) 7545 4017

Eurozone Issuance Outlook: 2008

Eurozone gross issuance is expected to increase in
2008, while net issuance falls. This discrepancy is
largely due to larger redemption payments in 2008
compared to 2007.

We are neutral on countries like Ireland, Spain and
Belgium, which will remain susceptible to negative
sentiment, but expect spreads for Austria, Finland
and Netherlands to tighten further.
We provide the outlook for government bond issuance in
the Eurozone for 2008. Gross issuance is likely to increase
by approximately EUR 36 bln in 2008, predominantly due
to larger redemptions. However, net issuance is still set to
improve by about EUR 28bln. Full details of respective
issuance programs have yet to be announced, and are
expected over the coming weeks. As such these are
preliminary estimates based on budget deficit projections
and redemption payments.
Redemptions amount to EUR 511 bln in 2008, up EUR 63
bln from 2007. These are highest in Germany, France and
Italy, where France in particular sees the largest increase
from the previous year. Gross issuance should increase in
Italy, France, and Greece but remain roughly stable
elsewhere. With a few exceptions (Italy, Greece, Portugal
and Ireland), net issuance should decrease in 2008, with
total net issuance at EUR 78bln.
In the past, debt management agencies have typically
front-loaded issuance. Market conditions are currently
more volatile than in previous years, and the timing of
debt sales will be important for issuers next year. Having
said that, it is likely that we still see large issuance in Q1
last year, approx 14% of the total years issuance was
done in Jan, of that most was long end supply. Q1 saw
about a third of the years issuance.
The past couple of years have seen bond issuance scaled
back over the second half of the year as favorable
economic performance led to higher-than-expected tax
takes. Looking forward, the growth uncertainty makes it
difficult for us to imagine that this will continue, and we
would not expect positive fiscal surprises.
Gross Issuance
2007 2008F
Germany 143.0 143.0
France 103.7 123.0
Italy 171.6 187.0
Spain 22.4 17.0
Netherlands 18.2 18.0
Belgium 25.6 27.0
Austria 17.6 12.0
Finland 5.0 4.7
Portugal 8.8 13.5
Greece 32.0 40.0
Ireland 6.0 5.0
Total 553.8 590.2
Net Issuance
2007 2008F
Germany 16.5 3.6
France 31.9 20.5
Italy 33.4 38.4
Spain -4.8 -9.9
Netherlands 3.5 -3.3
Belgium 3.6 -2.4
Austria 6.4 3.9
Finland 0.0 -2.0
Portugal 2.2 4.8
Greece 13.7 19.5
Ireland -0.1 5.0
Total 106.3 78.1
Breakdown by Maturity
2Y-3Y 5Y 10Y 15Y 30Y IL CCT/
CTZ
FRN Total
gross
2007 104.2 110.5 144.5 27.9 46.2 43.2 44.7 4.0 525
2008R 127.1 120.8 154.2 38.1 49.1 49.4 48.6 3.8 591
Redemptions
0
20
40
60
80
100
120
140
160
2008 Redemptions
2007 Redemptions
Source: Deutsche Bank, various government agencies

Germany
Germany ( EUR bln)
2Y-3Y 5Y 10Y 15Y 30Y IL Total
gross
2007 56 32 39 0 10 6 143
2008R 60.775 30.03 34.32 0 10.01 7.865 143
We expect issuance to remain at last years levels,
despite the commitment to budget improvement. This is
due to redemptions increasing by EUR 12.9 bln to EUR
139.4 bln. It is most likely that the maturity splits remain
roughly the same. We would also expect continued
support for the linker program with the possibility of a
new 30Y IL.
France
France (EUR bln)
2Y-3Y 5Y 10Y 15Y 30Y+ IL Total
gross
2007
17.8

25.8

27.3

10.3

5.8 16.7 103.7
2008F 27.675 30.75 24.6 12.3 7.38 20.295 123
In France, issuance should increase, again due to
significant redemptions, which rise by EUR 50bln to EUR
102.5 bln. We would expect potentially more issuance in
the front end, with new benchmarks in the 2Y, 5Y and 10Y
sector. In the long end, the 15Y and 30Y benchmarks will
probably be tapped, as will the ultralong. Given that 2009
is another big year for redemptions, the AFT may conduct
buybacks to reduce this. Linker issuance should continue,
as is the case for taps of current bonds.
Italy
Italy (EUR bln)
2Y-3Y 5Y 10Y 15Y 30Y IL CC
T
ICTZ Total
gross
2007 30.5 28.5 30.7 7.5 11.0 16.4 20.
3
23.5 168
2008F 30.9 32.7 37.4 9.4 11.2 16.8 22.
4
26.2 187
In Italy, both gross and net issuance is likely to increase.
We expect new benchmarks for the 3Y and 5Y sector. In
the long end, we see potentially a new 15y, while the
current 10Y and 30Y benchmarks continue to be tapped.
We anticipate the linker programme will continue to be
supported with further taps of current issues and possibly
a new issue.

Austria
Austria ( EUR bln)
gross
2007 0 2.8 7.8 1.3 5.8 0 18
2008F 0 2.1 5.7 1.0 4.3 0 13
In Austria, we estimate the Treasury will issue EUR 12 bln
in 2008, an improvement from this year. We expect a
new 10yr RAGB benchmark, most likely in Q1, issued by
syndication.
Belgium
Belgium (EUR bln)
2Y-3Y 5Y 10Y 15Y 30Y FRN Total
gross
2007 0 7.7 10.8 2.4 0 4 25
2008F 0 8.4 11.9 2.7 0 3.8 27
The political deadlock in the country since June has meant
that a 2008 budget has not been proposed yet. However,
it has been reported that legislation will be enacted soon,
which will enable spending to continue but will cap it to
2007 levels. The finance minister has announced its
financing requirement, which entails EUR 27 bln in OLO
issuance. We expect at least two new benchmarks, most
likely issued via syndication. The buyback program is also
likely to continue
Finland
Finland (EUR bln)
gross
2007 0 5 0 0 0 5
2008F 0 0 4.7 0 0 0 4.7
Gross issuance should remain broadly unchanged from
2007. As last year a 5Y benchmark was opened, a new
10Y benchmark is possible.
Greece
Greece (EUR bln)
gross
2007 1.7 5.8 9.8 6.2 4.0 4.5 32
2008F 2.125 7.25 12.25 7.75 6.25 4.375 40
We see Greek issuance at around EUR 40 bln in 2008. In
terms of maturities, we expect new benchmarks in the 5Y
and 10Y sector, while the 30Y and 15Y sector current
issues will likely be tapped.
Holland
Holland (EUR bln)
gross
2007 3.0 1.9 9.5 0.0 3.9 0.0 18
2008F 3.1 1.9 9.6 0.0 3.9 0.0 18
In the Netherlands we see gross issuance remaining
steady at EUR 18bln as redemptions increase by EUR 7
bln. We might see a new 10Y benchmark and further taps
in other sectors.
Ireland
Ireland (EUR bln)
gross
2007 0 0 6 0 0 6
2008F 0 0 0 5 0 0 5
While Ireland has no significant redemptions in 2008, it is
likely to post a deficit. As a new 10Y benchmark was
already issued in 2007, we expect a new benchmark,
possibly in the 5Y sector, or even a longer issue.

Portugal
Portugal (EUR bln)
gross
2007 0.9 1.0 5.9 0.0 1.0 0.0 9
2008F 1.4 1.5 9.8 0.0 1.5 0.0 14
Portuguese issuance is likely to increase by EUR 4.7 bln in
2008. Redemptions increase by EUR 2 bln. We expect at
least a new 10y, and perhaps another new line.
Spain
Spain (EUR bln)
gross
2007 1.4 8.6 5.9 0.0 6.5 0.0 22
2008F 1.2 5.4 3.9 0.0 4.2 0.0 15
In Spain we expect EUR 17 bln in issuance, a decrease
from 2007. We believe a new 3Y and 10Y benchmark is
possible, as the current 5Y continues to be tapped. In the
long end, no new issuance is likely as the current
benchmarks continue to be tapped.
Comparative Deficit-to-GDP Estimates
DB DB Govt
2007e 2008F 2008F
Germany 0.0 -0.1 -0.5
France -2.5 -2.4 -2.3
Italy -2.4 -2.4 -2.2
Spain 1.7 0.9 1.2
Netherlands -0.2 0.6 0.5
Belgium 0.3 0.0 n/a
Austria -1.5 -1.3 -1.1
Finland 0.8 1.1 1.1
Portugal -3.0 -2.7 -2.4
Greece -3.0 -2.0 -1.6
Ireland 0.5 -1.0 -0.2
Growth Forecasts
DB Consensus Govt
2008F 2008F 2008F
Germany 1.9 1.9 2.0
France 1.8 1.8 2.3
Italy 1.4 1.3 1.5
Spain 2.8 2.6 3.3
Netherlands 2.3 2.3 2.3
Belgium 1.8 2.0 n/a
Austria 2.4 2.4 2.4
Finland 2.7 3.0 3.0
Portugal 1.5 1.9 2.2
Greece 3.4 3.3 4.0
Ireland 4.0 3.7 3.5
On the whole, our economists are less optimistic than the
respective governments in deficit projections, as revenues
are unlikely to continue improving, while budgets remain
largely neutral. Although net issuance looks set to improve
over 2008 at this point, things can easily shift over the
course of the year. In addition, specific local risks may
emerge, or in some cases worsen. Spain, Ireland and
Belgium will probably continue to feel the brunt of
worsening sentiment. We may start to see further
differentiation between the core group, and almost
certainly more susceptibility to headline risk.

Estimate of housing overhang as % of GDP
Germany -6.5
Spain 24.6
France -8.6
Ireland 44.3
Italy -0.9
Euro Area 1.5
UK 4.9
US 7.1
Japan 10
Source: CEPS working document No 276 Bubbles I Real Estate, GEPS Oct 2007
The housing sector will likely remain a source. A GEP
publication (8 Oct 2007) and a working paper by the CEPS
that estimates the amount of housing overhang suggests
that both Spain and Ireland will remain on radar screens.
CDS spreads appear to have become one way of playing
this, not just via shorting the bonds, as repo markets in
the periphery are less developed. We expect this to
continue.
10Y ASW Spread to Germany
0
5
10
15
20
25
Mar-
07
Apr-
07
May-
07
Jun-
07
Jul-
07
Aug-
07
Sep-
07
Oct-
07
Nov-
07
Dec-
07
Belgium
ireland
Spain
10Y ASW Spread to Germany:
0
2
4
6
8
10
12
14
Mar-
07
Apr-
07
May-
07
Jun-
07
Jul-
07
Aug-
07
Sep-
07
Oct-
07
Nov-
07
Dec-
07
Austria
Finland
Netherlands
Peripheral spreads ( to Germany) have recovered from the
highs since the beginning of the month. We are neutral on
countries like Spain, Belgium and Ireland, as it is likely that
negative newsflow will continue to adversely affect
sentiment. Meanwhile, we are positive on Austria, Finland
and the Netherlands, looking for a further 5bps of
tightening as their housing markets present little potential
for negative headline risk, and given their strong fiscal
positions.
Soniya Sadeesh +44 207 547 3091

Covered Bond Outlook 2008

The strong spread widening of EUR Jumbo
covered bonds, particularly in US, UK and Spanish
covered shows the increasing differentiation of
investors according to issuer specific (cover pool
credit quality, issue structure, bank credit quality)
and market specific topics (housing market risk,
country risk).

Given that housing market concerns are unlikely
to disappear quickly, we see very little chance of
returning to where we came from in terms of
spreads, i.e. we expect that investors will
continue to demand very different spreads for
different covered bonds.

In 2007, the average spread difference between
mortgage and public covered bond increased
considerably. As housing market concerns in
some countries may get worse before they get
better, we do not expect this spread difference to
reverse.

In our view, the willingness of issuers around the
world (Europe, USA, Canada, Australia; Japan) to
issue EUR Jumbo covered bonds might well
amount to EUR 230 bn in 2008. Depending on the
average issuance volume, this would mean almost
one new EUR Jumbo covered bond issue per
business day. Given the monthly supply in 2007,
one can easily see how severe financial market
turmoil reduced monthly covered bond supply in
August/September and November/December.
Hence, to allow issuers to bring the intended
issues to the EUR Jumbo covered bond market,
we believe a no-crisis scenario in the financial
market environment is needed.

There are already 13 Jumbo covered bonds deals
in the pipeline. Hence, liquidity will be crucial, in
our view. With interbank market making not yet
fully back in place, liquidity in the interbank
market is still limited. In our view, interbank
market making is crucial to providing continuous
liquidity in size to rates investors.
Some spread recovery in case of 2Y
swap spread tightening likely
Spread divergence* continued covered bond market
got split even further
-12
-2
8
18
28
38
48
J
a
n
-
0
7
F
e
b
-
0
7
M
a
r
-
0
7
A
p
r
-
0
7
M
a
y
-
0
7
J
u
n
-
0
7
J
u
l
-
0
7
A
u
g
-
0
7
S
e
p
-
0
7
O
c
t
-
0
7
N
o
v
-
0
7
France Covered
German Mortgage Pfandbriefe
German Public Pfandbriefe
Spanish Covered
Other Covered
Ireland Covered
UK Covered
*indices have different durations
Source: iBoxx
The strong spread widening of EUR Jumbo covered
bonds, particularly in US, UK and Spanish covered shows
the increasing differentiation of investors according to
issuer specific (cover pool credit quality, issue structure,
bank credit quality) and market specific topics (housing
market risk, country risk). However, in line with their
status as bonds typically backed by a dual claim against a
bank and a cover pool, covered bonds strongly decoupled
from general bank credit spreads, which trade around an
8-year high.
Covered bonds showed stability versus senior and
subordinated bank debt
-15
-5
5
15
25
35
45
55
65
75
85
95
105
115
125
135
145
O
c
t
-
0
6
N
o
v
-
0
6
D
e
c
-
0
6
J
a
n
-
0
7
F
e
b
-
0
7
M
a
r
-
0
7
A
p
r
-
0
7
M
a
y
-
0
7
J
u
n
-
0
7
J
u
l
-
0
7
A
u
g
-
0
7
S
e
p
-
0
7
O
c
t
-
0
7
N
o
v
-
0
7
D
e
c
-
0
7
Corporate Financial
Covered
Corporate Financial: Banks : Senior
Corporate Financial: Banks : Subordinated
Source: IBoxx
Demand for covered bonds from real money accounts
The secondary market in the second week of December
showed better buying interest from customers across the
curve. We also saw further buying interest from central
banks especially in German, Nordic and French covered
bonds. All in all, bonds traded on slightly tighter vs.
swaps.
Spreads may tighten in line with 2Y swap spread
tightening
Cdulas spreads versus swaps had not been correlated to
2Y swaps since 2003 (R square of almost 0). However,
since July this year, Cdulas spreads versus swaps have
been correlated with 2Y swaps (R square of almost 0.9).
Hence, beside pure credit concerns, the liquidity shortage
is clearly weighing on spreads of covered bonds. Hence,
in line with the expectation of some normalisation of swap
spreads next year and in the absence of negative credit
events, spreads of Spanish and UK covered bonds should
tighten. However, given that housing market concerns are
unlikely to disappear quickly, we see very little chance of
returning to where we came from in terms of spreads, i.e.
we expect that investors will continue to demand very
different spreads for different covered bonds. Moreover,
event risk regarding bank credit quality (also impacted by
the ongoing deterioration in housing markets) remains.
Cdulas spreads versus swaps highly correlated with
2Y swap spread (since July)
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
J
u
l
-
0
2
N
o
v
-
0
2
M
a
r
-
0
3
J
u
l
-
0
3
N
o
v
-
0
3
M
a
r
-
0
4
J
u
l
-
0
4
N
o
v
-
0
4
M
a
r
-
0
5
J
u
l
-
0
5
N
o
v
-
0
5
M
a
r
-
0
6
J
u
l
-
0
6
N
o
v
-
0
6
M
a
r
-
0
7
J
u
l
-
0
7
N
o
v
-
0
7
iBoxx Euro: Collateralized: Covered: Spain Covered
(ASW in bp)
2Y Smooth GER (Par ASW in bp)
Investor demand is critical
In contrast to widespread expectations, 2007 will end
with less EUR Jumbo covered bond supply. Around EUR
160 bn of EUR Jumbo covered bonds have been issued.
In 2006, EUR 182 bn of Jumbo covered bonds were
issued. Due to current funding problems in senior bank
bonds and RMBS, covered bonds might be the first
choice for most banks in 2008. With three-month Euribor
showing its nineteenth consecutive rise on Tuesday (fixing
at 4.927%), hence 13.5 bp above the previous post-
summer high and 35 bp above its post-summer low,
pressure on bank liquidity remains high.
Investors still in the driving seat
With 13 new EUR Jumbo covered bonds already in the
pipeline for 2008, it appears that investors will likely be
price makers rather than price takers in 2008. This should
also be true for the covered bonds that have remained
most stable so far. E.g. 5Y public Pfandbriefe of BHH
trade at ms 4 bp in the secondary market and 5Y public
Pfandbriefe of 10Y DG Hyp trade at ms 3 bp in the
secondary market. In the case of new issues, even the
issuers of public Pfandbriefe may have difficulties funding
sub-libor currently.
EUR Jumbo covered bond issuance in 2007 lower
than in 2006
0
20
40
60
80
100
120
140
160
180
200
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
AT CA FI FR GE IR IT LX
NL NO PT SP SW UK US
In our view, the willingness of issuers around the world
(Europe, USA, Canada, Australia; Japan) to issue EUR
Jumbo covered bonds might well amount to EUR 230 bn
in 2008. Depending on the average issuance volume, this
would mean almost one new EUR Jumbo covered bond
issue per business day. Given the monthly supply in 2007,
one can easily see how severe financial market turmoil
reduced monthly covered bond supply in
August/September and November/December. Hence, to
allow issuers to bring the intended issues to the EUR
Jumbo covered bond market, we believe a no-crisis
scenario in the financial market environment is needed.
2007 EUR Jumbo volume lower in August/September
and November/December
0
5
10
15
20
25
30
35
40
Jan Feb Mar Apr May Jun July Aug Sep Oct Nov Dec
2006
2007
This can also be seen by the quarterly EUR Jumbo
covered bond issuance distribution. Whereas Q2 2007
was the strongest Q2 ever in terms of supply, Q3 fell
short of Q32006. Despite financial market turmoil, Q3 and
Q4 2007 supply slightly exceeded Q3 and Q4 2005
supply, respectively, showing that there is a strong
willingness or even need on the part of banks to issue
EUR Jumbo covered bonds as soon as there is an
opportunity.
Q3 and Q4 2008 with lower EUR Jumbo covered bond
supply
0
10
20
30
40
50
60
70
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
Q1 Q2 Q3 Q4
The banks full-year results will not yet be out in the
opening days of January. Hence, in our view, investors
will continue to be cautious. There has not been even one
long-term Jumbo covered bond issue since August. As
already mentioned, we believe investors continue to be in
the driving seat. In 2008, circa EUR 92 bn of EUR Jumbo
covered bonds become due. Redemptions of Spanish
Cdulas in 2008 amount to less than EUR 5 bn. In this
respect, by issuing long dated in recent years, Spanish
issuers (at least) do not face the pressure to refund high
redemption volumes. The risk to our cautious view on
investor demand is that most bad news is out already and
that hunting for yield by real money in 2008 could allow
issuers to get all their funding needs done. However, even
in such an scenario, it seems unlikely that we return to the
pre-crisis environment where covered bonds of whatever
structure could be issued without material pick-up to
established covered bonds of established issuers.
Around EUR 92 bn of EUR Jumbo covered bonds
become due in 2008
0
20
40
60
80
100
120
140
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
2
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1
6
2
0
1
8
2
0
2
0
2
0
2
2
2
0
2
4
2
0
2
6
Austria Finland
France Germany
Ireland Italy
Luxembourg Netherlands
Norway Portugal
Spain Sweden
United Kingdom USA
Canada
Low redemptions of EUR Jumbo covered bonds in
January and February 2008
0
2
4
6
8
10
12
14
16
18
0
1
-
0
7
0
3
-
0
7
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5
-
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-
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0
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1
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0
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-
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0
3
-
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8
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5
-
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-
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8
0
9
-
0
8
1
1
-
0
8
0
1
2
3
4
5
6
7
8
9
Volume in EUR bn (LS)
No. of maturing issues (RS)
Investor demand the key question
Particularly for countries currently under increased
observation regarding credit quality, like US, UK, Spain
and Ireland, we believe investor demand will be the key
question. In some covered bond issues since September,
bank buyers accounted for over 50%. Even though
demand from banks for covered bonds since September
has been reasonably strong, we continue to see the need
for issuers to diversify away from banks to get their
increased funding needs done. That said, in our view, due
to a lack of safe investment alternatives and the ECB
eligibility of covered bonds, which by the way provide a
carry of around 50 bp currently, banks will continue to be
strong buyers of covered bonds. Covered bond investors
have a tendency to buy domestic covered bonds, e.g.
while German demand for Jumbo Pfandbriefe is around
50%, the bid for foreign covered bonds is only around
20% on average. Spanish investors take on average
around 5% of Spanish Cdulas but do not buy foreign
covered bonds. Also in the Nordics and Benelux, there is
typically a higher demand for domestic covered bonds.
Banks continue to dominate as investors in Jumbo
covered bonds

RMBS investors may start buying covered bonds in the
future. But given the pre-crisis investor distribution of
ABS/RMBS (see appendix), high non-bank investor
demand from former RMBS investors seem unlikely,
particularly for longer-dated covered bonds.
Market making important for investor demand
There are already 13 Jumbo covered bonds deals in the
pipeline. Hence, liquidity will be crucial, in our view. With
interbank market making not yet fully back in place
(according to the minimum standards recommended by
the German Association of Pfandbriefbanks), liquidity in
the interbank market is still limited. In our opinion,
interbank market making is crucial to providing continuous
liquidity in size to rates investors (even though the EUR
Jumbo covered bond market is only a fraction in terms of
outstanding volume compared to EUR government debt
market and with EUR 1.6 bn has far lower average
volume). Without decent liquidity in size, some investors
may no longer see Jumbo covered bonds as a
government surrogate or rates product. Hence, we
believe some kind of preservation measure has to be
taken to restore market making fully. Currently, interbank
market making is still reduced to EUR 5 m and bid-offer
spreads are still tripled.
Adjustments in market making may be
necessary
Given the ongoing differentiation of covered bonds by
investors, there are many proposals and discussions
about how to change market making going forward, i.e.
how to preserve high liquidity: One possible avenue might
be to differentiate market making according to spread
ranges. If one assumes that covered bonds with greater
credit risk trade wider to swaps than covered bonds with
lower credit risk (and hence have differences in volatility),
different bid-ask spreads might be justified. As the spread
volatility is usually higher for longer-term covered bonds,
one would have to adjust volatilities according to maturity
bracket (unlike in the following chart). The chart shows
spread volatilities for covered bonds trading in different
spread ranges. The sudden drop of the volatility for
covered bonds trading between 25 and 50 bp versus
swaps was mainly the result of Northern Rock and
WAMU covered bonds leaving even this spread range.
Volatility different for different spread ranges
0
5
10
15
20
25
2
8
-
A
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7
0
5
-
S
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1
2
-
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1
9
-
S
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2
6
-
S
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0
3
-
O
c
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1
0
-
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1
7
-
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2
4
-
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t
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0
7
-
N
o
v
-
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1
4
-
N
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v
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0
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2
1
-
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o
v
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2
8
-
N
o
v
-
0
7
0
5
-
D
e
c
-
0
7
(- x to 5 bp)
5 bp to 15 bp
15 bp to 25 bp
25 bp to 50 bp
The following chart shows the year-to-date mean of 30-
day volatility plotted according to spread range and
duration bucket for around 300 EUR Jumbo covered
bonds. The results basically show that for any given
duration, volatility is higher in a higher spread
Banks
40%
Central bank
11%
Fund Manager
27%
Insurance
10%
Pension Fund
6%
Other
6%
Higher volatility for EUR Jumbo covered bonds
trading at a higher spread (for any given duration)
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
2 to 3 3 to 4 4 to 5 5 to 6 6 to 7 7 to 8 8 to 9 9 to 10 10+
Upto 5
5 to 15
15 to 25
25 to 50

Due to different spread volatilities, covered bonds with
the tightest spreads might deserve to have the tightest
bid-ask spreads. There are various pros and cons to this
idea: one counter-argument is that liquidity will dry up in
case of a spread widening -- exactly at the time it is
needed most. Moreover, the different spread ranges and
the bid-offer spreads for each respective spread range in
relation to the normal market making commitment is
certainly up for discussion. However, in our view, some
measure has to be taken to improve interbank market
making. Given the differences in volatilities of different
covered bond sectors, a return of all covered bonds to the
normal market standards early January seems difficult.
Without a well functioning market making, the structure of
the Jumbo covered bond market may change going
forward. Generally, no matter which measure is taken and
which form of market making commitment is the result of
the current discussion, we see no way to avoid frictions in
market making in times of severe crisis. This is not
restricted to covered bonds but is also true for sovereign
bonds.
Trading platforms enhance transparency but may
make providing liquidity more costly for banks
In our view, well-functioning market making is crucial to
get rates investors investing in covered bonds. Hence, in
a case where the covered bond community is not able to
re-establish well-functioning market making, part of the
investor base may reduce its exposure to covered bonds,
particularly in upcoming new issues. Providing liquidity to
the market is a costly service. The suggestion of shifting
all trading to trading platforms may enhance transparency,
but may make providing liquidity even more costly for
market makers. Hence, the market making mechanisms
should, in contrast to the current minimum requirements,
provide sanctioning mechanisms for banks acting as free
riders. In cases of covered bonds trading at wide levels,
credit investors may take a closer look at investing in
covered bonds, as has already happened in the case of
covered bonds by Northern Rock or Washington Mutual.
Public Covered Bonds remain well
supported
AyT still No 1 issuer in terms of outstanding volume
With around EUR 50 bn in terms of outstanding volume,
AyT remains the No 1 issuer of EUR Jumbo covered
bonds, followed by French CFF with around EUR 45 bn.
AyT remains the No 1 issuer of EUR Jumbo covered
bonds
0 10 20 30 40 50 60
AYTCED
CFF
EURHYP
HYPESS
BBVASM
CRH
DEXMA
DEPFA
CAIXAB
SANTAN
Sum of Outstanding Volume (bn)
The difficulties in the primary market of EUR Jumbo
covered bonds fed through into the 2007 years top
ranking of issuers. CFF was the No 1 issuer with almost
EUR 15 bn of EUR Jumbo covered bonds issuance,
followed by BNP with almost EUR 9 bn and DEXMA with
around EUR 8 bn. Hence, French issuers dominated the
primary market, interestingly, without severely hurting
spreads.
CFF No 1 issuer in 2007 EUR Jumbo covered bonds
0 3 6 9 12 15
CFF
BNPPCB
DEXMA
EURHYP
HBOS
LBBW
BAC
NWIDE
CAJAMM
SANTAN
Sum of Outstanding Volume (bn)
Public Pfandbriefe continue to dominate the public
covered bond market
Public Pfandbriefe continue to dominate the EUR Jumbo
public covered bond market. As around 40% of the
collateral of public Pfandbriefe still consists of state-
guaranteed public-sector bank debt, their share looks set
to shrink in the next years. In 2008, we should see EUR 65
bn of redemption of German Pfandbriefe, accounting for
the highest share of the total of EUR 92 bn. Due to the
high negative net supply, spreads of public Pfandbriefe
continue to be well supported.
Public Pfandbriefe still dominate the public sector
covered bond market with a market share of 72%
PP HYP
54%
PO
9%
PP LB
18%
PACS
8%
PL
1%
CDEP
3%
CT
5%
ATFB
2%

Short cuts public sector covered bonds
PP HYP Public Pfandbriefe of former Mortgage Banks
PP LB Public Pfandbriefe of Landesbanks
PO Public Sector Obligations Foncires
PACS Public Sector Asset Covered Securities
CT Cdulas Territoriales
CDEP Public Sector Covered Bonds of CDP
PL Public Sector Lettres de Gage
ATFB Austrian Fundierte Bankschuldverschreibung
Even though non-German Pfandbriefe make up some of
the decline, the outstanding volume of the whole public
covered bond market continues to decline and is likely to
do so also in 2008.
Outstanding volume of public covered bonds (EUR
bn)
0
50
100
150
200
250
300
1999 2000 2001 2002 2003 2004 2005 2006 2007
Outstanding Public (bn)

With the decline in outstanding volume and the increasing
volume in mortgage backed covered bonds, the share of
public covered bonds continues to decline. Hence,
besides the typically strong quality of public collateral, the
lack of public covered bonds in general is expected to
support spreads of all public covered bonds.
Share of public covered bonds decreasing
72.1%
69.7%
66.3%
60.5%
53.8%
48.7%
42.7%
35.8%
30.8%
0%
10%
20%
30%
40%
50%
60%
70%
80%
1999 2000 2001 2002 2003 2004 2005 2006 2007
Share of Outstanding

High redemptions in public covered bond indicate
declining volume
0
10
20
30
40
50
60
70
80
1
9
9
9
2
0
0
1
2
0
0
3
2
0
0
5
2
0
0
7
2
0
0
9
2
0
1
1
2
0
1
3
2
0
1
5
2
0
1
7
2
0
1
9
Gross Issuance
Redemptions

In 2007, the average spread difference between mortgage
and public covered bond increased sharply. As housing
market concerns in some countries may get worse before
they get better, we do not expect this spread difference
to reverse. Another reason why we believe a reversal will
be difficult is that ongoing new issuance of mortgage
covered bonds should prevent spreads from tightening
significantly. On the other hand, as described above, the
negative net supply should support spreads of public
covered bonds. The risk to our view is a strong
improvement in the situation on the money market and a
softening of housing market concerns. In this scenario,
mortgage covered bonds could outperform. However,
even in this case, we believe a return to previous levels is
unlikely.
Spread difference between public an d mortgage
collateral increased in 2007
0
2
4
6
8
10
12
14
16
18
J
a
n
-
0
7
F
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b
-
0
7
M
a
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7
A
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r
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7
M
a
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7
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N
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v
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7
D
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-
0
7
Duration All Mortgage - All
Public
Spread (All Mortgage - All
Public)

Although the spread difference between mortgage and
public Pfandbriefe is still comparably low (mainly due to
limited housing market concerns and the negative net
supply of German Pfandbriefe in general, in our view), the
spread also increased strongly. Given that inaugural
issuers in 2008 should be mainly in the mortgage sector
and negative net supply is mainly in public sector
collateral, we do not expect this to change significantly.
Mortgage Pfandbriefe have to pay a higher pick-up
versus public Pfandbriefe
0.00
1.00
2.00
3.00
4.00
5.00
6.00
J
a
n
-
0
7
F
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7
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M
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7
Spread (Mortgage Pfandbriefe-
Public Pfandbriefe)
Duration (Mortgage Pfandbriefe
over Public Pfandbriefe)
The Spanish Cdulas market experienced a significant
divergence of spreads between Cdulas Territoriales (CT)
and Cdulas Hipotecarias (CH). As housing market
concerns should continue in 2008, we not expect this to
change significantly. Moreover, the enhanced protection
provided by the amendment of the legal framework for
Cdulas increases the focus of investors on the collateral.
Structured covered bonds continue to
increase in importance
With outstanding volume of almost EUR 190 bn,
structured covered bonds have seen sharply increased
outstanding volumes. Since 2001 the annual share of
structured covered bonds in the gross supply of Jumbos
has risen steadily to reach over 32% in 2006. At the end
of 2007 it is around 35%. With that, the share of
outstanding volume amounts to 22%. Even though in the
current environment, structured covered bond are not well
bid, we continue to see potential in structured covered
bonds.
Structured covered bonds: sharp increase in
outstanding
0
20
40
60
80
100
120
140
160
180
200
1999 2000 2001 2002 2003 2004 2005 2006 2007
Outstanding SCB (bn)
Moreover, with the introduction of the legal framework for
covered bonds in the UK, a substantial share of structured
covered bonds will have to be categorized as legal
framework covered bonds in the future.
Structured covered bonds have a share of 22%
9
.
8
%
1
3
.
3
%
1
8
.
2
%
2
2
.
2
%
0%
5%
10%
15%
20%
25%
1999 2000 2001 2002 2003 2004 2005 2006 2007
Share of Outstanding
Spread of structured covered bonds widened sharply
As expected, due to the ongoing skepticism about
structured products in general and doubts regarding
insolvency remoteness, structured covered bonds
widened sharply. The difference is somewhat
exaggerated as a big share of legal framework based
covered bonds, German Pfandbriefe, have an average
duration of around 3 years only. However, the chart nicely
shows the trend.
Structured covered bonds widened sharplly versus
swaps (average of all outstanding EUR Jumbo
covered bonds)
-20
-10
0
10
20
30
40
50
J
u
l
-
0
6
S
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p
-
0
6
O
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t
-
0
6
D
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c
-
0
6
J
a
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-
0
7
M
a
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-
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7
A
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r
-
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7
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7
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7
A
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O
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7
N
o
v
-
0
7
Structured
Covered Bonds
Legal Framework
Bonds
SCB-Legal Spread
If we exclude Northern Rock and Washington Mutual
covered bonds, which both got hit hard because of
deterioration in senior credit quality (though for different
reasons), the spread widening of structured covered
bonds is less severe. Moreover, it is generally difficult to
isolate the impact of the difference of structured versus
legal framework based covered bonds. Around EUR 60 bn
of outstanding UK covered bonds count as structured
covered bonds at the moment. In March 2008, a specific
legal framework for UK covered bonds is supposed to
come into force. However, mainly due to concerns about
the UK housing market, it seems unlikely that the
introduction of the specific legal framework will have a
groundbreaking impact on spreads. Due to higher security
for investors, it should be positive; however, we believe
easing housing markets concerns are needed to see a
notable spread tightening in UK covered bonds.
Structured covered bonds widened less sharply if
Northern Rock and Washington Mutual are excluded
-10
-5
0
5
10
15
20
25
30
J
u
l
-
0
6
S
e
p
-
0
6
O
c
t
-
0
6
D
e
c
-
0
6
J
a
n
-
0
7
M
a
r
-
0
7
A
p
r
-
0
7
M
a
y
-
0
7
J
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7
A
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7
O
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0
7
N
o
v
-
0
7
Structured Covered Bonds ex( NRBS ,WM)
Legal Framework Bonds
SCB - Legal Spread ex (NRBS, WM)
Non bank covered bond issuers possible in 2008
It is possible that non-bank borrowers start issuing
covered bonds. Veolia Environment showed interest in
issuing Obligations Foncires backed by payments it
receives for its services under contract with local
authorities. In the case of Veolia, the specific topic is that
Veolia would issue via a Societe Credit Foncier (SCF), i.e. a
banking subsidiary. Even though the issue of Veolia has
not yet appeared in the market, other non-bank issuers,
even directly issued out of corporates, might also try to
tap the covered bond market.
BNP the fourth-largest issuer of structured covered
bonds
0 10 20 30 40 50 60
AYTCED
HBOS
CEDTDA
IMCEDI
BNPPCB
NRBS
NWIDE
BRADBI
AAB
WM
Top Ten Issuers
Expected issuance volume of EUR
Jumbo covered bonds
In the following, we give some very rough indication what
can be expected in terms of EUR Jumbo covered bonds
issuance volume. However, we highlight that the whole
covered bonds market amounts to around circa EUR 2000
bn, whereas the EUR Jumbo covered bonds amounts to
circa EUR 860 bn. Assuming an average maturity of 5
years, redemptions would on average amount to EUR 400
bn (as a lot of covered bonds have been issued in the
recent past, it might be lower than the average in 2008).
Assuming a growth of EUR 140 bn (similar to the past few
years), total gross issuance of covered bonds in all
currencies and all types (Jumbo, non-Jumbo, bearer
format, registered format, public, private placements) may
well amount to EUR 540 bn. In our view, it will become
increasingly important to have a view on the whole
covered bond market. As funding will likely remain a major
topic for banks in 2008, banks may focus even less than in
the past on the covered bond type (Jumbo versus non-
Jumbo), legal form (bearer versus registered ), type of
placement (public versus private) or currencies. As we see
it, the important topic will be how funding can be done.
Hence, the isolated view on the EUR Jumbo covered
bond market may be less useful than in the past
However, as we believe the demands of rates investors
will continue to be extremely important for issuers to get
Jumbo issues executed, we focus the following
discussion on the EUR Jumbo covered bond market.
A new record in terms of new issuers of EUR Jumbo
covered bonds is expected for 2008.
The continuous demand from real money accounts for
covered bond in the secondary market in recent days,
even though not in decent size, makes us feel
comfortable that the primary market for covered bonds
will be the first to re-open. But as full-year results of banks
will not be published in the first days of January, a new
issuance wave is unlikely. However, almost EUR 40 bn of
Jumbo covered bonds (26 benchmarks) were issued since
September. With around 20 inaugural issuers to be
expected in 2008 (more than in any recent year), new
issuers should continue to be the main driving force of
covered bond market growth, even though with less than
EUR 30 bn, this driving force lost some of its power in
2007 compared to 2006.
Number of new covered bond issuers declined in 2007
0
2
4
6
8
10
12
14
16
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
Number of New Issuers
Whereas 15 new issuers tapped the market in 2006, only
12 new issuers showed up in 2007 (including CRH, which
issued in benchmark format for the first time, and
Achmea, which introduced a new covered bond program).
As almost every big international bank (and also a lot of
regional banks) intend to establish a EUR Jumbo covered
bond program, we expect a new record number of new
issuers tapping the market in 2008.
New issuers brought around EUR 30 bn of new EUR
Jumbo covered bonds
0
5
10
15
20
25
30
35
2000 2001 2002 2003 2004 2005 2006 2007
Due to decline in issuance volume in 2007, share of
new issuers volume even increased slightly
0%
5%
10%
15%
20%
25%
2000 2001 2002 2003 2004 2005 2006 2007
Germany high Pfandbrief issuance volume expected
In 2007, EUR 33.5 bn of EUR Jumbo Pfandbriefe have
been issued. The outstanding volume of EUR Jumbo
public Pfandbriefe amounts to circa EUR 180 bn, the
outstanding volume of EUR Jumbo mortgage Pfandbriefe
to circa EUR 64 bn. Due to high redemptions, the
outstanding volume of German Pfandbriefe declined for
the fourth year in a row in 2007. The same should hold
true in 2008.
In the mortgage sector, the discussed increase of the LTV
for residential mortgage loans to be eligible for
Pfandbriefe, to 80% from 60% currently, could lead to
higher issuance. However, we do not expect the
amendment to come into force earlier than at the end of
H1 2008, if at all. Hence, it may not have a significant
impact on new issuance of Pfandbriefe. We expect EUR
Jumbo Pfandbrief issuance amount to around EUR 40 bn
(EUR 18 bn mortgage Pfandbriefe, EUR 22 bn public
Pfandbriefe). We expect that new issuers like Deutsche
Postbank will increase the issuance volume of mortgage
Pfandbriefe. The pooling model of Landesbanks and
savings banks may also finally appear on the Jumbo
Pfandbrief market. Given redemptions of around EUR 65
bn (circa EUR 13 bn mortgage, circa EUR 52 bn public),
we see a continuous decline in the outstanding volume of
EUR Jumbo Pfandbriefe. As non-Jumbo Pfandbriefe
continued to work well during the crisis, issuers may
easily shift between non-Jumbo and Jumbo funding and
vice versa, depending on market conditions. HSH
Nordbank is to issue its inaugural ship Pfandbriefe. We do
not expect another bank to issue ship Pfandbriefe in
Jumbo size. Deutsche Schiffsbank and NordLB will most
likely stick to the non-Jumbo market.
Public Pfandbriefe continue to dominate the
(declining) EUR Jumbo Pfandbrief market
0
50
100
150
200
250
300
350
400
J
a
n
-
9
5
J
a
n
-
9
6
J
a
n
-
9
7
J
a
n
-
9
8
J
a
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9
9
J
a
n
-
0
0
J
a
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1
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a
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2
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a
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3
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a
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4
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a
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5
J
a
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-
0
6
J
a
n
-
0
7
0.00
0.40
0.80
1.20
1.60
2.00
2.40
2.80
3.20
3.60
Total volume of outstanding Jumbo Mortgage
Pfandbriefe in EUR bn
Total volume of outstanding Jumbo Public
Pfandbriefe in EUR bn
Average size of Jumbo Pfandbriefe in EUR bn (RS)
German housing market not a major driver of
Pfandbrief issuance
With circa EUR 1.2 tn of total mortgage loans outstanding
at the end of Q3 2007, the German mortgage market is
the second-largest in Europe. UK ranks No. 1. With around
47% of the housing stock, rental housing dominates the
German market.
German house prices continued to fall
85
90
95
100
105
110
115
120
J
a
n
-
0
3
M
a
y
-
0
3
S
e
p
-
0
3
J
a
n
-
0
4
M
a
y
-
0
4
S
e
p
-
0
4
J
a
n
-
0
5
M
a
y
-
0
5
S
e
p
-
0
5
J
a
n
-
0
6
M
a
y
-
0
6
S
e
p
-
0
6
J
a
n
-
0
7
M
a
y
-
0
7
S
e
p
-
0
7
Existing Single Apartments
Existing Homes
Source: Hypoport
Moreover, subsidies for owner-occupiers were abolished
as of 1 January 2006. Hence, despite a low owner-
occupation rate of only 42%, new mortgage lending
should not be a driving factor of mortgage Pfandbrief
issuance. Also, for new issuers, the driving factor should
not be sharp growth in new lending, but existing collateral
or at least an existing good market position.
France like in 2007 strong new issuance expected
Due to high lending volume, issuance of French covered
bonds is likely to remain high. Uncertainty remains
regarding issuers of French structured covered bonds,
which may still be in the process of optimizing their
funding plans, taking into account the new funding tool
that has been extensively used by BNP so far. If market
conditions improve, French structured covered bond
issuance is likely to be very strong, amounting to up to
EUR 25 bn. On the other hand, issuance of Obligations
Foncires may amount to EUR 48 bn (in all currencies).
Hence, depending on the market conditions in different
currencies, EUR Jumbo Obligations Foncires issuance
may amount to EUR 40 bn.
Secondary market spreads not a good indication for
primary spreads
Secondary market spreads will likely continue not to
provide a good indication for primary spreads. E.g with
10Y Multi-Cedulas spreads at around ms + 32 bp and a
new issue pick-up of 5-6 bp recently, the primary market
spread is perhaps not where issuers want to tap the
market. Moreover, the secondary market spreads are
more indications than anything else. If a big block were to
be offered, spreads would likely widen significantly.

EUR 30-38 bn of Jumbo Cdulas expected
With 68 banks issuing Cdulas, the Spanish covered bond
market is (together with Germany) the deepest in terms of
participating banks. AyT still dominates the market with a
market share of 21%.
With a market share of 21%, AyT still dominates the
Cdulas market in terms of outstanding volume
BBVASM
15%
CAIXAC
1%
CAJAMM
10%
CAIXAB
11%
AYTCED
21%
BANEST
6%
PASTOR
1%
BANCLE
2%
SANTCF
0.5%
IMCEDI
6%
PITCH
0.5%
CEDGBP
2%
CEDTDA
9%
BPESP
2%
BANSAB
3%
SANTAN
11%
CAGALI
1%
Whereas EUR 55 bn of Cedulas were issued in 2005, EUR
65 bn (including EUR 4 bn Cdulas Territoriales) in 2006
and EUR 36 bn in 2007, we expect EUR 30-38 bn of
Cedulas issuance in 2008. The lower expectation is not
only based on concerns about access to the primary
market, but on reduced lending volumes and lower
volumes that are eligible for Cdulas funding due to the
increased OC requirement of 25% and the reduced LTV
for non-residential mortgage loans from 70% to 60%
(reducing the maximum issuance volume of Cdulas). In
January 2005, EUR 34 bn of Jumbo covered bonds were
issued, EUR 17 bn of which were Cedulas. These times
are gone, in our view. Moreover, we believe the issuance
of long-dated Cedulas is quite unlikely in the next months.
However, we do not expect the Cdulas market to remain
shut, particularly not for short-dated Cdulas of broadly
diversified banking groups. As the Bank of Spain and the
Spanish Confederation of Savings Banks warned that the
level of central bank borrowing by Spanish banks is not
sustainable long term, Spanish banks will have to come to
the capital market, providing investors a good position
regarding spread negotiations. Even though in other
banking systems the current amount of ECB lending may
also not be sustainable for the long term, the Spanish
economy is dependent on external funding, making the
situation much more pressing compared to e.g. Germany,
where Pfandbrief issuers typically find ways to use their
own Pfandbrief issues for ECB lending.
Growth of Spanish Cdulas flattened in recent
months
0
50
100
150
200
250
300
01-
99
08-
99
03-
00
10-
00
05-
01
12-
01
07-
02
02-
03
09-
03
04-
04
11-
04
06-
05
01-
06
08-
06
03-
07
10-
07
0.0
0.4
0.8
1.2
1.6
2.0
2.4
2.8
3.2
Total volume of outstanding Jumbo
Cdulas Territoriales in bn EUR (LS)
Total volume of outstanding Jumbo Multi
Cdulas in bn EUR (LS)
Total volume of outstanding Jumbo
Cdulas Hipotecarias in bn EUR (LS)
Average size of Jumbo Spanish Covered
Bonds in bn EUR (RS)
Domestic bid likely to remain low
The domestic bid might increase somewhat given that
Cdulas of other issuers will be eligible as substitute
assets up to 5 percent. But given that the assets in
Spanish insurance companies only amount to EUR 206 bn
and in pensions are only EUR 83 bn, the domestic bid in
Spain should remain limited, As a comparison, French life
insurance companies already had AuM of EUR 800 bn in
2003. German life insurance companies currently have
around EUR 650 bn of assets under management.
German pension funds administer around EUR 350 bn.
Hence, in our view, the Spanish bid for Cdulas will
remain in the single-digit percentage range. And the legal
amendment that allows substitute assets up to 5%, which
also allows Cdulas, should bring no significant change.
First, bank bonds are typically substitution assets; also in
other legal frameworks, like German Pfandbriefe.
However, it is unlikely that Cdulas issuers make
extensive use of Cdulas from other banks in their cover
pool. Even if this were done, the outstanding volume of
around EUR 275 bn of Cdulas could lead to EUR 13 bn
maximum demand. This may bring some small relief but
not change the structural domestic demand deficit. This
may also be a consequence of the fact that Spanish
households have a much higher share of their wealth in
property leading to the ownership ratio.
Impact of the strength of the legal framework
overestimated
Even though we think a strong legal framework for
covered bonds is crucial, we suspect that the impact of
the legal framework on spreads is currently
overestimated. E.g. the legal framework for Pfandbriefe is,
in our view, very strong. However, Fitch does not gives
German Pfandbriefe the best discontinuity factors. In our
view, the main reasons for Pfandbriefe trading so tight are
their negative net supply and the strong domestic bid. The
outstanding volume of German Pfandbriefe decreased for
the fourth year in a row. With the amendment of the legal
framework, we believe Cdulas should be considered as
founded on a sound legal basis. However, Cdulas trade
as wide as a lot of structured covered bonds based on
contractual law only. Due to the OC resulting from a high
mandatory OC and an even higher OC taking into account
the preferential claim on the whole mortgage book, the
need to have substitute assets to ease liquidity concerns
is not so pressing as in cases of covered bond with less
OC.
UK covered bond issuance with big question mark
The outstanding volume of EUR Jumbo covered bonds
amounts to EUR 61 bn. With a market share of 42%,
HBOS dominates the market.
HBOS still dominates the UK EUR Jumbo covered
bond market
NWIDE
15%
HBOS
42%
NRBS
18%
BRADBI
12%
ABBEY
6%
YBS
5%
HSBC
2%
Although most individual issuers bank credit quality still
looks sound, market access may require considerable
spread concessions due to housing market concerns. In
some cases, market access in general may be very
difficult. UK issuers may try to increase their non-Jumbo
issuance -- and in other currencies. With no UK covered
bonds coming due in 2008, there is at least no refinancing
pressure from the covered bonds side.
No UK covered bonds coming due in 2008 and 2009
Maturing
0
1
2
3
4
5
6
7
8
9
2
0
0
4
2
0
0
6
2
0
0
8
2
0
1
0
2
0
1
2
2
0
1
4
2
0
1
6
2
0
1
8
2
0
2
0
So far, there have been no taps of UK covered bonds.
GBP investors typically do not buy covered bonds. HBOS
social housing backed covered bonds in GBP are currently
the only exception in size. Given that the RMBS market
continues to be very difficult, UK issuers might take an
even harder look at covered bonds.
S&P recently compared different European countries
dependence on RMBS for mortgage refinancing.
UK highly dependent on RMBS funding
0
5
10
15
20
25
30
U
K
I
R
E
G
R
S
P
N
E
I
T
B
E
L
G
E
R
F
R
%

o
f

g
r
o
s
s

l
e
n
d
i
n
g
Source: S&P
Not only is UK the country with the highest dependence
on RMBS funding of mortgage loans, but this dependence
has also increased strongly since 2002. The outstanding
volume of UK RMBS amounts to over EUR 300 bn (as a
comparison, the total outstanding volume of German
mortgage Pfandbriefe as of 30 Sept 2007 amounted to
EUR 212 bn). S&P also said it expects renewed regulatory
focus on the adequacy of the current liquidity regime, and
potentially higher liquidity requirements for higher-growth
wholesale funded lenders in particular. In our view, such
an increase in regulation would be positive from a credit
quality perspective and hence support covered bonds,
which, first and foremost are bank bonds.
UKs dependence on RMBS funding increased steadily
0
5
10
15
20
25
30
35
2000 2001 2002 2003 2004 2005 2006 H1 07
%

o
f

g
r
o
s
s

l
e
n
d
i
n
g
Source: S&P
Given the difficult conditions in the primary market for
RMBS, UK issuers will likely take an even closer look at
covered bond (UK building societies are not allowed to
issue RMBS; hence, they have not relied on RMBS in the
past anyway).
Given the continuous negative news flow regarding the
UK housing market, the primary market for UK covered
bonds will remain difficult, in our view. However, as full
recourse bank bonds should continue to better bid than
segregated securitized mortgage portfolios, we do not
expect the UK covered bond market to remain completely
shut. UK issuers paying the right price should be able to
find buyers. Given the ongoing uncertainly, we expect UK
issuers to issue around EUR 20 bn.
Outstanding volume of UK covered bonds increased
continuously
0
10
20
30
40
50
60
70
2000 2001 2002 2003 2004 2005 2006 2007
Monthly issuance never exceeded EUR 6 bn
0
1
2
3
4
5
6
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2003 2004 2005 2006 2007
Ireland only mortgage ACS expected
The outstanding volume of EUR Jumbo ACS amounts to
EUR 37 bn. As WestLB covered bonds bank (quite
successfully) focuses on non-Jumbo issues and Depfa
seems to focus on USD issues in Jumbo format, the Irish
market may see only mortgage-backed ACS, residential
and commercial (issued by Anglo Irish) in 2008. Allied Irish
bank successfully tapped its 2017 issue by EUR 175 m
recently. Generally, Irish issuers might increase their share
of taps, non-Jumbo and foreign currency issues. In EUR
Jumbo Format, EUR 7 bn seem likely, depending on
market sentiment.
Depfa still dominates the EUR Jumbo ACS market
DEPFA
56%
BKIR
16%
AIB
19%
WESTLBCB
9%
US difficulties to access EUR covered bonds
In our view, US issuers might well be willing to issue EUR
6-8 bn in covered bonds each. Given the continuing
uncertainties in the US housing market, we doubt that US
issuers have access to the EUR covered bond market. A
successful USD issue could inject trust in the market and
open EUR funding opportunities. A significant pick-up to
other EUR covered bonds would likely be required. If
default statistics do not deteriorate further in Q1 and Q2,
investors might gain some new confidence.
Canada very different than US
AAA-rated EUR-denominated Canadian covered bonds
should continue to benefit from a general shortage of AAA
EUR Canadian exposure. Due to years of budget surplus,
the government bond market is almost non-existent. We
expect every major Canadian bank to set up a covered
bond program. Some issuers like Royal Bank of Canada
will likely even tap the market two or three times a year,
partly also in USD. With over 30%, the first issue of Royal
Bank of Canada received strong demand from Germany
too. Fundamentally, the Canadian mortgages benefit from
some specifics like the fact that there is no lending with a
LTV higher than 80% (if so, a mortgage insurance is
required for the part above 80%), interest rates are not tax
deductible (other than in the US) and banks are allowed to
charge prepayment penalties (preventing constant
refinancing, as is common in the US). All in all, even
though Canada might not be able to fully withstand an
economic downturn in the US, we believe fundamentals
of Canadian covered bonds look sound. We expect Bank
of Montreal and Bank of Nova Scotia to tap the EUR
Jumbo covered bond market in Q1 2008. Total 2008
issuance volume might amount to EUR 8 bn.
EUR 14 bn from Portugal and EUR 10 bn from Italy
Portuguese covered bonds benefit from a strong legal
framework and limited long-term supply. The whole
mortgage market amounts to only around EUR 90 bn.
Hence, despite a very low domestic bid, we expect
Portuguese issuers to have no problems accessing the
market. With Banco Espirito Santo, and Santander Totta
further issuers should follow. Caixa Geral and BCP may
tap the market, perhaps twice a year. Also public sector
covered bonds might be issued out of Portugal. With
Unicredit, Banca Opi (subsidiary of Intesa Sanpaolo SpA),
BPU, BPM and Banca Carige expressing interest in issuing
covered bonds, Italian covered bonds may well amount to
EUR 10 bn at the end of 2008. In addition, CDP might
again tap the market (under the current program or under
the new law). Housing market concerns are as limited as
credit quality concerns about Italian banks. However, the
wide spread levels of BTPS may burden new issue
spreads.
Nordic covered bonds continued stability expected
With DnB NOR, Sparebank 1, Terra and BN Bank four
Norwegian issuers will have tapped the market, with
issuance volume expected to amount to around EUR 7 bn.
As acknowledged in a new S&P report, Swedish and
Danish banks typically rely heavily on wholesale funding.
However, the domestic mortgage/covered bond market
strongly supports funding and liquidity. Nordea,
Stadshypotek and SBAB plan to continue issuing in EUR.
Besides SEB, Swedbank is expected to join the EUR
Jumbo covered bond market in 2008. As SEB issued
Pfandbriefe in the past via its subsidiary SEB AG (typically
trading very tight), the new issue via SEB AB should bring
an interesting comparison between Nordic covered bond
and Pfandbriefe against the backdrop of the question
about the adequate spread difference.
New issue volume could amount to EUR 14 bn. Like
Norwegian banks, we expect that Swedish banks will
continue to look at CHF funding. With EUR 2 bn of
expected issuance, OP Mortgage Bank will likely be the
only EUR Jumbo issuer out of Finland. We believe Aktia is
likely to continue to issue non-Jumbos. With Danske and
Nykredit the most probable issuersk, in our view, EUR 4
bn might be possible out of Denmark. According to our
understanding, Danske will have two pools -- one Danish
domestic and one international with Norwegian, Swedish
and Irish mortgages. In case of Nykredit, it seems unclear
yet that they will tap the market in 2008. Due to stable
banks and less housing market concerns, we continue to
see Nordic covered bonds as fundamentally very safe.
S&P commented that Swedish and Danish banks have a
high wholesale funding dependency. In line with S&P, due
to strong domestic mortgage/covered bond markets, we
remain confident on these markets.
New markets
Being mainly a non-Jumbo market in recent years, Lettres
de Gage might experience a revival in 2008 by issuance
through Dexia. The total Luxembourgian covered bond
market amounts to around EUR 34 bn (end-2006: EUR 28
bn), whereas the outstanding volume of Jumbo Lettres de
Gage amount to only EUR 2.25 bn currently. Given the
lack of public covered bonds supply, we are confident that
if Dexia emerges as a Jumbo Lettres de Gage issuer,
given the strong legal framework and the strong issuer
credit quality, investor demand should be substantial,
certainly depending on the spread. Japan, Australia,
Greece, Turkey and Croatia are also potential new issuers.
In our view, Japan, Australia and Greece are most likely to
tap the market in 2008.
Bernd Volk (49) 69 910 31967

UK
Overview

We believe the UK economy will be impacted
severely by the global deleveraging that we are
seeing in financial markets

The combination of significant levels of household
debt, coupled with large mortgage resets, and
tightening credit standards will make life difficult
for consumers

Rising foreclosures, increasing refinancing costs
for smaller volumes and tighter margins on the
other hand will put pressure on banks and
mortgage originators

We see the risks skewed firmly to the downside
compared to current market pricing. We retain a
long position in the front-end of the UK curve, as
well as 2Y-10Y steepeners

For the long-end we see the risk of a re-
appearance of the LDI bid, as long-end valuations
have normalized somewhat and pension fund
activity has been slow in Q4
Consumers feel the heat
The leverage of the UK consumer is not only significantly
higher than that of its mainland counterpart, but has also
been increasing much more rapidly. Since 1999, the ratio
of consumer debt to GDP has increased by 36 pp in the
UK to over 100%, compared to only 13 pp (to 54%) in the
Eurozone. This obviously makes the UK economy much
more vulnerable to a change in the availability and cost of
credit, in particular given the clear overvaluation in the UK
housing market (see A sharper slowdown, UK Housing
Watch, 4 December 2007). We see two main risks:

a tightening of credit standards, which will make the
rolling of existing obligations more difficult

an increase in margins/rates as existing obligations
are refinanced
We therefore believe we are likely to see more tangible
evidence of the de-leveraging of financial markets and
consumers in the UK, than in the Eurozone.
Leverage of the consumer poses risks to the economy
Household credit % of GDP
50%
60%
70%
80%
90%
100%
110%
1993 1995 1998 2001 2003 2006 2009

The evidence from the mortgage market suggests that we
will be seeing a significant amount of loans resetting over
the coming quarters of 2008, similar to the mortgage
resets experienced in the US over the second half of
2007.
Loan resets to pick-up in Q4 2007
0%
2%
4%
6%
8%
10%
12%
Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4
2007 2008 2009
We also see these resets taking place at significantly
higher interest rates, with even the prime sector
experiencing rate shocks in the order of 20-30% (see
chart below). Our colleagues in RMBS research have also
collated some evidence of the non-price components of
the lending decision with significant evidence of tighter
borrowing criteria (see Spotlight, European
Securitisation Monthly, December 2007). In the near-
prime sector, LTVs have been lowered on average by 5
pp, while in the riskier segment of the non-conforming
market, LTVs have been lowered by as much as 10 pp.
Resulting in large payment shocks
-50%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
01 02 03 04 05 06 07
75% LTV Refi to cheapest
mortgage
75% LTV Refi to 2yr fixed
mortgage
With the availability of credit coming under pressure we
would expect to see a further increase in foreclosures and
repossessions, the early signs of which are clearly visible
in the data.
Repossessions are picking up and may rise further
0
25
50
75
100
125
150
175
200
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
Claims
Orders

With the effects of the credit crunch so visible not just in
the non-conforming mortgage market, but also the prime
mortgage market, one would expect the tightening of
credit in the unsecured lending market to be even more
severe. The evidence we have suggests that certainly on a
price basis we are seeing a more significant adjustment
within this space. The Bank of England data suggests that
for unsecured lending, rates have increased as much as
100 bp since the summer, while for mortgage lending, the
rate increases have been closer to 25 bp. The buy-to-let
market (16% of outstanding mortgages) in particular
raises concerns: with average rental yields below
mortgage rates this market has clear speculative
elements; the dominance of specialized lenders in this
sector highlights the significantly higher stress in funding.
Lenders under pressure, too
Lenders are also coming under pressure, not only
because of the increase in delinquencies highlighted
above, but also, because of the very sharp increase in
funding costs across the entire liability spectrum.
Refinancing costs are rising not just in money markets
-40
-20
20
40
60
80
100
120
140
160
180
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07
Weighted Prime RMBS Spread
Weighted Non-conf RMBS Spread
UK Covered Bond Spread
GBP Libor vs Base

Lenders are effectively caught between a rock and a hard
place. Not passing the increase in funding costs onto
borrowers leads to significant reduction in margins and
erosion of profitability. Even banks with relatively diverse
funding options such as HBOS report new mortgage
lending spreads of around 5bps, with lending done on the
assumption of a normalisation of base rate / libor at some
point helping margins recover somewhat. However, as
long as liquidity conditions remain as challenged as at
present, substantial pressure on margins and earnings
forecasts are inevitable.
The BoEs announcement on Wednesday (providing 3M
liquidity against a wide pool of collateral through a variable
rate tender with the base rate as the minimum rate)
should alleviate some of the funding issues at UK
institutions. However, even assuming the BBR/LIBOR gap
does normalise, the overall remaining increase in the cost
of bank funding - both in savings and in wholesale markets
- and an increased demand for balance sheet strength and
greater liquidity by bank managers and investors means
that credit will cost borrowers more and will be harder to
source in future. This is expected to lead to further
declines in leverage asset prices (esp. residential and
commercial property), higher bank bad debts and lower
economic growth.
Risks to the downside
We believe that the risks to consensus growth forecasts
lie firmly to the downside. Since we are at unchartered
levels in terms of the build-up in credit since 1999, the
impact of the reversal of this trend will be very difficult to
gauge. What leading indicators are available are pointing
to a significant cooling of economic activity since this
summer.
PMIs point to downside risks for growth
40
45
50
55
60
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
-0.75
-0.50
-0.25
0.00
0.25
Weighted PMI index (lhs)
Change in repo rate, % (rhs)
BoE
easing
range
SoSource: Deutsche Bank
So while the market is indeed pricing in a fairly aggressive
easing cycle from the Bank of England, we believe that
the risks remain skewed to the BoE acting faster and
cutting deeper than what is currently priced in. We
therefore maintain our longs in the front-end of the
UK curve.
Even relative to current market pricing we see upside
in long front-end positions in GBP
4.25
4.50
4.75
5.00
5.25
5.50
5.75
6.00
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08
Base rate pricing (assuming 6 bp SONIA spd)
Base rate
We see two main risks to our view: First, the easing in
monetary conditions that we believe is necessary to
buffet the impact of tightening credit conditions could at
least in part take place through a further depreciation in
GBP. Second, a significant pick up in inflation through
either a weaker currency or through passing through of
the price pressures visible in the leading indicators, which
would make it very difficult for the BoE to outcut current
forward pricing.
We would therefore also maintain steepeners as a core
position within our portfolio, which we believe should also
perform on concerns that the BoE is acting too
aggressively. The risk to this position is a return of the LDI
bid in the long-end of the curve, which would also expose
the 2Y-10Y sector of the curve to further flattening risk.
A review of the long-end
One of our main positions on the UK curve in 2007 has
been our long-end normalization trade. We argued a year
ago, that the main driver of the further inversion of the
long-end of the UK curve over the course of 2006 had
been the consistent underestimation of the Bank of
Englands rate hikes. Stripping out the directionality of
10Y-30Y with respect to 2Y rates would therefore yield a
much cleaner way of trading the long end of the curve.
This measure of the excess flatness of the long-end has
almost normalized over the course of this year, as the
combination of corporate and government long-end and
Linker supply has filled the demand from pension funds
for inflation protection and duration.
Excess flatness of 10Y-30Y has corrected
-0.40
-0.30
-0.20
-0.10
-
0.10
0.20
0.30
0.40
00 01 02 03 04 05 06 07
GBP 10-30 slope regressed on 2Y
With hindsight, we had recommended taking profits on
this trade somewhat early (see FIW 5 October 2007), as
the LDI bid we had been expecting in November failed to
materialize. Against the backdrop of reduced corporate
supply and the risk of reduced Gilt issuance in 2008/09
relative to current expectations a re-emergence of pent-up
LDI demand could renew pressures on the long-end of
the UK curve.
But is now at risk from further de-risking of pension
funds
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
-
0.05
0.10
J
u
n
-
0
5
A
u
g
-
0
5
O
c
t
-
0
5
D
e
c
-
0
5
F
e
b
-
0
6
A
p
r
-
0
6
J
u
n
-
0
6
A
u
g
-
0
6
O
c
t
-
0
6
D
e
c
-
0
6
F
e
b
-
0
7
A
p
r
-
0
7
J
u
n
-
0
7
A
u
g
-
0
7
O
c
t
-
0
7
D
e
c
-
0
7
5000
5500
6000
6500
7000
10-30 residual
FTSE-100
With current deficits on aggregate having been closed we
believe that the LDI bid we had been expecting for the
end of the year in line with normal seasonality may
instead come in early next year, as the de-risking
incentives remain very powerful.
Given current surplus, the de-risking incentives are
powerful
-120,000
-100,000
-80,000
-60,000
-40,000
-20,000
0
20,000
02 03 04 05 06 07
FRS17 Surplus - FTSE 350 Co's (m)
Source: Watson Wyatt
The changes to the PPF levy enacted and proposed may
also provide further incentives to accelerate the de-risking
of pension funds. The PPF levy is now charged up to a
higher level of solvency, and the PPF has not ruled out
returning to a risk based levy which would add significant
pressure to the long-end.
Typical Q3 seasonal flattening pressure did not
materialize risk for Q1?
-0.15
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
feb mar apr may jun jul aug sep oct nov dec
%
Another key risk going into next year is corporate supply.
Q4 linker and long-end issuance was at its lowest level
since 2005, and the outlook for next year remains highly
uncertain. PFI issuance is dependent on the support of
monolines, and given the strains they find themselves
under due to their involvement in the subprime market,
this raises question marks over their ability to print
significant new business in this sector. Also, issuance in
USD and EUR remains easier for UK corporates than in
GBP, given the relative market sizes.
Corporate issuance needs to recover for long-end
valuations to remain stable
0
1
2
3
4
5
6
7
8
9
10
Q1
05
Q2
05
Q3
05
Q4
05
Q1
06
Q2
06
Q3
06
Q4
06
Q1
07
Q2
07
Q3
07
Q4
07
Non IL (>15)
Index Linked
b
non-gilt sterling long dated issuance
Gilt issuance for the remainder of the fiscal year, in
particular in the long-end of the curve is somewhat higher
than in Q4 (but similar to Q1 07), with GBP 10.7 bn of
long-dated and linker issuance expected compared to GBP
8.5 bn in Q4.
Gilt supply in Q1 reasonably high
Issuance Q1'08
0.00
0.50
1.00
1.50
2.00
2.50
3.00
S M L Inflation Linked
Jan-08
Feb-08
Mar-08
bn
However, the bigger risk is the fact that Gilt issuance is
expected to come down reasonably sharply from 2007/08
to 2008/09, from GBP 58.4 bn to GBP 50 bn (see UK
Review & Outlook: The risks to Gilt issuance, Focus
Europe, 26 October 2007). There are also further
downside risks to this forecast, since our economists see
a reasonable chance that the current fiscal year is over-
funded.
But 2008/09 issuance is lowest for three years
0
5
10
15
20
25
30
S M L I/L
2006/07
2007/08
2008/09
bn

Ralf Preusser (44) 20 7545 2469
Francis Yared (44) 20 7545 4017

GBP Derivatives

The second half of 2007 has turned-out to be the
period when the excess leverage in the financial
system finally began unwinding and volatility
rebounded from the lows

GBP Gamma outperformed EUR Gamma since
late August as it became apparent that the
inadequate response of the authorities to the
liquidity crisis, the Northern Rock debacle and the
vulnerability of the UK economy were increasingly
likely to result in rate cuts

The degree of inversion of the Gamma curve
makes long forward volatility trades attractive.

The low level of GBP vega, the seasonal patterns
in LOBOs issuance and the likely lower
availability of banks funding for local authorities
makes long dated GBP vega attractive

Back in July, the UK Treasury announced that it
was envisaging measures to promote the use of
long term fixed rate mortgages in the UK.
Assuming that prepayment risk will be borne by
the lender, if the issuance of fixed rate mortgages
does take off, it will generate additional vega
demand which will be positive for Vega.

Given the recent market development and the
interest rate reset risks faced by consumer, it is
possible that fixed rate mortgages will now
appear more attractive to borrowers. However, on
the supply side, the appetite for launching new
mortgage products which involve additional
prepayment risk taken by the lender is in all
probability low.

Thus we do not consider the development of the
long term fixed rate mortgage market as being
imminent although the most recent market
development probably highlighted the benefit for
the economy to have such a product on offer

2007- The return of volatility
when excess leverage in the financial system finally began
unwinding and volatility rebounded from the lows.
Gamma in GBP (in line with other markets) bounced back
from the lows achieved in March 2007 first on the back of
the bear steepening of the curve and subsequently as a
result of the liquidity and credit crisis.
GBP Volatility in 2007
45
50
55
60
65
70
75
80
Gamma
(3M10Y)
Vega (5Y5Y)

GBP Gamma outperformed EUR Gamma since late
August as it became apparent that the inadequate
response of the authorities to the liquidity crisis, the
Northern Rock debacle and the vulnerability of the UK
economy were increasingly likely to result in rate cuts. The
steep inversion of the Gamma curve which has reached
extreme levels is also giving rise to some interesting
relative value opportunities which we explore below.
GBP Gamma outperformed EUR Gamma as the crisis
unfolded
45.00
55.00
65.00
75.00
85.00
95.00
105.00
M
a
r
-
0
3
J
u
l
-
0
3
N
o
v
-
0
3
M
a
r
-
0
4
J
u
l
-
0
4
N
o
v
-
0
4
M
a
r
-
0
5
J
u
l
-
0
5
N
o
v
-
0
5
M
a
r
-
0
6
J
u
l
-
0
6
N
o
v
-
0
6
M
a
r
-
0
7
J
u
l
-
0
7
N
o
v
-
0
7
EUR 3M10Y
GBP 3M10Y
GBP vega on the other hand continues to be mostly driven
by LOBO activity. The unwind of some LOBO transactions
and their corresponding hedges in Q2, when rates backed
up, was positive for Vega. But increased LOBO supply in
Q3 generated downward pressures on Vega.
GBP Volatility in 2007
45
50
55
60
65
70
75
80
Gamma
(3M10Y)
Vega (5Y5Y)

.
Outlook for 2008
Go long forward volatility
As we mentioned above, Gamma has generally been well
bid and short expiries in particular have outperformed the
rest of the grid. As a result, the volatility surface is highly
inverted.
GBP Volatility Surface
2y 5y 7y 10y 20y 30y
1m 94.9 82.6 78.1 74.3 66.6 64.4
3m 90.0 77.6 73.3 69.7 63.8 61.8
6m 87.3 75.3 71.2 68.2 62.0 59.1
1y 81.5 70.3 67.2 63.3 58.2 55.5
2y 73.0 65.7 63.0 60.1 55.7 52.1
5y 62.4 59.7 58.0 56.1 51.0 47.7
7y 58.7 57.1 56.0 55.2 49.8 45.8
10y 56.7 54.9 54.4 53.2 47.7 44.0
20y 49.3 49.1 48.3 47.1 42.9 39.3

Mean reversion in rates and in volatility will generally
result in a volatility surface which will be downward
sloping when volatility is high and upward sloping when
volatility is low. However, a strongly inverted volatility
surface (such as the one in place at the moment) can offer
opportunities to be long forward volatility. We believe that
such a strategy would be attractive as we expect the
current volatile environment to persist
Hence, we like to go long forward volatility in GBP.
We like to express this in terms of a gamma neutral
calendar spread as Forward Volatility Agreements (FVA)
are not liquid in GBP. Our favoured point to express this
view is 6M fwd 6M 10Y Volatility (as discussed in FIW 23
Nov 2007).
6m forward-6m10y Vol is attractive
40
50
60
70
80
90
100
Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07
6m10y vol
6m fwd 6m10y vol
6m fwd 6m10y
Go long Vega
While forming our expectations for LOBO issuance in
2008, we consider the relative share of local authority
funding from government vs. banks and the seasonal
nature of this borrowing.
Over the past two years, the share of financing from the
government has gone up relative to bank financing. Local
authorities have therefore funded more at a fixed rate
from the government, relative to the financing from banks.
Moreover there are some seasonal patterns in LOBO
issuance: issuance in Q1 tends to be lower than in Q4.
More systematic LOBO issuance in Q4 relative to Q1
-200
-100
0
100
200
300
400
500
600
700
Q1 Q2 Q3 Q4
2003 2004 2005 2006 2007
mn
We look to find a similar pattern in long dated volatility. To
remove the effect of trends affecting the whole volatility
surface, we look at the residual of 15Y15Y volatility (proxy
for long dated vega) regressed on 5Y5Y volatility (proxy for
the first principal component of the volatility surface). We
find that the residual tends to decrease in Q4 and increase
in Q1. The one exception has been Q1 2004, when there
had been unusually high issuance of LOBO.

Seasonal residuals of 15Yx15Y regressed on 5Yx5Y
Q4 Q1
2007 0.32 -0.57
2006 -1.04 2.86
2005 -0.47 0.93
2004 -4.08 -2.48
2003 3.77 2.81
2002 -0.23 0.48
2001 -4.4 3.8
2000 -2.85 5.96
Given the current liquidity crisis, the rising cost of
borrowing for UK banks and the pressures on their
balance sheet, we would expect lower LOBO issuance
next year as borrowing from government becomes more
attractive. We therefore like to enter 2008 long GBP
vega.
Development of long term fixed rate mortgage in the
UK
Back in July, the UK Treasury announced that it was
envisaging measures to promote the use of long term
fixed rate mortgages in the UK. The introduction of long
term fixed rate mortgages would involve the hedging of
the early prepayment risk as it is unlikely that consumers
would be willing to pay repayment charges at the time of
prepayment. Such prepayment risk would generate a
natural bid for low strike receivers, as prepayments are
more likely when rates are low. The DMO considered
supplying low strike receiver swaptions to the market to
cover such potential demand. However, we do not believe
that it will be in the DMOs interest to sell low strike
receivers. The DMO is indeed more likely to face
increased funding needs when the economy is doing
poorly which is likely to be when rates are low. Thus, the
DMO will be faced with additional liabilities resulting from
the written options exactly at the time when pressures on
public finance will be the highest. Thus, we would expect
that if the issuance of fixed rate mortgages does take off,
it would generate additional vega demand which may not
be matched by the DMO issuance (if any) of swaptions.
This would be a positive for the vol market.
Given the recent market development and the interest
rate reset risks faced by consumer, it is possible that fixed
rate mortgages will now appear more attractive to
borrowers. However, on the supply side, the appetite for
launching new mortgage products which involve
additional prepayment risk taken by the lender is probably
low in current market environment. Thus we do not
consider the development of the long term fixed rate
mortgage market as being imminent although the most
recent market development probably highlighted the
benefit for the economy to have such a product on offer.
Aditya Challa (44) (020) 7547 5966
Alessandro Cipollini (44) (020) 7547 4458
Gopi Suvanam (44) (020) 7547 5966
Francis Yared (44) (020) 7545 4017
EMEA

Three key global factors will drive rates returns in
EMEA in 2008: high non-core inflation, the global
growth slowdown and the continued effects of
the credit crunch

These will be superimposed on the idiosyncratic
factors of each market: the expectations and
pricing of supply and demand of government debt,
monetary policy and inflation expectations

We are bearish on the outlook for Poland and
Hungary and bullish on Turkey and Israel

Over the course of 2008 we expect most rates
curves in EMEA to steepen with the ZAR curve
likely to disinvert by 100bp

We recommend exposure using real rates to take
market exposure in Turkey and Israel over Q1
before switching to nominal assets for H2

Position for Q1 rate cuts using HUF 2Y-10Y
steepeners; receive the PLN 3X6 FRA at 6.1%

Inflation is cheap in Poland: buy the Aug-16 CPI-
linker and pay PLN 10Y

We maintain our short-term recommendation to
pay ZAR 5Y rates. We also keep our Euro-entry
risk-reward position in Slovakia through paying
SKK 2Y against EUR 2Y
EM 2008: ten in a row?
In 2007, emerging markets produced their ninth straight
year of positive returns to both external (USD-
denominated) and local debt markets. Recovery after the
disaster of 1997/98 was slowed by the bursting of the
equity market bubble 2000-02, but subsequent years have
seen strong returns and vigorous growth of emerging
markets as an asset class. Investor inflows have reflected
an on-going asset allocation into EM and become
increasingly focused on local currency as opposed to
external debt markets as yields have diminished in the
latter and opportunities and access have grown in the
former. International investor portfolio flows have boosted
EM currencies, compressed bond yields and allowed
governments to increase local market issuance and
extend their debt maturity profile.
2008 will prove to be an interesting year for emerging
markets as growth across G10 economies is set to slow
significantly on the back of the credit crunch. In previous
cycles, a downturn in G10 would have affected emerging
markets through a combination of lower commodity
prices and lower demand for exports leading to a rapid
worsening of the external accounts. The virtuous cycle of
current account surplus and net FDI is replaced by a
vicious cycle of portfolio and debt-creating flows and
higher local interest rates. Whilst there should be some
deterioration of the EM balance of payments next year,
the fundamental improvement seen over past few years
has been impressive and the average credit rating of EM
indices is at all time highs. Furthermore, it is hard to
discount the possibility of a continuation of the asset
allocation into EM that has been so supportive whilst
global credit markets were falling apart in 2007.
Most probably a robust response from EM is largely in the
price but even so, it is difficult to take a too bearish
outlook when the central global scenario is for weakness
in H1 followed by rebound in H2. With this in mind, we
adopt a relatively market-neutral approach to the 2008
outlook with a focus on both discrepancies between the
local pricing of global stories and any idiosyncratic themes.
EMEA 2008: three key factors
EMEA is probably the most diverse of the three principal
regions of EM (the other two being LatAm and Asia) and
one of the best examples of this diversification is the
monetary policy cycle. With Turkey and Hungary cutting
rates, Poland, Czech Republic, Israel and South Africa
hiking and the Slovaks in the waiting room for Euro-entry,
2008 provides the opportunity for a strong divergence
between the returns of different rates markets.
In our view there are three key factors which will mostly
determine returns in EMEA local markets over the course
of the next twelve months. All three of these are global
factors and the differential response of the EMEA markets
will be determined by a combination of idiosyncratic
fundamental factors and current market pricing.
Non-core inflation and the central bank response.
Surging food and energy prices have pushed headline CPI
readings much higher over recent months. Given that
most central banks tend to target headline rather than
core CPI, in some cases inflation now exceeds top of the
target band. In many cases policy makers have alluded to
the temporary or non-core origins of the inflationary
divergence and therefore are looking through the CPI
spike to lower levels over the next 12-18 months.
Core market driven growth slowdown and the central
bank and fiscal response.
The dilemma for EMEA central banks will be how to react
to a slowdown in growth whilst inflation remains high. DB
expects the US to slowdown considerably in H1 07 before
rebounding in H2. If this is the case, then it will add
further caution to any policy response to higher-than-
expected inflation levels and in some cases lead to a
wait and see approach to determine the knock-on
effects on the local economy. However, any rebound in
US growth should mean that the medium-term impact on
EM economies is minimal.
On the fiscal side, there are risks that after several years
of fiscal out-performance on the back of strong GDP
growth, 2008 proves the first reversal. Given the strong
position of most countries in the region this is not a big
directional risk but will make a difference at the margin.
The tightness of global credit markets and their
impact on EMEA in 2008.
Current account deficits are widespread across the region,
especially in the new EU member states. Whilst FDI has
historically been the principal source of financing (and
major cause) of the current account deficit, the growth of
FX-denominated borrowing by households has become
increasingly important. This has led to a reduction of the
effectiveness of the policy rate in monetary policy and a
deterioration of external fundamentals. Whilst this is
principally a macroeconomic issue in markets such as the
Baltic States and Bulgaria, which are too small and illiquid
to be dealt with here, Hungary finances some 50-75% of
its current account deficit through consumer borrowing in
CHF and even JPY. Continued tightness of liquidity across
G10 market and raised funding costs will reduce both the
attractiveness and availability of this financing.
Furthermore, the build-up of external debt increases both
balance-sheet and cash flow vulnerabilities and raises the
risk of currency devaluation and disruption of local equity
and bond markets. Rates markets are especially
vulnerable as any currency weakness will be countered by
a tightening of monetary policy.
The second effect of the tightness in credit markets is the
departure of money market rates from policy rates and
policy rate expectations. This is most keenly shown in the
USD, EUR and GBP markets, but as we have noted before,
there has been a substantial widening of the spread
between interbank and the policy rate in Poland and to a
lesser degree in Czech Republic. Whilst this is likely being
exaggerated by year-end funding concerns, the principal
cause is a lack of ready funding for bank balance sheets, a
factor that is unlikely to disappear as the calendar moves
over to 2008.
These three factors are our central themes for 2008 and
should lead to four main investment conclusions:
1) Buy CPI-linked bonds. These are available in four
markets in the EMEA region and are conveniently
linked to headline rather than core CPI so they will
receive the full benefit of the high CPI. Furthermore,
the lack of central bank action should keep real rates
steady.
2) Receive rates in markets where implied tightening
is too aggressive; and, of course, pay rates where
too much easing is expected. Lower growth will
mean less aggressive central banks. In 2008, the key
switch in this investment strategy will be between
the CPI-linked bonds mentioned above and nominal
rates to take full advantage of any slowdown.
3) Curve steepeners. Given that we expect growth to
slow only temporarily in core markets, any implied
monetary loosening by EMEA central banks is also
likely to be temporary. Along with G10 rates markets
we expect curves will steepen as the longer-term
growth outlook appears solid and inflationary risks
remain.
4) Pay rates in countries which have a heavy reliance
upon debt financing of current account deficits.
There is only downside for receiver positions in these
markets as currency weakness and tight local liquidity
are both bad for rates.
Finally, there are two clear risk scenarios which need to
be considered when evaluating any investment decision in
2008:
What happens if global growth falls by much more
than expected?
The idea of a US recession in 2008 is moving into the
mainstream of market thinking. A recession in the US and
corresponding drawdown of US demand for emerging
market exports would not be a positive for EM. External
accounts would deteriorate as current accounts moved
from surplus to deficit and capital accounts suffered
outflows as equity markets were re-rated; currencies
would likely weaken. Given that most markets in this
region have current account deficits, they might benefit
from any falls in commodity prices, but surely this would
be overwhelmed by outflows on the capital account.
The degree of weakening will likely be governed by the
extent of portfolio outflows from the capital account.
These would have a greater effect on the typical high
beta countries like Turkey and South Africa, but central
Europe would not be immune. Central banks would be
torn between lowering rates to stimulate growth and
raising rates to combat the inflationary effects of a weaker
currency. The overall outcome for rates market is
therefore unclear although it is likely that Turkey, South
Africa and Hungary will underperform the rest.
What happens if inflation does not come down?
Clearly, one of our major assumptions is that the higher
levels of non-core inflation seen globally are a temporary
phenomenon and that once food and energy prices
normalise, or at least stop increasing, then CPI will
eventually fall. Currency targets aside, all central banks in
the region have a single mandate controlling inflation
and therefore it is imperative for our second strategy that
there are few second round effects. With most labour
markets in the region at their tightest levels for several
years, a lack of second round effects is not a given.
Indeed, in this way, South Africa could be ahead of the
curve compared to the rest of this region as second-round
effects are thoroughly entrenched and the SARB are
fighting to restore credibility.
South Africa therefore forms a useful model and one
which gives a uniformly bad outlook for rates in a higher
inflation scenario. The CPI-linker recommendation will
benefit from higher CPI but should also lose-out to higher
real rates. Furthermore, curve steepener positions will
quickly reverse into bear-flatteners. We seek to combat
this risk through paying rates in countries where pricing is
too dovish to hedge the positions in our favoured longs.
EMEA 2008: supply and demand
In general, fiscal financing plans across the region are
little-changed relative to those in 2007. In most cases,
government fiscal balances have benefited from the
economic cycle and given that most growth projections
are little changed from 2007, fiscal balances are projected
to be largely in-line. The one key change in the region is
Hungary where the benefits of the September 2006 fiscal
package will be palpable: net issuance is set to fall about a
third from the peak in 2007 and the debt management
agency, AKK, have announced that auction frequency will
fall from 2 weeks to 3 weeks.
The chart shows the level of monthly gross issuance
expected for 2008 against that in the past two years.
Changes in net issuance are largely masked by
redemptions, which largely account for the expected
surge in gross issuance in Poland. In Israel, the increase in
gross issuance relates to our uncertainty over the level of
non-market issuance. The Israeli Ministry of Finance has
reduced issuance of non-marketable bonds over recent
years but these bonds, issued to local pension and
insurance companies form an important minority share of
domestic financing.
For the demand side, we can construct a model for
government debt demand by splitting the investment
community into three broad groups: local real money
asset managers, local banks and non-residents. For this
analysis we forecast demand from asset managers and
local banks and assume that non-resident demand will be
the residual.
Monthly average gross domestic debt issuance
0
1
2
3
4
5
6
7
Czech
Rep
Hungary Poland Slovakia South
Africa
Turkey Israel
2006
2007
2008
USD bn
Notes: budgeted gross issuance in 2007 on a monthly basis. Source: Deutsche Bank, Czech MoF, AKK,
Poland MoF, ARDAL, SA Treasury, Turkey Treasury, Israel MoF
Local asset managers
Institutional investors in the local market can be divided
into three main groups: pension funds, mutual funds and
insurance companies. We give a comprehensive overview
of pension funds in the region and in the rest of EM in
The rise of pension funds in emerging markets,
published 13
th
July 2007. Most pension funds are defined
contribution schemes which are essentially a growing
pool of cash which is invested in local assets under a
series of asset allocation rules. In the case of Poland,
Hungary and Slovakia, these state-run schemes are
growing rapidly, whilst the more mature systems in Israel
and South Africa are more stable. Turkey and Czech
Republic lack a large pension fund industry and therefore
their importance as investors is smaller. South Africa aside,
asset allocations tend to be quite conservative with large
holdings of cash and fixed income. In Israel, the majority
of most pension schemes remains invested in non-
marketable ear-marked government bonds, although
the restriction in supply of this debt is slowly moving the
asset allocation into market instruments. Flows into
pension schemes are predictable as they are reliant upon
medium- to long-term variables such as demographics
and wage levels.
Relative to pensions, mutual funds have a more
aggressive asset allocation, especially in Poland, Slovakia
and South Africa. Flows and the marginal asset allocation
of these flows are less predictable and tend to be
correlated with market performance. Insurance company
reserves represent the underlying capital of the firm.
Apart from in Hungary, legislation is stable and we have
assumed no major changes in the overall asset allocation.
In Hungary, the state funded pension system is being
revised to force pension funds to adopt a greater risk-
taking strategy. This should reduce the overall demand for
government debt, but the change is being implemented
gradually, beginning at the start of 2008, and should have
little impact on flows next year.
Local banks
Our expected net demand from local banks is also
indicated in the table. Unlike the flows from local asset
managers, bank demand for government debt does not
grow uniformly and depends on a series of factors
involving both their ability to expand their balance sheets
and their willingness to buy bonds. This means that some
years will see large allocations to government debt and
other years will see very little and possibly even debt
liquidations.
Currency composition of the deposit base
USD bn
end-05 end-06 now value of 1%
PLN 16% 15% 14% 2.2
HUF 16% 21% 20% 0.7
CZK 12% 11% 10% 1.3
SKK 22% 22% 26% 0.6
ZAR 3% 3% 2% 2.4
TRY 35% 38% 35% 2.4
ILS 35% 37% 38% 2.2
Notes: proportion of deposit base in FX at end-2005, end-2006 and currently. Also shown is the USD
value of a 1% shift in composition. Source: Deutsche Bank, NBP, NBH, CNB, NBS, SARB, CBT, BoI
Deposit growth is key as it regulates the size of a banks
balance sheet and therefore the ability to expand the
asset base. Our focus is on local currency deposits
because it is the funds from these which can be invested
in local government debt. We assume organic deposit
growth in 2008 at a rate of projected nominal GDP growth,
but aside from this, the key source of local currency
deposits is reverse currency substitution, or reduction in
FX deposit levels. The table above shows the level of
dollarisation in history and at present and also the USD bn
value of a 1% change in the ratio. The two countries
which stand out are Hungary, where the ratio has not
changed since the 2006 crisis and Turkey, where any lira
weakness will likely be met by USD selling. The increase
in FX deposits in Slovakia is probably in preparation for
Euro-entry in 2009. We have assumed that that proportion
of FX deposits falls by 2% in Hungary and Turkey in 2008.
We have not assumed any reduction in dollarisation in
Israel, although this could be an important factor for
boosting shekel liquidity in 2008.
Time for some retrenchment of bank balance sheets?
The past few years have seen strong growth for banks in
the region as low interest rates coupled with financial
innovation have allowed credit growth to take off in both
local currency and FX. The FX loan story is interesting
from the capital account perspective but does not concern
us here, but the rapid growth of local currency credit is
important because banks will actively substitute balance
sheet space away from government debt for more
lucrative consumer and corporate credit lines. This is
shown to some extent in the chart below which shows
the current YoY growth of local currency deposits, loans
and government debt. This shows that in Poland, Czech
Republic and Turkey, growth of credit has outstripped
deposit growth by a factor of 2 in some cases. Growth of
government debt holdings has also been variable but is
generally lower than credit growth except in Hungary. We
believe that Hungary is the exception due to the
slowdown in growth and the surge in domestic
government debt issuance over the past 12-18 months
which has effectively crowded out all other forint lending
activities.
EMEA bank b/s growth: time for some retrenchment?
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
PLN HUF CZK SKK TRY ZAR ILS
Deposits
Credit
Govt debt
Notes: YoY growth of local currency deposits, loans and government debt on bank balance sheets.
Source: Deutsche Bank, NBP, NBH, CNB, NBS, SARB, CBT, BoI
Strong credit growth is a sign of healthy economic growth
and rising confidence. Furthermore, levels of credit in
EMEA economies are generally low relative to those in
G10 and therefore banks are not over-exposed to a
deterioration in the credit quality of the underlying loans.
Where they are exposed is to the funding of this loan
growth. The chart below shows the level of balance sheet
extension through the ratio of local currency credit to local
currency deposits. By far the most mature market in the
region is South Africa, where the ratio is just above 100%,
but it has recently been joined by Poland, Slovakia and
Turkey. Note that despite the strong growth in Czech
Republic, loans remain a much smaller fraction of their
balance sheet.
EMEA: ratio of local ccy credit to local ccy deposits
60%
65%
70%
75%
80%
85%
90%
95%
100%
105%
110%
PLN HUF CZK SKK TRY ZAR ILS
Oct-06
Oct-07
Notes: ratio of the amount of credit extended by banks in local currency to the amount of local currency
deposits in the banking sector at Oct-06 and Oct-07. Source: Deutsche Bank, NBP, NBH, CNB, NBS, CBT,
SARB, BoI
What does this mean? Set against an external context of
easy access to credit and liquid money market, we can
expect further credit growth next year. However, with
major money markets seized-up since summer, it is likely
that access to financing is becoming difficult at a local
level too. We have noted that zloty liquidity has tightened
significantly since the summer and has worsened into
year-end, a clear sign that credit growth in Poland was a
step too far. Furthermore, we are concerned that similar
problems could occur in Turkey and Slovakia. These
conclusions would indicate that balance sheet expansion
and the ability to take on risk in 2008 is going to be rather
constrained in Poland and likely Turkey and Slovakia too.
Funding rates and carry
The final piece of the puzzle for banks is the attractiveness
of government debt. As banks are carry investors, this can
be assessed using the spread between the yield
government debt against the cost of the funding base, for
which we use the average marginal deposit rate. This is
shown in the chart. Rising funding costs in CZK and PLN
are making bonds less attractive, but bonds are becoming
more interesting in HUF, ILS and SKK. Interestingly, the
margin has always been by far the highest in Czech
Republic, possibly explaining why banks are lagging in
terms of provision of credit.
Putting this all together, there is a strong case for bond
investment for banks next year if they can get hold of the
necessary cash. In Hungary, funding costs have fallen and
FX sales by residents should allow banks to buy bonds.
Furthermore, Israeli and Czech banks still appear in a good
position to add more debt to their portfolios. The only
question is whether credit provision takes priority, which
is likely given that our growth expectations are only for a
slight slowdown in both countries.
Spread between funding cost and bond yields
0
50
100
150
200
250
300
350
Nov-06 Mar-07 Jun-07 Sep-07 Jan-08
-60
-40
-20
0
20
40
60 PLN
CZK
ILS
SKK
HUF (rhs)
Notes: spread between yield on 5Y government debt and the average marginal deposit rate. Source:
Deutsche Bank, NBP, CNB, BoI, NBS, NBH
In Turkey, balance sheets are rather extended and funding
costs in TRY remain high; a massive increase in debt
holdings is therefore unlikely unless there are very large
sales of FX by locals. The same is the case in Poland,
Slovakia and South Africa, although the problem is most
acute in Poland. It is difficult to see Polish banks buying
much of anything in 2008.
The overall picture for supply and demand
The table below sets out our expectations for net demand
for government debt from local institutions and banks and
shows non-residents with the residual.
Supply and demand in EMEA (USD bn)
USD bn PLN HUF CZK SKK ZAR TRY ILS
net supply 15.8 4.8 3.1 0.8 -0.7 3.8 2.3
pensions 7.2 0.9 0.8 0.8 0.2 1.1 1.8
mutual fds 2.7 0.8 0.2 0.4 0.7 0.2 2.3
insurance 0.9 0.6 0.3 0.1 0.0 0.0 0.3
banks 0.0 0.6 1.0 0.0 0.0 0.8 0.8
non-resid 5.1 2.0 0.8 -0.5 -1.7 1.8 -2.9
2007 0.6 1.7 0.9 -0.5 0.7 0.0 -0.7
2006 1.8 1.9 1.0 0.0 4.4 6.6 0.2
Notes: amounts in USD bn. Net supply is net issuance of government debt and other figures are
projected demand from local pension schemes, mutual funds, insurance companies and banks. The
residual is assumed to be bought by non-residents. Non-resident demand in 2007 and 2006 shown in
bottom two rows. Source: Deutsche Bank, Poland MoF, AKK, Czech MoF, ARDAL, SA Treasury, Turkey
Treasury, Israel MoF
The supply-demand situation appears as strong as ever in
South Africa and like in 2007, debt for government debt
will be very tight in both Slovakia and Israel. Israel has the
potential to be the best performer as many local
institutions are in the process of switching out of non-
market bonds into marketable bonds. In Central Europe,
Czech Republic looks as bad as ever due to the lack of
institutional demand, but bank demand improves the
situation. The countries to be concerned about are Poland,
Hungary and Turkey. All three have had a negative funding
gap in past years but non-resident demand has been
strong enough to cover the gap. Next year could be tough
with all three countries requiring inflows in excess of
those seen in 2007. For Poland the situation is the worst;
a lack of bank demand means that non-residents need to
buy more than USD 5bn of zloty bonds. The last time that
demand was this high was in the 2004.
We see several risks to our core scenario for supply and
demand in 2008.
The turning of the fiscal tide
With 2008 likely to see a slowdown in global growth after
several years of strong expansion, we believe that there is
a significant risk that for the first year in a while, fiscal
results are going to undershoot their targets.
We believe that the risk of a fiscal overshoot is lowest in
Poland where the new government will likely fix a tighter
deficit target from that currently in the budget and
assumed in our projections. Aside from this, we highlight
South Africa as being particularly vulnerable given that the
strong fiscal story is fully priced-in.
Ratio of cash reserves to financing requirement
0
1
2
3
4
5
6
PLN HUF CZK SKK RON TRY ZAR ILS
cash/financing
cash/budget
Notes: ratio of government cash deposits to the total financing requirement (including debt redemptions)
and the budget deficit. Source: Deutsche Bank, NBP, NBH, CNB, NBS, NBR, CBT, SARB, BoI, Poland
MoF, AKK, Czech MoF, ARDAL, SA Treasury, Turkey Treasury, Israel MoF, Romania MoF
Stocks of cash in the government account
The strong fiscal performance of the past few years has
another legacy; large reserves of cash in the
governments deposit accounts. The ratios of the Treasury
cash reserve to the 2008 financing requirement and the
2008 budget deficit are shown in the chart below. The
high level of these ratios illustrate just how comfortable
the situation is for Czech Republic, Slovakia, Romania and
South Africa and explains why both Slovakia and Romania
can cancel the majority of their debt auctions they
simply do not need the cash. Given adverse market
conditions we would expect these countries to reduce
issuance or halt it altogether, providing some support to
the market.
On the other side, the countries with a severe lack of cash
are Turkey, Hungary, Israel and Poland. Turkey is
unsurprising given the high level of short-term debt
maturities, and this appears to be the case with Israel too.
Indeed, given the likelihood of roll-over of short-term debt,
the more pertinent ratio is that of the budget deficit to
Treasury cash, in black. The fact that the government does
not have enough cash to cover half the budget deficit
underlines the precarious state of the Hungarian
government finances and the requirement for continuous
funding. Running a projection to monitor developments in
the cash stock and assuming full financing of redemptions,
Hungary would default sometime in Q2 08. Poland is also
surprisingly vulnerable. Market volatility in these countries
would be exacerbated by continued debt issuance; a
further deterioration of conditions would lead to the use of
the Eurobond markets to raise extra capital, like Hungary
in September 2006.
Non-government debt issuance
Russia aside, there is only one market in the region where
local currency non-government debt issuance is
economically significant: South Africa. Corporate debt
issuance has exploded over the past few years and
currently rivals government debt issuance in terms of
volume. However, the duration impact is generally much
lower and it seems that many local investors still prefer
the security of SAGBs over corporate debt. The risk in
2008 comes from an increase in parastatal issuance by
companies such as Eskom to finance infrastructure
projects. Over the past few years, parastatal net issuance
has increased from ZAR 3bn in 2006 to ZAR 17bn in 2007
and is budgeted to be ZAR 29bn in 2008, greater than the
level of gross government debt issuance which we
estimate to be ZAR 25bn. Furthermore, the inversion of
the curve and demand for duration will mean that this
debt will be raised at maturities of at least 10 to 30 years,
increasing the impact on the market. Even taking these
numbers into account, the supply-demand situation in
South Africa is still robust, but represents an increase in
domestic net issuance over last year to ZAR 13bn (USD
2bn) from ZAR 5bn in 2007. Net issuance of government
debt and parastatal paper in South Africa will be at its
highest level since 2005.
EMEA 2008: monetary policy pricing
EMEA contains countries at all stages in the monetary
policy cycle. Given that it is widely expected that global
growth will slowdown in 2008, but it is uncertain just how
deep the slowdown will be, our economists have a
baseline and a risk scenario for global rates. The lower
growth environment would likely lead to increase in risk
aversion and weaker emerging market currencies over the
course of the year. In the higher-beta countries such as
Hungary and Turkey, the inflationary effect of the currency
sell-off would probably lead to monetary tightening
relative to our baseline scenario. Being at an advanced
stage in its hiking cycle, South Africa is the exception a
sharp slowdown would weaken the rand, but we believe
that growth would become the SARBs overriding concern
and our projected cuts would be accelerated. In the less
volatile countries, such as Poland, Czech Republic and
Israel, lower US and Eurozone rates will mean a more
dovish monetary policy. We have Slovakia, expected to
join the Eurozone in January 2009, following any ECB rate
moves.
EMEA: 2008 monetary policy pricing
baseline risk pricing
CZK 0 -25 50
HUF -75 -50 -40
ILS 50 0 90
PLN 75 25 90
SKK -75 -100 15
ZAR -100 -150 -70
TRY -225 -75 -225
Notes: change in policy rate implied under the DB baseline scenario, risk scenario and current market
pricing calculated from the local money market curve or in the case of Turkey, from the FX-implied curve.
The table highlights that there is value in rates in both
scenarios in all countries apart from Turkey. We would like
to highlight Poland as especially over-priced given that
more than 75bp of the 90bp in the price are expected at
the next 3 NBP meetings. Hungary has a similar level of
short-term value: even though inflation is currently high,
the NBH are still sensitive to the level of the forint. If
EUR/HUF maintains the 250-255 level it is likely that there
will be at least 25bp of rate cuts over the course of Q1
these are not in the price. Another country which stands
out is Israel, which as a consequence of the prevalence of
USD investments in the country and the ease of switching
between USD and ILS, tends to be highly sensitive to
USD rates. Further Fed cuts and falls in USD rates will be
beneficial for both the shekel and ILS rates.
For the moment we are less interested in the value
present in South Africa, Czech Republic and Slovakia
because inflationary risks should maintain current market
pricing for some time.
EMEA 2008: inflation breakevens
Our final source of analysis for 2008 is on the inflation-
linked debt markets in the region. Inflation-linked bonds
are available in Israel, Poland, South Africa and Turkey,
although only Israel and South Africa have more than one
bond. Liquidity is generally lower than for the nominal
bonds but interest has increased recently due to the
higher-than-expected inflation readings in EM. Real rate
swaps are also available in South Africa and Poland. The
table below details the current pricing of these bonds. We
have calculated the real yield, inflation-breakeven and also
the average inflation expected to the maturity of the bond.
The average inflation is calculated using the DB forecasts
for 2007-09 and then the central bank inflation target. The
irp is the inflation risk premium, or difference between
priced and expected inflation.
EMEA: inflation-linked bond pricing
real yield b/e infl infl expect irp
Israel Jun-10 3.09% 2.02% 2.32% -30
Israel May-36 3.59% 2.58% 2.03% 55
Poland Aug-16 2.74% 3.06% 2.98% 8
ZAR 5Y 3.59% 5.98% 4.78% 120
ZAR 10Y 3.15% 5.68% 4.64% 104
Turkey 8.96% 6.78% 5.39% 139
Notes: real yield and break-even inflation calculated using current market prices. Inflation expectations are
calculated using the DB forecast and the central bank target rate. Source: Deutsche Bank
Turkey, as ever, stands out due to the high level of real
yields. However, as the analysis shows, the CPI-linked
Feb-12 bond is expensive to nominal bonds as the
breakeven inflation level is almost 1.4% higher than the
expected inflation rate over the life of the bond. Given that
we expect disinflation to return later in 2007, it is likely
that the inflation breakeven will also fall later this year.
Having said this, the current annualised carry on this bond
is a formidable 33%, much higher than any other asset in
EM. Given the high sensitivity of Turkey to any further
food and energy price inflation, and the possibility of falls
in the real yield with CBT rate cuts, we maintain a positive
view on this asset.
The inflation risk premium is also high in South Africa.
Inflation is also expected to fall considerably over the
course of 2008, and even in the presence of second round
effects, we believe ZAR inflation is expensive.
Inflation appears much cheaper in Poland and Israel. In
Poland, the break-even inflation level has risen above 3%
for the first time since 2004, but the DB inflation
projection shows that inflation projections will provide
almost the same return as with nominal bonds.
Furthermore, the high inflation readings mean that the
annualised carry on this bond will maintain levels of at
least 10% until at least end-Jan.
The market which has been least affected by the recent
rise in global CPI is Israel. Here, monetary policy
expectations have inched higher, but short-term inflation
breakevens remain close to the 2% inflation target and
the break-even curve remains normal. Whilst shekel
strength has been keeping inflation low for some time, we
believe that the risks of at least some effects from higher
inflation are non-trivial and therefore there is value in
buying short-term inflation risk.
EMEA 2008: views for 2008
The arguments above centre on three idiosyncratic
factors: the expectations and pricing of supply and
demand of government debt, monetary policy and
inflation expectations. To formulate our views we must
set these against the global background described at the
start of this article and the risks to the baseline DB outlook.
These global factors include the current spike in inflation,
slowdown in the US and much tighter credit conditions.
The other pertinent factor relates to the steepening of the
USD and EUR curves expected by our G10 strategy team.
Purely from a relative valuation perspective, this view will
force most of the central European curves steeper, but
the combination of lower liquidity, risk aversion and
inflationary uncertainty inherent in the G10 call will also
have their effects on EMEA markets. We therefore make
curve steepeners the baseline case for markets across the
region. Another steepening factor relates to the excess of
supply over demand in Poland and Hungary (and South
Africa, including parastatals). The only curves that we
believe will retain their shape are Turkey, where rates are
too high to be affected by moves in EUR and USD, and
Israel, where the supply-demand dynamic remains strong.
EMEA views for 2008: a summary
Direction Curve ASW Inflation
Poland Short Steeper Wider Wider
Hungary Short Steeper Neutral
Czech Rep Neutral Steeper Neutral
Slovakia Neutral Steeper Neutral
S Africa Neutral Steeper Wider Tighter
Turkey Long Neutral Wider Tighter
Israel Long Neutral Tighter Wider
Notes: summary of DB views for 2008 for fixed income direction, curve steepness/flatness, asset swap
spreads and inflation breakevens. Source: Deutsche Bank
The monetary policy view argues for a relatively bullish
outlook for EMEA fixed income, especially given that
monetary policy expectations are more hawkish than the
DB view in all countries apart from Turkey. However, at
present the key problem for monetary policy is the current
high level of non-core inflation. Unless a central bank
believes that rates are already too high such as Hungary
and Turkey it will be difficult for the market to price-out
tightening until we have real evidence that an economic
slowdown is underway.
With Hungary, we have longer-term doubts about the
continuation of rates cuts beyond Q1 and due to our
concerns over the viability of FX-lending in the current
credit environment we believe that rates will not perform
this year. The key problem for rates markets in central and
eastern Europe is the FX-passthrough, which makes rates
very sensitive to FX performance; essentially receiver
positions in rates have the risk-reward of a currency view
but with negative carry. Given the global environment
and the current pricing of HUF rates, we take a
negative view on Hungary in 2008.
We therefore keep a more neutral view on monetary
policy across most countries and use inflation-linked
bonds to express bullish views on real rates, pick-up the
high current coupon and also offer some protection
against a further surge in inflation. The key countries here
are Turkey and Israel. None of the factors we have
considered highlight Turkey as a particularly strong
rates play and therefore for the moment we are relatively
cautious and exploiting the high inflation through the CPI-
linker. However, even at 14%, policy rates are high and
after a period of stasis in H1 we expect that the
market will begin to price-in a renewed easing in 2009.
Israel is probably the strongest pick in the region.
Spreads to USD are wide and the curve is still priced for
hikes that will likely not occur. The supply-demand
dynamic is strong for 2008 and could be enhanced either
through de-dollarisation or an acceleration in the switch
away from non-marketable debt by local institutional
investors. At present, inflation pricing is low and the
inflation break-even curve is normal so the risks are
skewed to a short-term inflation scare, but over the
course of next year, rates should perform well either
outright or as a spread to USD.
Poland is where we have the most comprehensive
bearish view; there is fundamental value in Polish rates,
both short-term and long term but 2008 will be a difficult
year. Short-term expectations of rate hikes seem
overdone, but the inflation outlook remains poor.
Furthermore, Poland is likely to see a continuation of the
banking sector stress that has raised WIBOR rates over
the past few months and with banks unable to increase
their POLGB allocations, issuance of debt is going to put
steepening pressure on the curve and cause bonds to
widen further relative to swaps. We would not be
surprised if the PLN curve disinverted in 2008.
At present the inflation situation in South Africa is
serious and there remain substantial upside risks for
Q1. However, the SARBs focus is moving over to the
growth outlook and any signs of a slowdown should be
enough to prevent further hikes. This should mean rate
cuts in H2 08 but there remains the strong likelihood of
zero cuts if growth remains strong or a lot more than
currently priced if growth collapses. Either way we expect
the curve to steepen. Long-term ZAR forwards remain too
low and the spread to USD too tight. Also, the surge in
parastatal issuance should remove the tightness of bonds
and the continual flattening pressure on the curve. Finally,
the political outlook is decidedly messy. At present we
are not sure whether South Africa will bull- or bear-
steepen but we expect 2Y-10Y to be a full 100bp
steeper by end-08.
2008 is a big year in Slovakia as the decision will be
taken in H1 whether to let the country join the
Eurozone in January 2009. A yes would glue SKK
rates to EUR and relative volatility will fall to zero; a no
would push SKK rates much higher as we expect that
such a decision would be accompanied by crown
weakness. Currently Slovakia adheres to all the Maastricht
criteria but there is still a possibility that the country could
be rejected on the expectation that Slovakia cant meet
the criteria on a sustainable basis. The year is therefore
likely to be quiet for SKK rates but the event risk of strong
volatility remains.
Despite Czech Republic inflation likely reaching 6% in
Q1, it is difficult to be too bearish on the outlook. The
crown is strong and likely to exert a dis-inflationary
influence next year. Furthermore, the supply-demand
dynamic remains poor but is not as weak as in 2007. We
expect the curve to steepen, but likely in-line with EUR.
Our top trades for Q1
With a shorter time horizon we have more flexibility to
express ideas with an eye on market timing. These are
largely in-line with our 2008 views given above, but with a
bias to the shorter term developments expected in Q1.
1. Buy inflation in Poland, Israel and Turkey. As
outlined above, the current spike in inflation has pushed
the carry on inflation-linked bonds to very high levels; 33%
in Turkey and 10% in Poland. Furthermore, although the
Turkey Feb-12 is not cheap relative to nominal bonds, the
Israel Jun-10 and Poland Aug-16 are cheap.
In addition to the inflation carry, we expect real yield
compression in Turkey and Israel over the course of Q1.
We target a real yield of 8.5% on the Feb-12 in Turkey and
2.5% on the ILCPI Jun-10 by end-Q1. In Poland we have a
bearish view on rates and therefore do not expect real
yield compression; we recommend buying the Aug-16 in
combination with a payer in PLN 10Y IRS. We target a
break-even inflation to 3.5% from just above 3% currently.
2. South Africa: stay paid ZAR 5Y for now. With
inflation and monetary policy uncertainty set to remain
high in Q1, we continue to recommend payer positions in
ZAR rates for at least the next month. Given the low level
of 5Y and 10Y rates and long-tenor forwards, payer
positions have attractive carry and roll. We target 10% in
ZAR 5Y from 9.6% currently.
3. Hungary: HUF 2Y-10Y steepeners, target -20bp from
-60bp currently. The recent re-pricing of the Hungary
curve is overdone. The NBH remain keen to cut rates and
the conservative pricing of the market means that 2Y
receiver positions are attractive. Furthermore, the upside
in rates is limited as the market will only begin to price
hikes if EUR/HUF moves well above 260. We expect the
curve to steepen in Q1 and combine our 2Y receiver with
a 10Y payer with a target of -20bp from -60bp.
4. Poland: sell PLN 3X6 FRA at 6.1%, target 5.6%.
Higher inflation and higher policy rates are the headline-
grabbing reasons to be concerned about the direction of
yields, but we believe that the current liquidity squeeze
highlights problems with zloty-funding in the banking
sector. This will at least partly abate after New Year. We
find the FRA rates very high and whilst some of the
pricing reflects tight liquidity, some of the implied
monetary tightening is likely to unwind in Q1, if the ECB
move towards a cut as expected by our economists.
5. Slovakia: pay SKK 2Y against EUR 2Y, target 20bp
from -17bp. This is a risk-reward trade that we have
recommended for some time. We expect Slovakia to
enter the Eurozone, but given that this eventuality is fully
priced, we recommend paying SKK rates and receiving
EUR on an expectation of divergence.
Angus Halkett +44 20 7547 3512

Japan

Overview

Last week has been fairly volatile with overseas
markets being the main driver

We recommend cutting remaining outright and
the payer spread positions

We discuss defensive butterfly positions in the
Relative Value section

In preparation for the budget discussions that are
likely to start next week, we discuss our budget
outlook for FY2008
This week saw significant market volatility on Wednesday.
While the global market was apparently disappointed with
the refusal of the Fed to do more than cut the funds target
and discount rates by 25bp each on Tuesday, the joint
liquidity injection announced on Wednesday by five
central banks (Fed, ECB, BoE, SNB, BoC) failed to
engender a reversal in rates. Swap spreads reacted more
positively to the news, tightening between 5.5bp at the
front end and 2.5bp in 30Y on Thursday. Our
recommended outright short position fared badly due to
the sharpness of the rally on Wednesday which left no
time to stop out. The 8Y sector is now trading practically
where we recommended shorting it, after having dropped
up to 65 sen. The payer spreads we recommended as a
safer alternative last week were largely unaffected by this
week's rally.
Going forward, flow-of-funds considerations are likely to
play an increasing role. Figure 1 shows that the trend
towards higher deposit balances and subdued demand for
bank loans is still ongoing.
Deposits, loans, and net balance (SA, JPY tr)
420
440
460
480
500
520
540
560
Dec-99 Dec-01 Dec-03 Dec-05
-20
0
20
40
60
80
100
120
140
Total Lending (SA)
Total Depo (SA)
Deposits - Loans (rhs)
Source: BoJ, Deutsche Bank
This growth in the gap between deposits and lending is
now beginning to affect regional banks more strongly
after they had shown a declining trend up to October
(figure 2).
Deposits-Loans (JPY tr)
60
62
64
66
68
70
72
74
76
Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07
40
42
44
46
48
50
52
Regional banks I and II (lhs) City banks (rhs)
Source: BoJ, Deutsche Bank
While banks are accumulating cash balances, we do
expect further flows into the JGB market. However, our
outlook for the 2008 budget suggests a more reflationary
environment ahead so that we see more value in the front
end of the curve than at longer maturities.
In this context, the hedge we recommended on 9
November against the market becoming bullish on the
BoJ, the 3Mx4Y-3Mx20Y conditional bull-steepener, has
behaved in an interesting fashion (figure 3).
JPY swap 4Y-20Y spread vs 10Y rate
90
95
100
105
110
115
120
1.6 1.7 1.8 1.9 2 2.1 2.2
15 Jun - 8 Nov 9 Nov - 4 Dec 5 Dec - now
Bear
steep
Bull
steep
While bull-steepening/bear-flattening had indeed been the
trend movement until about one month ago, the market
switched to a bull-flattening/bear-steepening behaviour as
we recommended the trade. Moves in the front end of
the swap curve appear to have been driven more by
changes in the Libor-OIS basis rather than moves in OIS
itself until the past month, while the steepener is now
determined mostly by the long end of the curve (figure 4).
OIS-Libor basis and 4Y-20Y swap spread
10
15
20
25
30
35
40
45
50
80
85
90
95
100
105
110
115
120
1Y OIS-Libor basis
4Y-20Y (rhs, inverted)
We still believe that positioning for further falls in both the
OIS rates and the basis are useful positions, especially
when established through options, so we recommend
holding this trade. The low point in the P/L of the trade
was -20 cents and it is now trading at 8 cents profit.
Budget outlook
Although the concrete discussions about the FY2008
budget are likely to start next week, we find it useful to
form some expectations about the general picture
towards the end of this calendar year. In our view, the
coming year is likely to see a significant expansion of the
central government budget relative to expectations, and
with it an increase in JGB supply. Prime Minister Fukuda
has directed the MoF to produce a budget draft that will
lead to a reduction in new JGB supply but we are
somewhat sceptical that such a budget would pass the
legislative process. We expect instead that increased net
JGB supply will arise from the impact of both lower tax
receipts as well as higher discretionary spending. The
lower tax receipts, and to some degree the higher
spending, are due to a significant undershooting of GDP
growth relative to government estimates. We note that
the 2007 Debt Management Report issued by the Ministry
of Finance presents planned budget figures based on
2.2% nominal growth in FY2007 and 2.5% in FY2008
(2.2% in the risk scenario) whereas we expect only 0.5%
in FY2007 and 1.6% in FY2008.
On the tax receipt side, we see the most significant
uncertainty in the higher rate gasoline tax which, if
repealed completely, would remove about JPY 1.4tr from
the budgeted income while road construction is unlikely to
be reduced. Furthermore, the slowdown in economic
activity relative to expectations that started in the second
quarter has had, and will continue to have, a significant
negative impact on corporate and income tax receipts.
While tax receipts in FY2007 are higher than last year, the
growth rate is lower than expected and will undershoot
expectations for the first time in 5 years. We have pointed
out earlier that the impact of such a slowdown on the
central government budget is not straightforward.
Shortfalls in central government receipts during FY2007
largely affect the FY2007 supplementary budget and
subsequent budgets mainly through debt financing costs.
Shortfalls at the regional level affect the central
government budget in FY2008 though an increase in Local
Allocation Tax (LAT) demands. Projected tax receipts are
one input for the calculation of the LAT amount that is
transferred from the coffers of the central government to
the municipalities (prefectures, cities, villages, etc.) each
year. When the realised tax receipts differ from the
projections, the municipalities expect to see the shortfall
made up in the next year's allocation. The technical
situation has changed over the last few years and the
municipalities are now less able to borrow long term
against such future LAT entitlements which would
cushion the impact on the central government budget.
Based on press reports, we estimate the impact on the
FY2008 budget to be around JPY 0.8tr. Other planned
fiscal measures, such as changes to the distribution of
Local Corporate Tax, dividend taxation, etc., are unlikely to
have a major impact on next year's budget.
On the expenditure side, a flurry of stimulus programmes
have been announced, such as spending on regional
revitalisation, improvements in energy efficiency, etc. We
do not have sufficient details on these programmes to be
able to evaluate them properly but estimate these
baramaki costs to add some JPY 1-2tr to the expenditure
side of the government. Overall, therefore, we expect the
primary balance to worsen by about JPY 3-4tr relative to
projections.
In this context, the use of reserve accounts in the Special
Budget has emerged as an important topic in the public
discussion. Reserve accounts are dedicated line items in
public accounts that track earmarked payment flows in the
cameralistic accounting approach used in Japan. Although
these accounts are allocated to particular purposes, there
is significant administrative leeway in their use. At a time
when legislation is made difficult by an opposition
majority in the Upper House, the availability of funds that
are not subject to detailed legislative oversight seems like
an attractive option.
The particular reserve account that is relevant for the JGB
budget is inside the Fiscal Investment and Loan Program
(FILP) special account which is part of the Special Account
of the Japanese sovereign. The purpose of this reserve
account is to accumulate funds to cover the funding gap
between the long-term, low interest loans extended to the
relevant borrowers (mainly zaito institutions and
municipalities) and the shorter maturity FILP JGBs that are
issued to fund these loans. The size of this reserve
account is linked by ministerial decree to the volume of
existing loans and was expected to reach JPY 20tr by the
end of 2008. The MoF announced on December 12 that
they will look to use JPY 9.8tr to redeem JGBs. Such a
transaction has occurred already in FY2006 when JPY 12tr
were transferred from the FILP reserve account to the
JGB management account in order to reduce the volume
of outstanding JGB.
We are somewhat sceptical that a reserve transfer will
occur in such a size. The legal basis for these transfers is
17(2) of the Administrative Reform Promotion Law
enacted in May 2006. This article states that an amount of
JPY 20tr should be targeted for the transfer of surplus
amounts from the Special Account in order to improve
fiscal stability in the years 2006 to 2010. If the amounts
that have been transferred in FY2006 and FY2007 are
added, about JPY 15.6tr have already been used up. This
leaves a buffer of only about JPY 4.5tr that could be used
to hold down new JGB supply in FY2008. This would be
enough to compensate for our estimate of the
deterioration in the primary balance, but would leave no
reserves for the next two fiscal years. Needless to say, a
legislative change could be made so that more of the
reserve fund could be released, but that is probably not
possible without the asset of the opposition DPJ.
Even if the limit was higher than we believe and the MoF
could indeed release JPY 9.8tr, we believe that the market
impact of this balance sheet operation depends on what
assets the reserve funds are invested in. Like the US
Social Security trust fund assets, reserve fund assets
need not represent net claims of the government against
another party and may instead be claims against the
government itself. A transfer of reserve accounts in the
FILP special account would therefore on balance increase
FILP JGB supply by the same amount as debt repayment
increases or new fiscal measure JGB supply is reduced,
leading to a net impact of zero.
Alexander Dring, +81 (3) 5156 6199
Relative Value

We recommend paying 7Y against 5Y and 10Y swaps
in an equal weighted butterfly
One of the interesting features of the market over the last
week has been the apparent disconnect between strong
futures versus a somewhat weaker picture in other parts
of the curve. As a result, the 7Y sector now looks rather
rich (figure 1).
5-7-10Y equal-weighted butterfly (bp)
-12
-10
-8
-6
-4
-2
0
2
4
Dec-05 Jun-06 Dec-06 Jun-07 Dec-07
This butterfly is directional as shown in figure 2. However,
the directionality is less pronounced than for some other
butterflies along the curve and the butterfly is rich even
when viewed against its directional component. We also
do not believe that a bullish consensus has re-emerged in
the market so that we are not to worried about the
directionality at this time.
5-7-10Y swap butterfly vs 7Y swap rate
y = 10.192x - 19.718
R
2
= 0.3043
-12
-10
-8
-6
-4
-2
0
2
4
1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2 2.1
This trade (notionals 68.9:-100:36.0) has marginally
negative carry of -0.08bp over three months and negative
roll-down so that the total carry and roll-down is -0.33bp
over three months.
For investors who would like to remove the directional
bias of the trade, the PCA-hedged butterfly (risk weights
36.3:-100:-70.1, notionals 50.1:-100:50.5) offers slightly
less upside (figure 3).
5-7-10Y PCA-hedged butterfly residual (bp)
-5
-4
-3
-2
-1
0
1
2
3
4
5
Dec-05 Jun-06 Dec-06 Jun-07 Dec-07
The carry on this trade slightly positive (0.15bp over three
months) but that is compensated by negative roll-down so
that the overall carry and roll-down is virtually flat.
Alexander Dring, +81 (3) 5156 6199

Asia

We provide a list of strong views held in several
markets around the region.

For further details see our forthcoming 2008
Country Outlook pieces due shortly.
Asia: 2008 Views
China: Warehouse CNY exposure by hedging CNY
1Yx2Y NDFs with 12M NDFs. Elevated inflation, USD
weakness, and compressing USD/CNY interest rate
differentials should create a swirl of interest in long CNY
positions in 2008. We see 12M forwards as too
aggressive, implying 8.5% CNY appreciation, while
forward NDFs, for example 1Y Fwd 2Y, are a much
cheaper way to take long CNY risk, currently pricing in
appreciation at a pace of only 5.5%. For now we
recommend hedging the latter (1Yx2Y NDFs) with the
former (12M NDFs) in 1:2 ratios as a way of warehousing
long CNY risk and arbitraging the NDF curve at the same
time by taking in 2% in postive roll down per month (per
unit 1Yx2Y NDF). A reduction in the pace of implied CNY
appreciation in both tenors should provide an attractive
opportunity to lift the 12M NDF hedge, leaving the trade
exposed to faster CNY appreciation. [FZ/MH]
India: OIS Steepeners as a way to position for the turn
in the interest rate cycle. Implement on 1M forward
steepeners on the OIS curve (2Y/5Y). Current levels 8bp
(mid). Liquidity remains primarily driven out of balance of
payments inflows. With the overall liquidity management
of RBI more streamlined now, and as RBI gets
increasingly comfortable with the trajectory of monetary
aggregates over the course of 2008 (along with slowdown
in the real economy), we expect liquidity conditions to
improve and front end yields to come off and the curve to
steepen. We look to translate this position into outright
long cash bonds position once RBI initiates its rate cutting
cycle. [SG]
Korea: Buy Korean assets swapped into USD Buy 2Y
MSBs swapped into USD, target Entry Libor +150bp.
While we still expect volatility in USD/KRW basis
underlying this trade we think foreign investors are willing
to match the weakening position of banks in the market at
the right price. As the USD funding situation improves
globally going into 2008 and exporters hedging needs
recede, KRW assets swapped in USD should richen. For
investors with longer horizons 5Y KTBs swapped in USD
around Libor+100bp also provide attractive value.
Implement forward steepeners on the KRW IRS curve.
The unwinding of structured has led to extreme flattening
of the IRS curve leaving the 1Y and 3Y relatively cheap and
the 5Y and 10Y rather rich. Combinations such as 3M
forward 2Y/10Y below -20bp or 6m forward 1Y/5Y around -
40bp seem attractive. [CC]
Hong Kong: Add to 2Y/10Y curve steepeners on
weakness: The conflicting forces of higher long-term US
and China rates and increasing liquidity in the HKD money
market have steepening implications. We believe that
flattening to around +50bp provides an excellent
opportunity for HKD curve steepening positions. We
target a move above +100bp Pay the belly of HKD
2Y/5Y/10Y IRS: While 2Y/10Y IRS shows significant
flatness the pressure on the 5Y point is even more
extreme in relation to the wings of this butterfly. We
suggest paying the 5Y point between -5bp and flat to take
profit around +15bp while 2Y/10Y remains below 100bp.
We look for a break above +30 bp as 2Y/10Y slope
steepens further. [CC]
Cross Rates: Receive SGD rates against MYR on
contrasting inflation implications. Neighbors Singapore
and Malaysia seem to be sharing some similar underlying
inflationary pressures, with two key distinctions that imply
contrasting market implications. First, Singapore's
transparent use of currency policy to suppress inflation
means that an aggressively appreciating currency will
attract heavy capital inflows from model-oriented hedge
funds. As we saw in Q2 this year, these excessive inflows
with eventually lead to lower interest rates as the MAS
slows down sterilization to discourage inflows. Secondly,
in the case of Malaysia CPI inflation is muted by subsidies
on fuel prices, whereas Singapore's energy costs are
showing up more clearly in headline CPI. Eventually we
should see Malaysian authorities reducing subsidies, once
fiscal costs mount, sending inflation higher. Heavier
supply and the threat of higher interest rates should cause
5Y MYR swap rates to underperform SGD over the course
of 2008. [MH]

Christian Carrillo, Tokyo, +81 3 5156 6206
Martin Hohensee, Singapore, +65 6423
Sameer Goel, Singapore, +65 6423
Feng Zhao, Singapore, +65 6423

Peripheral Dollar Bloc Strategy

The outcomes for the $-bloc markets will depend
critically in developments in the US and globally.
A global soft-landing will eventually see the RBA
and the BoC tighten, with possibly even the RBNZ
having to move upward if housing recovers. This
will have implications for yield curves in
particular.

A hard-landing by the US and the implications
this has for global growth will be very negative
for the $-bloc markets given the importance of the
commodity boom to their recent success. In this
case the BoC will keep easing through 2008 and
both the RBA and RBNZ could join it by year-end.
Fate of the income shock is a key unknown in 2008
A key big picture trend this decade has been the
emergence of China, the strength of global demand and
the associated boom in commodity prices. This boom has
provided a strong boost to the peripheral $-bloc
economies, though the extent of the boost has varied
across the three and over time. In total since 2000
Australia has benefited the most as a whole, though NZs
terms of trade has risen the most in the past two years.
The terms of trade have risen across all the peripheral
$-bloc
90
100
110
120
130
140
150
Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07
CAN terms of trade
AUD terms of trade
NZD terms of trade
All set to 100 at Mar-00
Source: DB Global Markets Research, Stats CAN, ABS, SNZ
To a large extent the income boost from the positive
terms of trade shock explains much of the recent
economic history of these three economies. For instance,
it explains why income growth has been so strong in
Australia even when there have been times in the past
few years when GDP growth has appeared to be relatively
subdued. In our view the recent strength of NZs terms of
trade, with dairy prices making a key contribution, helps
explain why the NZ economy has proved reasonably
resilient despite aggressive RBNZ rate hikes.
How the external environment develops in 2008 is, in our
view, the key uncertainty facing these three economies.
If the global economy merely slows to trend, as seems to
be the consensus forecast at present, then we suspect
that by the end of 2008 the RBA and BoC will have
tightened from current levels and the RBNZ may well have
as well. If, however, the global economy slows sharply
then the BoCs overnight rate will likely be much lower
than present levels and the RBA and RBNZ will likely have
an easing bias (if they havent already moved to cut their
cash rates). The outcomes for yield curves, swap spreads
and so forth will be very different depending on which of
these scenarios pans out.
BoC priced to keep easing, RBA priced to hike, with
the RBNZ seen as on-hold
In terms of current market thinking, 2007 draws to a close
with the three markets taking very different views on the
outlook for 2008. The CAN front-end is pricing a series of
rate cuts from this point, with the Dec-08 BAX contract
implying an overnight rate of less than 3.75%. The AUD
IB contracts are pricing a cash rate of 7% by the second
half of 2008 (i.e. one rate hike), while the NZ front-end
effectively sees the RBNZ on-hold for 2008.
From a purely domestic standpoint we are broadly
comfortable with market pricing for the RBA and RBNZ at
this point, while that for the BoC looks out of step with
the strength of the economy. Yet last weeks actions by
the BoC make it clear that domestic economic
developments are not foremost in its mind at present.
Rather, its complete focus is on the downside risks
created by the US economy and developments in credit
markets. While this remains the case the BoC may
continue to ease even if the domestic data provides little
support.
If US outlook improves then short the CAN front-end,
implement the flattener and look for the 10Y CAN to
trade well above the 10Y UST
At this stage we think there is simply too much
uncertainty about the US outlook to take a bearish stance
on the Canadian front-end. If the US uncertainty is
resolved in a favourable way and the downside risks
diminish then we would look to go short the CAN front-
end. In which case, a companion trade would be to look
for the curve to flatten as the BoC returns to a tightening
bias. But this stance is unlikely to make sense while the
Fed is still in the process of cutting rates.
The CAN curve and the cash rate
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
Jul-05 Dec-05 May-06 Oct-06 Mar-07 Aug-07
2.0
2.5
3.0
3.5
4.0
4.5
5.0
2Y/10Y CAN spread (LHS)
BoC cash rate - inverted (RHS)
Source: DB Global Markets Research, Datastream
As far as the 10Y CAN/UST spread is concerned, we think
it should head into positive territory regardless of which
scenario turns out to be correct. When we review
domestic conditions in Canada and the US we think the
market should have a clear expectation that the Fed Funds
rate is going to fall well below the BoCs overnight rate.
While this is priced to some extent into the front-end of
the curve, it is not appropriately reflected in the 10Y
spread in our view. As such we see 10Y CAN as
expensive versus the US.
The RBA will retain a tightening bias until evidence
emerges of a sustained slowing in domestic demand
As part of its revamped communication policy the RBA
has published minutes for all the board meetings since
Glenn Stevens became the Governor of the Bank, i.e. back
to October 2006. In all these minutes the RBA had a
tightening bias, which we dont find overly surprising
given the strength of the economy, the tightness of the
labour market and so forth. And so long as these factors
remain in play we think the Bank will retain a tightening
bias.
But clearly the Bank hasnt acted on its tightening bias at
every meeting since October 2006. Whether the bias is
acted on in the first half of 2008 will depend critically on
global developments, in our view. If the global outlook
remains highly uncertain then we think it will take
especially strong domestic news to get the RBA over the
line for further rate hikes. This means our central view is
one which has AUD front-end pricing moving in a
relatively narrow range until the current uncertainty is
resolved one way or the other.
Absent an expected start to an RBA easing cycle the
AUD curve will remain inverted in 2008
In thinking about the likely evolution of the AUD yield
curve in 2008, the key in our mind is the markets
expectations for the RBA. Unless the market starts to
price an easing cycle we think the yield curve will likely
remain inverted for the duration of the year. Indeed, if our
official forecast for more rate hikes is correct then there
will likely be pressure on the curve to make new lows
during the year.
3Y/10Y ACGB futures curve
-0.70
-0.60
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
0.10
May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07
3Y/10Y ACGB
futures spread
Source: DB Global Markets Research, Reuters
Clearly expectations for the RBA will be sensitive to the
global news flow, especially developments in the US. But
as we have seen over the past few months bad news
from the US may not be enough to dissuade the RBA
from tightening if the news on domestic inflation
pressures remains negative. This means that the Q4 CPI
in late January is a key event for the curve outlook in the
early part of 2008. A poor CPI result that cements in a
February rate hike will pressure the curve to flatten further
almost regardless of global developments.
AUD swap spreads exceed 100bp and then pullback
In the first half of 2007 AUD swap spreads barely moved.
10Y spreads started to widen in June as rate markets
sold-off, and then from July spreads have been subject to
the impact of the credit crunch. Swap spreads widened
sharply in November as credit fears re-surfaced, with
spreads ultimately pushing above the levels reached in
1998 during the height of the LTCM crisis. Since that peak
they have narrowed, especially at the front-end of the
curve.
AUD swap spreads
30
40
50
60
70
80
90
100
110
Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
10Y ACGB ASW spread
3Y ACGB ASW spread
Source: Deutsche Bank, Reuters
The influence of credit on long-end swap spreads is
clear
We would typically argue that the yield curve is the key
influence on AUD swap spreads over time. Given that the
yield curve reached a new low in early November some
upward pressure on swap spreads from this source would
have been expected. But the curve has steepened from
that point, yet swap spreads pushed sharply wider for the
next few weeks. This is because credit concerns have
taken over as the dominant influence on 10Y swap
spreads, with funding pressures an added factor at the
front of the curve. The link between credit and swap
spreads is evident in the following chart.
10Y AUD swap spread and Itraxx
45
55
65
75
85
95
105
115
Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
15
20
25
30
35
40
45
50
55
60
65
70
10Y AUD swap spread
(LHS)
5Y AUD Itraxx (RHS)
This suggests that if we are still bearish credit we should
be looking for swap spreads to widen further.
We look for short-dated swap spread to narrow in
early 2008
As we see it short-dated swap spreads are being
impacted by liquidity pressures, as happened in August,
as well as credit concerns. We think these funding
pressures will ease in early 2008, which should see short-
dated swap spreads narrow even if credit concerns
remain. To take advantage of this we will look to receive
3Y swap versus the March-08 bond futures contract. As
far as 10Y swap spreads are concerned, we think the key
is the direction of credit spreads.
Swap spreads to finish 2008 below current levels
As far as our outlook for all of 2008 is concerned, we
expect to see swap spreads quite a bit narrower than
current levels. This is because we think the extreme risk
aversion priced into bank spreads will likely ease as
investors gain comfort that the worst of the loss
disclosures is past. But with the curve likely to remain
inverted, swap spreads should remain wider than their
long-run equilibrium levels of around 40bp.
Current 10Y ACGB/UST spread is the widest since the
RBA gained formal independence
2007 has been relatively unusual in that the 10Y UST has
rallied quite strongly over the year as a whole but as of 12
December the 10Y ACGB was actually above its starting
point for the year. In 2007 the movement in the 10Y
ACGB/UST spread overwhelmed the direction of the US
long-end. But the 10Y spread had to double to its widest
level in more than a decade to offset the strong Treasury
rally.
10Y ACGB/UST spread
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Jan-96 Sep-97 May-99 Jan-01 Sep-02 May-04 Jan-06 Sep-07
10Y ACGB/UST spread
Source: Deutsche Bank, Datastream
Of course, the 10Y spread doubled because the market
went from expecting a 12 month ahead RBA cash/Fed
funds spread of a little more than 150bp at the start of
2007 to one of almost 400bp at the time of writing. This
gives us a sense of what it will take for the 10Y ACGB to
again miss out completely if 2008 proves to be as good a
year for the 10Y UST as 2007.
That is, if the 10Y UST was to put in another strong rally in
2008 the 10Y ACGB will only miss out on at least some of
this rally if the market concludes that another couple of
hundred basis points of Fed rate cuts, on top of what is
already priced, has no implications for the RBA. We
struggle to believe the market will draw this conclusion if
the US economy has a hard landing. So in the event we
have another strong rally in the US we think it likely that
the long-end of the ACGB curve will participate more fully
in the gains than was the case in 2008 (though the 10Y
ACGB/UST spread will still widen well beyond 200bp in
this instance).
Spread compression to the US is our central
expectation
A 10Y UST rally to 3% is not our central case for 2008,
however. Rather, we expect the market to eventually
conclude that aggressive Fed action has lessened the
severe downside risks to the outlook sufficiently to push
long-end yields higher. Thus by the end of 2008 our
thinking is that the 10Y UST yield will be higher than now.
The question then is whether the movement in the 10Y
spread will dampen or amplify the transmission of the
move in the 10Y UST to the 10Y ACGB? In our view the
spread is likely to dampen the transmission of the US
move. That is, we see the 10Y spread narrower by the
end of 2008 than it is now. But just as we needed a
massive widening in the 10Y spread to completely offset
the 10Y UST rally in 2007, we will need a massive
compression in the spread in 2008 to allow the 10Y ACGB
to rally if the US long-end does sell-off. We think such a
move in the spread is possible, but unlikely. Our central
scenario for yields and spreads over 2008 is presented in
the table below.
10Y ACGB yield and spread forecasts

10Y yield

10Y ACGB/UST
spread
Mar-08 5.75% 200-225bp
Jun-08 6.25% 150-200bp
Dec-08 6.50% 100-150bp
Source: DB Global Markets Research.
The scenario under which the 10Y ACGB yield can fall
even if the US long-end is selling-off is one in which the
US sells-off quite modestly and, for some reason, the
AUD front-end prices a series of RBA rate cuts regardless
of the move in US rates. While this combination is not out
of the question it strikes us as reasonably unlikely. Much
more likely, in our view, is the growing belief in an
eventual US turnaround (as the Fed funds rate falls
sharply) against fairly stable expectations for the RBA.
This produces a much steeper UST curve, a higher 10Y
UST yield, a sharp narrowing in the 10Y ACGB/UST spread
and a modestly higher 10Y ACGB yield.
Unchanged OCR most likely scenario unless the global
economy weakens sharply or housing recovers
Our forecast is for the RBNZ to be on hold in 2008. Given
the slowdown in the housing market that is well
underway, the forecast of an unchanged OCR would
seem to be overly conservative. But last weeks RBNZ
Policy Statement highlighted that a weak housing market
does not necessarily mean a substantial improvement in
the inflation outlook. Indeed, the RBNZs inflation
forecasts for 2008 actually deteriorated even as the Bank
revised down its growth forecasts somewhat and lifted its
assumed level for the TWI.
In our view the OCR will only end 2008 lower than its
current level if the outlook for inflation improves
dramatically. And it needs to be more than just an
improvement in headline inflation. We think domestic
price pressures have to ease in a sustained fashion.
The thing that would most likely change the inflation
outlook for the better in a material fashion, in our view, is
a sharp global slowdown. This would remove the strong
commodity prices that have underpinned the economy for
a number of years and are set to boost it further in 2008.
A down-turn in commodity prices associated with a sharp
global slowdown would likely impact on NZ quite
severely.
Another scenario that could see a change in the OCR in
2008 is one in which the global economy remains strong,
underpinning the income side of the economy (both
directly and via expansionary fiscal policy) and allowing
the housing adjustment to work its way through without a
serious impact on the broader economy. In this scenario
NZ gets to late 2008 with signs that housing is starting to
recover without the inflationary imbalances having been
corrected to any degree. At the same time the start-up of
the NZ Emissions Trading Scheme in 2009 adds further
upward pressure to the inflation outlook. In this scenario
the RBNZ may feel it has little choice but to tighten
further.
Given current pricing and the range of possible scenarios
we are neutral the NZ front-end at present. We think the
next big test domestically will be the Q4 CPI data on 17
January. A reversal of the downtick in annual non-tradable
inflation recorded in the Q3 data, which we think is quite
likely, will underscore the challenging inflation
environment facing the RBNZ and keep the market from
pricing an early start to the easing cycle.
Stable OCR suggests little scope for material curve
steepening in 2008
In our view the key determinant of the 2Y/10Y slope in NZ,
and the rest of the $-bloc for that matter, is the direction
of short-rates. Unless short-rates start to decline we
doubt the NZ curve can sustain anything other than a
modest steepening from this point.
The yield curve and short-rates
-1.25
-1.00
-0.75
-0.50
-0.25
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
Apr-99 Jun-00 Aug-01 Oct-02 Dec-03 Feb-05 Apr-06 Jun-07
4.0
4.5
5.0
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
2Y/10Y swap slope (LHS)
3M rate - inverted (RHS)
Some modest steepening is possible even if the OCR
doesnt move. Against stable expectations for the RBNZ a
US sell-off could see a steeper curve. There have been
occasions this year when the direction of the US long-end
has been important for the curve. But of its own the US
long-end can only cause a relatively small shift in the NZ
curve. The key to a material steepening of the curve in NZ
is a lower cash rate. Until we are confident of this we will
not be recommending the curve steepener.
What about looking for a flatter 2Y/10Y curve? The curve
has actually flattened notably in the past few months as
the US long-end has rallied. It is a challenge to consider
the flattener when the curve is already as inverted as it is.
Yet this would have been the right strategy for a number
of years, other than for a brief period at the start of 2006.
Given the global backdrop we dont think implementing
the 2Y/10Y flattener makes sense from a risk/reward
perspective. We think the prospect of a hard landing
globally is too high to support such a trade. But if this risk
starts to fade and we see any signs of stabilization in the
NZ housing market then looking for a flatter curve
becomes a more attractive prospect.
With regard to the front of the curve, we note two prime
influences: the direction of the cash rate and the direction
of the 2Y swap. Which has the most influence depends on
the stage of the tightening cycle. Early in the cycle the
direction of the cash rate matters the most, with the curve
flattening as rates move higher. However, in the later
stages of the tightening cycle, when the market thinks it is
drawing to a close, the direction of the 2Y swap takes
over.
The 1Y/2Y slope often a function of the 2Y direction
-0.50
-0.40
-0.30
-0.20
-0.10
0.00
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07
6.4
6.6
6.8
7.0
7.2
7.4
7.6
7.8
8.0
8.2
8.4
8.6
8.8
9.0
1Y/2Y slope (LHS)
2Y swap rate (RHS)
We see this in the chart above, where since the start of
2006 the direction of the 2Y swap has had a big impact on
the direction of the 1Y/2Y slope. We think this
directionality will continue in 2008. Thus we would
express a bullish view on NZ rates via a 1Y/2Y flattener
at least so long as we think that any RBNZ easing is a long
way off. This is a trade we currently have on our book.
We think rate spreads with the US will widen in the
early part of 2008 and then narrow by year-end
The 10Y NZD/USD swap differential remains closely tied
to the evolution of the expected short-end spread. As we
write the market is looking for the expected short-end
spread to widen by almost 100bp in 2008 from its current
level. This is entirely due to the amount of Fed easing
priced into the US front-end. So the issue for the 10Y
swap differential is whether the market will price
additional widening in the short-end gap than is already
priced.
We think there is a high likelihood of this in the next few
months. That is, we think the US front-end will price more
than another 100bp of easing into 2008 at some point in
the first few months of the year (though the Fed may not
ultimately deliver this), while the NZ front-end will be
relatively stable. For this reason we are forecasting
additional modest widening in the 10Y NZD/USD swap
differential in the first three months of 2008. From the
middle of the year we are looking for the US market to
start pricing a turnaround in the economy and thus Fed
policy.
david.plank@db.com (612) 8258 1475

Dollar Bloc Relative Value
Looking to 2008: A return to normalcy in credit should
restore some order

The AUD implied vol surface has risen over the
year particularly at the short end as the credit
crunch has injected vol at shorter tenors. Once
the credit issues fade, we think the yield curve
slope will return as the key driver.

ACGB linker breakevens particularly the 2020
are at extremely wide levels. As more supply
comes to the market from Semi-government
issuers we look for breakevens to contract.

The AUD/USD basis swap remains wide. When
issuers regain confidence we think it will begin to
narrow. We would see a material widening in the
basis as an opportunity to enter a received
position.

AUD vol back to 2004 levels
The long decline of implied volatility in Australia since
2003 has reversed course during 2007. Even with the
continued flattening of the yield curve through the year,
average normalised implied volatility through Q4 2007 to
date has risen to be on par with its levels in Q4 2004.
Quarterly average of AUD normalised implied vol
55
65
75
85
95
105
115
125
135
1m 2m
3m 6m
12m
We have observed in the past that the AUD vol surface
tends to steepen as the curve flattens. However, through
the course of 2007 this link has been tested, with the vol
surface flattening despite the increasingly inverted curve.
Long tenor and long maturity volatility has risen negligibly
over the year, with 1Y*10Y normalized implied vol
climbing just 9 basis points since January. During the
same period, vols 3M and shorter in tenor have increased
by nearly 40bp.
Looking forward to 2008, we think the credit crunch will
continue to have an impact on vol markets. In early
October, when it looked as if credit might be returning to
some semblance of normality, the level of vol dropped
and the surface steepened. However, short maturity vols
were quick to rise again as swap spreads again began to
widen through late October and the second phase of
the credit crunch began.
If credit markets do return to normal for an extended
period of time, we think this will see vol falling again to its
pre-August 2007 levels. We do not expect credit
pressures to persist too far beyond Q1 next year.
Changes in normalised implied vol since 2-Jan-07
1Y
2Y
3Y
5Y
7Y
10Y
1M
2M
3M
6M
12M
0
5
10
15
20
25
30
35
40
Swap T eno r
Opt io n M at urit y
The other possibility (albeit seemingly a small one) for a
significant shift in vol levels would be a change to the
market pricing RBA easings. This could steepen the yield
curve significantly and would point towards levels of vol
more like what was seen in the last easing cycle through
2001.
Until this happens, it seems that vol movement in the
short term is that long-tenor vols will rise to fairer levels as
selling pressure we have been seeing in that region of the
curve dissipates. Buying long-tenor and selling short-
tenor vol is an attractive strategy in the short term. In the
medium term, however, we think it is likely that all vols
will fall back as the credit crunch fades.
2020 breakeven inflation at record wides
The inflation-linked bond market has had a big year in
2007. Breakevens collapsed at the end of 2006 as actual
inflation fell, but the 2015 and 2020 breakevens began a
steady upward trend in 2007, largely ignoring soft CPI
prints in January and April. The two longer-dated
breakevens peaked in mid-October, with the 2020
reaching 3.60%.
The 2010 breakeven broke the trend early in the year,
splitting away from the 2015 and 2020 breakevens. With
less than three years to go to maturity, it was expected
that this bond would move to track real inflation more
closely over the remainder of it life. As CPI continued to
print softly through the early of part of the year, 2010
breakevens did indeed fall, but the higher CPI prints
through the latter part of 2007 drove a sustained widening
that lasted for six months from May to November.
The ACGB linker market remains highly vulnerable to
significant flows. The strong demand for inflation linked
debt through 2007 has been the primary force responsible
for keeping real yields bid low and pushing breakevens
wider, particularly at long maturities.
ACGB breakeven inflation
1.80
2.00
2.20
2.40
2.60
2.80
3.00
3.20
3.40
3.60
3.80
Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07
Aug-10 Breakeven
Aug-15 Breakeven
Aug-20 Breakeven
RBA Range
Some relief has come to the market of late in the form of
Semi-government issuance, and there is currently $1b of
TCorp and QTC linkers to mature between 2025 and 2035.
This helped tighten breakevens for nearly a month before
end-of-November flows (which we attribute to portfolio
managers restructuring to match benchmark indices)
Through 2008 we are looking for a tightening in
breakevens. Bootstrapped inflation from the breakeven
curve for the period 2015 to 2020 is now 4.15% - an
amount which is clearly extreme given the RBAs inflation
target of 2-3%. The broader trend, however, exclusive of
moves driven by heavy flows will be for breakevens to
remain correlated with bond yields.
Basis swaps: Waiting for a credit market turn
The AUD/USD basis spread pushed tighter in the early
part of 2007 on the back of a small flurry of Kangaroo
issuance. Ultimately, however, issuance was not
significant enough through the first half of the year to
produce further large moves with spreads gradually
drifting tighter.
The credit crisis impacted the basis in August, pushing the
2Y basis nearly 3bp wider over two days. The 5Y and 10Y
basis were also affected. However, early in September it
began to look as if the credit crisis might be abating, and a
few tentative issuers stood up with some Kangaroos. The
2Y and 5Y basis recovered to near their July levels, but the
2Y remained significantly higher.
AUD/USD basis swap curve inverts during 2007
4.0
5.0
6.0
7.0
8.0
9.0
10.0
2 Year 5 Year 10 Year
The second phase of the credit crunch in November saw
the basis again lurch wider, but the recovery has not
happened yet. We are hearing word of issuance gradually
beginning to pick up again in offshore markets, but there
has not been much activity in Kangaroos yet (the typical
driver of a basis tightening). When this picks up we think
the basis will return to its normal flows.
2Y/10Y basis spread slope
-3.5
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct-07
2Y/10Y basis spread slope
Given that 2008 is likely to start with some uncertainty
about the extent to which the AUD market is open for
Kangaroos, we expect volatility in the basis swap market
to persist in the short term. Our bias is to use any
material widening that might occur to enter into a
received position.
kenneth.crompton@db.com (612) 8258 1361
Global Linkers Update
TIPS Outlook 2008

The dynamics of intermediate and long
breakevens this year was particularly interesting.
B/Es were virtually unchanged although the level
of real yields declined significantly. We believe
the market is pretty efficient to reflect diverging
views on growth and inflation. Whether 2008 will
be the year of the demand shock or the year of
the supply shock will determine the dynamics of
real yields and of B/E.

Front breakevens have continued to behave in line
with the expected path of CPI MoM, i.e. with the
projected path of carry. We expect seasonal
effects and energy prices to continue playing a
major role, although the materialization of a
recession could overlay a significant downward
trend on breakeven levels in the 2Y to 5Y sector.

We believe that the correction experienced by
front TIPS B/E over the past few weeks has fully
captured the expected slowdown in CPI-U MoM
between Nov and Dec. We expect the pace of CPI
MoM to accelerate from January onwards and
would expect some outperformance particularly
given quite attractive forward breakeven levels.
We are mildly bullish on front B/E for the first
quarter of 2008.

Although the depreciation of the US dollar in
2007, combined with elevated commodity prices
and accommodative monetary policy could create
conditions for high headline inflation in 2008, the
downside risk to growth and the softness of core
inflation could annihilate these bullish factors for
B/E.

We believe that the uncertainty regarding the
future direction of intermediate and long TIPS B/E
is extreme and we favor long inflation risk
premium trades, i.e. 10Y-30Y B/E steepeners. Still,
our relative optimism on growth for 2008 and our
view on flows would make us mildly bullish
strategically on 30Y B/E.

The wide level of Libor-GC spread offers attractive
opportunities to buy TIPS ASW spreads. Against
UST ASW, the trade offers an exposure on tighter
nominal swap spreads with mildly positive carry.
We also identify a cross country opportunity
following the strong divergence of EUR vs USD
forward real yields. We would recommend selling
the USD vs EUR 10Y15Y forward real yield.

Lessons from the TIPS market in 2007
TIPS breakevens in the 10Y to 30Y sector experienced
only limited volatility this year as they traded in a pretty
tight range (see chart below).
Long and intermediate B/E unchanged this year
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
3.0
TIPS 10Y BE
TIPS 30Y BE
TIPS 2Y BE (rhs)
This dynamics was at odd with the dynamics of nominal
yields and real yields. While the current level of 10Y
breakeven is virtually the same as it was at the beginning
of the year, the 10Y real yield is lower by 60bp (see chart
below). In other words, the beta between real yields and
nominal yields has been 1 this year. The story is the same
in the 20Y and 30Y sector. The typical directionality of
breakevens did not apply, despite a very sharp rally in
yield and recurring flight to quality periods following the
Summer of Subprime.
despite an impressive richening of real yields
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
3.0
TIPS 10Y BE (lhs)
TIPS 10Y real yield (rhs)
We believe that the recent dynamics of the real yield
curve and of the breakeven curve has been consistent
with the macroeconomic context. The strong real yield
rally has been a reflection in our view of the downward
revisions of market expectations for real GDP growth (on
the back of the housing market meltdown and of the
financial crisis). On the other hand the resilience of long
breakevens in the face of the strong rally suggests that
the market has remained worried about the long term
inflation outlook. The combination of loss of credibility of
the Fed, of dollar depreciation, and of a continued rally in
commodity prices, has dominated market fears about
inflation. The market has been pricing a supply shock
scenario where inflation can coexist with subdued
growth. Whether breakevens will remain well bid in 2008
or whether they will decline and catch up with real yields
will mainly depend on the magnitude of the economic
slowdown in our view. We will develop in detail the
outlook for intermediate/long B/E in a subsequent section.
Front breakevens on the other hand have continued to
behave in line with the expected path of CPI MoM, i.e.
with the projected path of carry. However we have
started seeing a disconnection between the underlying
trend of 2Y to 5Y breakevens and the trend of headline
CPI YoY in the second half of the year as growth
expectations started declining.
Divergence of front B/E vs. headline CPI YoY
1.6
1.8
2
2.2
2.4
2.6
2.8
Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07
-1%
0%
1%
2%
3%
4%
5%
TIPS 5Y BE (lhs)
YoY Headline Inflation (rhs)
Disconnection B/E vs YoY CPI
Downward trend
on front B/E
A 2Y breakeven has to reflect realistic expectations about
the future average rate of headline inflation in the next
two years and although short term inflationary shocks
related to sharp increases in food or energy prices lead to
temporary/seasonal increases in front B/E (on the back of
the improvement of carry), front breakevens also have to
trend downward somewhat to reflect higher probabilities
of a disinflationary recession scenario taking place in the
next 2 years. Historically, in the 90s, headline inflation
YoY has reached levels below 1.5% in weak economic
environments.
In 2008 we therefore expect seasonal effects and energy
prices to continue playing a major role in the monthly
dynamics of front breakeven, although the
materialization of a recession could overlay a
significant downward trend on breakeven levels in the
2Y to 5Y sector.
Outlook on front TIPS breakevens
Practically, we believe that the market has now fully
priced in the likely upcoming slowdown between
November CPI MoM and December CPI MoM. Given
that November CPI is likely to come out particularly strong
at 210 i.e. +0.50% MoM (on the back of a 10% increase
in average gasoline prices between October and
November) and given the typical negative seasonals
associated with December and the correction in gasoline
prices so far since the start of the month, the slowdown is
almost a certainty and is going to lead to a deterioration of
carry.
Comparing the historical dynamics of CPI-U NSA MoM
and of the TIPS 09 breakevens, it seems that the strong
tightening experienced since the end of November has
brought the spot breakeven close to fair value. Given the
presence of positive carry in the next 3 months, and our
view that CPI MoM is likely to accelerate again from its
December level in January, we can observe a
disconnection between the forward levels of the TIPS
09 breakeven and the expected future levels of spot
B/E implied by the projected path of CPI MoM in Q1 2008
(see chart below).
Cheapness of front B/E in forward space
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07 Mar-08
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
BE CPI 2009
MoM US CPI-U NSA (1M lag)
1M, 2M
and 3M
fwd BE
Discon-
nection
This tends to show in our view some cheapness in
forward breakevens, a potential opportunity to become
long TIPS breakevens in the front-end at good levels in
anticipation of the start of the typical period of positive
seasonals in Q1 08. Moreover the recent increase in
import prices is likely to create upward pressures on
headline inflation in the next 2 to 3 months (see section
below for more details on the link between dollar, import
prices and headline inflation) and should therefore favor
the typical acceleration of MoM inflation early in 2008.
The risks associated with the implementation of long
positions in the front-end are threefold. First the realization
of the positive seasonals and of the acceleration of
inflation will depend on the short term dynamics of energy
prices. As long as gasoline prices stabilize, the carry
improvement should take place in Q1, but any collapse
could jeopardize the expected rebound in front breakeven.
The second risk is the materialization of a recession.
Seasonal effects make breakevens move around their
trend and should Q4 07 real GDP growth come out slower
than expected and the outlook for Q1 deteriorate further,
front breakevens could reprice the expected inflation for
2008 on the downside. Finally, although CPI MoM is
expected to rebound in Jan vs. Dec, 2M carry is going to
continue to decline until the end of January, which could
delay the expected rebound of front breakevens.
All in all, taking into account the recent Fed cut and the
new joint venture of central banks, united to solve the
liquidity crisis, we feel that market sentiment could
improve and support front breakevens. We recommend
implementing a widening bias on front B/E for Q1 08.
Finally, we find that relative value opportunities involving
the Jan-11 breakeven are still present and we would
recommend monitoring them closely as liquidity could
come back in the market in the upcoming days or weeks.
The TIPS Jan-11 breakeven is extremely cheap relative
to Jan-10 and Jan-12 B/E as shown by B/E butterflies.
This cheapness is such that we find strong distortions
along the term structure of forward breakevens. While
1Y1Y BE (implied by TIPS 09 and Jan-10) is close to
2.12%, the cheapness of the Jan-11 B/E has brought the
2Y1Y BE (implied by Jan 10 and Jan 11) to extreme lows
around 1.9% and the 3Y1Y BE (implied by Jan 11 and Jan
12) close to extreme highs around 2.65% (see chart
below).
3Y1Y BE disconnected vs. 2Y1Y BE
1.70%
1.90%
2.10%
2.30%
2.50%
2.70%
2.90%
Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Nov-07
2Y1Y BE (from TIPS Jan-10 and Jan-11)
3Y1Y BE (from TIPS Jan-11and Jan-12)
A 75bp spread between 3Y1Y BE and 4Y1Y BE does not
make any sense and we would expect TIPS Jan-11 BE to
richen going forward. We recommend buying TIPS Jan
11 breakeven against Jan 10 and Jan 12 BE, either as a
butterfly or by buying the 2Y1Y BE vs 3Y1Y BE.
Outlook on 10Y to 30Y TIPS breakevens
We have argued in previous publications that long TIPS
breakevens were somewhat caught between the
weakness of the US economy and the presence of
inflationary pressures generated by the recent
depreciation of the US dollar in a context of higher
commodity prices and the loss of credibility of the Fed as
an inflation fighter. We review below the factors that
could lead to persistent inflationary pressures in 2008,
typically positive for long breakevens. We will then review
the arguments for softer inflation and tighter breakevens.
Bullish factors for inflation and long B/E in 2008
- First, we believe the recent depreciation of the US
dollar could put upward pressure on headline inflation in
2008 and potentially 2009 through the channel of higher
import prices. Elasticity studies from the OECD show that
a 10% depreciation of the US dollar TWI typically leads to
a 1% positive inflation shock one year later. We verify the
relationship between the USD appreciation/ depreciation
and subsequent inflation in the charts below. We first
observe the lagged impact of the dollar depreciation on
import prices with a 15-month lag (see chart below).
Weaker dollar leads to higher import prices
-15%
-10%
-5%
0%
5%
10%
15%
20%
Oct-95 Nov-97 Dec-99 Dec-01 Jan-04 Feb-06 Feb-08
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
US Import prices YoY all commodity
US dollar YoY depreciation (15M lag, rhs, inverted)
We also witness the lagged impact of the dollar
depreciation on headline inflation itself, with a longer lag
around 18 months. This relationship takes place via the
strong link between headline inflation YoY and import
prices YoY with a 3 months lag (see chart below). Based
on these historical relationships, the depreciation of the
US Dollar TWI, of about 10% since last year, could have a
lasting impact on inflation at least until the end of 2008.
The latest reading of import prices YoY for November
came out at +11%, an all time high level, suggesting that
we are going to continue to see continuous upward
pressure on headline CPI in the next couple of months.
High import prices typically lead to high headline CPI
0%
1%
2%
3%
4%
5%
6%
Oct-95 Nov-97 Dec-99 Dec-01 Jan-04 Feb-06 Feb-08
-15%
-10%
-5%
0%
5%
10%
15%
20%
US CPI-U Headline YoY (lhs)
US Import prices YoY all commodity (3M lag - rhs)
Given the lagged effect of the dollar on inflation, the
evolution of the dollar in 2008 is likely to have an impact
on inflation only over the course of 2009 and 2010, but
could play a role on long term inflation expectations. We
believe the dollar could remain relatively weak in the
medium run. With a current account deficit of 6% of GDP,
the US is willing and likely to maintain its interest in a
weak dollar for years to come, via a revaluation of Chinas
Renminbi in particular. Middle East countries have also
started questioning the peg of their currencies to the
dollar. These oil-exporting states and other emerging
markets, which invested a large share of their foreign
exchange reserves in US treasuries, have begun to
refocus on international capital markets for diversification
and return optimization reasons. Thus reserves are being
transferred into sovereign wealth funds, and are
increasingly being held in euros. The dollar could
therefore continue to show signs of weakness in the
medium run.
However, in the longer run, the improvement of the US
economic situation, the end of rate cuts, and a reduction
of the deficits should stabilize the dollar. Ultimately the
positive demographic outlook in the US, relative to Japan
and Europe, the flexibility of the US economic and
financial system vs. Europe, could ensure that the US
dollar remains a leading currency.
- Second, elevated energy commodity prices have
been one of the key factors of upside risk to inflation cited
by the Fed and other observers. In the short term the rise
in energy prices typically boosts headline CPI on a
contemporaneous basis since energy CPI is a very
significant component of the overall CPI-U index. The
recent increase in gasoline prices is going to push
headline Nov CPI YoY above 4% and CPI-U YoY should
remain above 3.5% until the end of Q1 08.
In 2007, the near doubling of oil prices from about $50 a
barrel to levels close to $100 has been the result of strong
global growth, especially in emerging markets, and of
various constraints on supply, in a very tense geopolitical
context. In our main scenario where the US economy
experiences a slowdown but does not enter into a deep
recession, we would expect growth in emerging markets
to remain sustained and demand for energy commodities
to be relatively strong. Moreover should the Fed continue
to cut rates on the back of the deteriorating financial
conditions and of the downside risk to growth, the dollar
could continue to depreciate further, increasing the cost
of imported energy commodities in dollar terms.
- Third, food and other non-energy commodity prices
could also continue to represent a threat to price stability.
Their increase was driven by the global growth and
demand and by new policies encouraging the
development of biofuels. Analysts expect falling
inventories, growing shortages in Asia and rising US
ethanol production to continue to push corn and wheat
prices higher over the coming year. The charts below
show how higher food commodity prices translate
contemporaneously into higher food PPI YoY and how
higher food PPI leads to higher food CPI (15% of the
global CPI) with a 3-month lag.
Continuous increase in food commodity prices should
put upward pressure on Food CPI
-30%
-20%
-10%
0%
10%
20%
30%
40%
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12% CRB Food Index YoY (lhs)
PPI processed food YoY
0%
1%
2%
3%
4%
5%
6%
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Food & Beverages CPI (lhs)
PPI processed food YoY 3m lag
S i 3
We have also started observing a substantial increase in
Chinese import prices in the US. More precisely China has
increasingly been exporting inflation as higher food prices
have been causing increased wage pressures and
therefore have been leading to higher costs for exported
goods (see chart below).
- Finally the Fed has been facing a complex situation of
simultaneous downside risk to growth and upside risk to
inflation from food and energy components. The
deterioration of the credit and liquidity conditions
following the subprime crisis played the role of referee
and pushed the Fed to start cutting its target rate by 50bp
in September. At that time the Fed clearly chose to
support growth and financial markets at the expense of
inflation control (unlike the ECB). When the Fed initiated
its rate cut process, it itself acknowledged the presence
of inflationary pressures, in marked contrast to previous
rate cut cycles, when the FOMC described inflation as
being constrained. To justify the rate cuts despite the
presence of inflationary pressures, the Fed relied on soft
measures of core inflation. It simply argued that recent
inflationary pressures from commodity prices had not
reached core prices and that therefore, they should not
persist over time. As long as financial stress remains, the
housing market puts the economy at risk, and core
inflation remains soft, the Fed is likely to continue to cut
interest rates, and at the margin, to favor the development
of inflationary pressures in the longer run.
Increase in Chinese import prices in the US
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
Nov-04 May-05 Nov-05 May-06 Nov-06 May-07 Nov-07
US Import prices (all commodities)
from China YoY
- Moreover the concerted liquidity injections
(announced on Wednesday) from the Fed, the ECB, the
BOE, the BoC, and the SNB, to alleviate the pressure in
short-term funding markets is somewhat inflationary in our
view. The improvement of borrowing/refinancing
conditions for banks, the likely return of liquidity, and the
easing of credit rationing should be positive for the US
economy, and should therefore create a more favorable
environment for inflationary pressures to persist.
Bearish factors for inflation and long B/E in 2008
- Recession risk represents the key downside risk to
inflation and breakevens in 2008. Although TIPS
breakevens are typically directly connected to MoM and
YoY headline inflation on a monthly basis (at least
mechanically for carry reasons) larger trends for levels of
breakevens are rather determined by the evolution of US
real GDP growth (see chart below). Moderation in real
growth is a typical factor of future inflation moderation
through the canal of the negative demand shock. In other
words, low growth environments are typically associated
with lower demand for core products, lower wages,
higher unemployment, creating disinflationary pressures.
Although our main scenario corresponds to a moderate
slowdown of real GDP growth (in a range around 1.5%
and 2%) in 2008, the downside risk is significant given the
potential negative wealth effects of the housing market
meltdown on US consumers.
Real GDP growth, key factor of breakeven trends
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Aug-99 Feb-01 Aug-02 Feb-04 Aug-05 Feb-07
-1%
0%
1%
2%
3%
4%
5%
6%
TIPS 5Y BE
TIPS 10Y BE
Real GDP YoY (rhs)
Although a specific supply shock on a certain type of
commodities could lead to short term upward pressures
on headline inflation, we believe that a recession would
prevent these external cost and price developments to
lead to a sustained rise in inflation. Inflation can only rise
on a sustained basis if these higher input prices lead to
consumer price increases that in turn trigger further
rounds of cost increases. Firms can only raise prices if
aggregate demand is strong enough. In a recession,
higher input prices or wage costs would reduce profit
margins for companies. They could then cut production or
lay-off workers. Simultaneously, as income growth is
slowing, higher food or energy prices could depress
consumer spending on all other goods and services. This
weakness in demand would be disinflationary.
- Core inflation should remain soft in the months to
come in the context of moderating GDP growth even if
headline inflation remains relatively high. One of the key
components of core CPI, the owners equivalent rent
(OER), which corresponds to about 30% of the core
inflation index, should remain soft at least in the first half
of 2008 according to our analysis and should maintain
core inflation measures under control. The chart below
shows indeed that trends in OER tend to drive trends in
Core CPI. The OER measures how much an owner would
receive for renting out his home. Interestingly though a
more direct measure of rents is imbedded in the CPI,
namely the Rent of Primary Residence but represents
only 6% of the CPI-U. We find that OER growth has
typically been slower than rent growth historically,
maintaining core CPI at soft levels artificially. A key
reason is that the OER measure corresponds to pure-
shelter-service price and hence must exclude utilities.
Given that rents in the US include utility costs most of the
time these rents of utilities-included-units must be
adjusted downward to remove the utilities-component (for
a more detailed analysis of the OER vs Rent distortions,
please see our FIW 2-Nov-07).
OER YoY tends to drive core CPI YoY
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
Sep-97 Sep-99 Sep-01 Sep-03 Sep-05 Sep-07
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
Core inflation YoY
OER YoY growth (rhs)
As a consequence an increase in the cost of utilities (i.e.
an increase in energy prices) typically leads OER inflation
to slower levels than rent inflation. In order to develop an
outlook for OER, we give a view on the future trend of
Rents, and then on the spread between OER and Rents
(i.e. on the change in utilities CPI). We find a very long and
significant relationship between Rent CPI YoY and the
12M lagged headline CPI YoY since the mid 70s. The
interpretation is as follows: landlords typically observe, ex-
post, the level of inflation for the past year, and becoming
aware of the increase in their cost of living and in utilities
cost, they adjust their rent higher for the following year.
The chart below shows this relationship recently.
Rent inflation react with a 12M lag to CPI YoY
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
99 00 01 02 03 04 05 06 07 08 09
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
US CPI-URent of Primary Residence YoY (rhs)
US CPI-U NSA YoY with 12M lag -smoothed (lhs)
Given last years decline in headline inflation due to the
sudden crash in energy prices, we expect rent CPI to
remain soft in the months ahead, with some potential
upward pressure in Q4 in 2008 given the recent surge in
headline inflation YoY. Finally given the strong link
between Utilities CPI (cost from natural gas, fuel, etc)
and Energy CPI and the recent increase in Energy CPI YoY
(likely to persist in the next few months because of a base
effect), we are likely to observe in the next few months
OER CPI YoY growing at slower levels than Rent CPI YoY.
We would therefore argue that core inflation is likely
to remain soft for most of 2008, which could limit the
performance of TIPS 5Y5Y B/E, very correlated historically
to Core CPI MoM (see chart) and thus of the 10Y BE.
Soft Core CPI should keep 5Y5Y BE under control
2.1%
2.2%
2.3%
2.4%
2.5%
2.6%
2.7%
2.8%
2.9%
Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07
0.00%
0.05%
0.10%
0.15%
0.20%
0.25%
0.30%
0.35%
0.40%
5Y5Y TIPS B/E
Core CPI MoM
Simple macro model and conclusions
We have just shown that we could argue either for a
positive or for a negative environment for TIPS over the
coming year. On the one hand the unique context of
strong dollar depreciation, of higher commodity prices,
and of accommodative monetary policy, could create a
durably favourable environment for long TIPS breakevens
on the back of high headline inflation. On the other hand,
the materialization of a US recession could bring down
inflation to much lower levels, not only because of the
negative demand shock but also because a US recession
would likely bring down global growth and global demand
for commodities. With no clear view on the US growth we
could argue that inflation going forward could surprise
significantly on the upside and on the downside. The
distribution of TIPS breakevens could therefore be
characterized by fat tails i.e. by high kurtosis. In this
context we would favour trades that would benefit
from high inflation uncertainty in the months to come,
i.e. inflation risk premium trades.
We have recommended two weeks ago implementing a
TIPS 10Y-30Y breakeven steepener trade to capture the
inflation risk premium. Although the trade has started
performing, we still expect risk premia to remain high
for most of 2008 and we believe the 10Y-30Y BE
spread has more room to widen. Given that the 10Y B/E
is more sensitive to carry and seasonality than the 30Y B/E,
there is an element of seasonality in the trade. It is
possible to implement a beta weighted 10Y-30Y B/E
widener to remove the directionality of the spread with
respect to the 10Y breakeven.
More room on 10Y-30Y B/E steepener
0
5
10
15
20
25
30
35
40
45
50
30
40
50
60
70
80
90
100
110
120
130
TIPS 10Y-30Y BE slope (lhs)
DGX implied volatility (rhs)
Trade rec
In terms of outright view on long TIPS breakevens, the
decision depends mainly on the perception of the most
likely economic scenario and on current valuations. We
therefore run a simple macro model on 10Y and 30Y
breakevens involving 3 simple key variables: real GDP
growth YoY, USD TWI YoY (14M lag), and Crude oil MoM
(see chart below for the link between GDP, USD, and BE).
Lagged dollar depreciation and real GPD explain B/E
1.20
1.70
2.20
2.70
3.20
3.70 -30%
-20%
-10%
0%
10%
20%
30%
TIPS 30Y BE
USD Dollar TWI YoY inverted (14-months lag)
1.20
1.70
2.20
2.70
3.20
3.70
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07
-2%
-1%
0%
1%
2%
3%
4%
5%
6% TIPS 30Y BE
Real GDP Growth YoY
We run the model for 3 distinct economic scenarios.
The first one is our base scenario, of moderate
slowdown of real GDP growth in 2008 (the eventual
weakness in the US consumer being somewhat
compensated by stronger net export, boosted by the
dollar). We assume an average real GDP growth rate
around 2%. Given the lagged impact of the dollar
depreciation on inflation and on long breakevens (about 14
months on breakevens), the dollar outlook in 2008 does
not matter. In other words, long breakevens should
benefit in 2008 from the 10% depreciation of the US
dollar experienced in 2007, irrespective of the GDP
growth scenario in 2008. As for crude oil as a proxy for
commodity prices, we assume that a moderate growth
scenario could lead to a moderate price increase by 10%.
Our second scenario is our most pessimistic one and
the model output should give us what we believe are floor
levels for TIPS breakevens. In this scenario, we assume
that the US economy experiences a strong recession
leading to 0% real GDP growth in 2008. The US recession
leads to a global slowdown in growth in emerging market,
and to lower demand for commodities, hence an
assumed decline by 30% of crude oil prices. As for the
dollar, the lagged impact of the dollar depreciation in 2007
would be the only positive factor for breakevens.
Finally, our third scenario is our most optimistic one
and corresponds to surprisingly strong real GDP growth,
around 3.5%, leading to a new surge of commodity prices
by +30%. Again the recent dollar depreciation by 10%
would have a positive impact on B/E over 2008.
The tables below summarize the results:
Macro model output
Real
GDP
Crude
Oil
Lagged
USD
TIP S
10Y BE
TIP S
30Y BE
M ain scenario
( mild slowdown)
+2.0% +10% -10% 2.18% 2.57%
St rong US
recession
+0.0% -30% -10% 1.78% 2.28%
Resilient
economy
+3.5% +30% -10% 2.48% 2.80%
10Y 30Y Slope
Current levels 2.31% 2.57% 0.26%
M ain scenario
( mild slowdown)
-0.13% +0.00% +0.13%
St rong US recession -0.53% -0.29% +0.24%
Resilient economy +0.17% +0.23% +0.06%
The model shows that the current level of 30Y B/E (TIPS
32 B/E) is currently fully consistent with our base/main
scenario while the 10Y B/E is currently pricing in a slightly
more optimistic scenario. The downside risk on the 10Y
B/E appears more important than that on the 30Y B/E in
case of a recession while the upside risk is higher on the
30Y B/E than on the 10Y B/E in case of a resilient
economy. The model therefore confirms our view that
the 10Y-30Y BE spread should widen irrespective of the
economic scenario and that the performance of the 10Y
sector could be particularly limited in 2008, as suggested
by the 5Y5Y B/E chart shown previously.
Moreover 30Y breakevens in particular could benefit at
any point from structural demand emerging from US
pension funds or insurance companies willing to hedge
their long-dated inflation-linked liabilities. Recently we
have started seeing strong real money flows in the long-
end of the TIPS curve as investors have been focusing on
alternative and credit-risk-free investments. Fundamentally
we still believe that for a long term real money
investor, TIPS remain an attractive asset class
compared to nominal Treasuries. The probability of
outperformance of TIPS vs. nominal UST in the 10Y or 30Y
sector is significant in the long run, in our view. We
indeed believe that the probability of US headline inflation
running faster than 2.30% YoY on average for the next 10
years is quite high. Ideally in 08, buyers of long B/E should
simply hedge their position with a recession trade (i.e.
OTM bull steepeners).
Given our view that the inflation risk premium should
increase, that our main economic scenario is one of
moderate economic slowdown only, and that flows
could support longer breakevens, we maintain a mild
strategic widening bias on the 30Y B/E outright. We
mainly recommend holding 30Y vs.10Y B/E.
Opportunities on TIPS ASW
The extreme wideness of the LIBOR-GC spreads leads to
very attractive opportunities on trades involving TIPS
asset swap wideners. We present them below.
Buy TIPS ASW vs. UST ASW (convergence trade)
Historically, TIPS asset swap spreads have traded at
much cheaper levels than nominal US Treasuries
ASW. The reason for this phenomenon has been
structural. On the demand side US pension funds and
insurers for instance are end-users of inflation and are
significant buyers of inflation swaps. Supply of inflation,
on the other hand, only comes on the bond side in the
form of TIPS issuance. This supply/demand mismatch has
richened significantly ZC inflation swaps (ZCIS) vs. TIPS
B/E. Given that nominal cash flows of TIPS are estimated
using the forward CPI curve implied by the ZCIS, the
richness of the CPI swap market leads mechanically to
some cheapness in the TIPS ASW relative to nominal
ASW.
Typical cheapness of TIPS ASW vs. UST ASW
-100
-80
-60
-40
-20
0
0y 5y 10y 15y 20y 25y
TIPS ASW net-proceeds
UST ASW net proceeds
Years to maturity
bp
Structural
cheapness of TIPS
ASW vs UST ASW
Interestingly TIPS ASW move with a beta lower than 1
against nominal ASW, therefore in the recent widening
move of UST ASW, TIPS ASW have also richened but
to a lesser extent (see chart below). Consequently, the
spread between UST and TIPS ASW has widened to
extreme levels, particularly in the 2Y-3Y sector where the
widening of swap spreads has been the most important.
The spread between UST and TIPS swap spreads
currently ranges between 40bp and 50bp in the 2Y to 5Y
sector. This context generates an excellent
opportunity to implement a tightener of the spread
between the TIPS ASW and the UST ASW as a way to
gain an exposure on the tightening of nominal ASW and
on the resolution of the liquidity crisis.
Recent widening of TIPS and UST ASW
-120
-100
-80
-60
-40
-20
0
May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07
TII 3.50% 01/11ASW
UST 5.00% 02/11ASW
Net-proceeds
Many investors have been reluctant to implement
tightener trades on nominal 2Y ASW given the magnitude
of the LIBOR-GC spread, source of significant negative
carry (about -14bp on the UST Jan-10 and -10bp on the
UST Feb-11 over 3 months). Implementing the tightener
trade indeed involves receiving Repo GC vs paying LIBOR
minus the spread.
By buying the TIPS ASW (spread widener) against selling
the UST ASW (spread tightener), i.e. by implementing a
TIPS vs UST ASW convergence trade in the 2Y to 3Y
sector, the carry is mildly positive (even assuming a GC
rate realistically lower on the UST than on the TIPS, thanks
to the high differential between the TIPS ASW and the
UST ASW) while the global exposure is virtually
equivalent to that of a UST ASW tightener trade
outright (see below the strong correlation between the
UST Feb-2011 ASW itself and the spread of TIPS vs UST
ASW).
3Y TIPS vs UST ASW trade is a carry efficient way to
implement a nominal swap spread tightener
-110
-100
-90
-80
-70
-60
-50
-40
-30
-20
May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08
10
20
30
40
50
60
UST 5.00% 02/11ASW (lhs)
Spread TIPS 01/2011 vs UST 02/2011ASW (rhs)
3M
forward
-10bp
+1bp
We would recommend investors willing to take a
tightening view on nominal ASW, i.e. to implement a
market normalization trade, but finding the negative carry
of the trade particularly off-putting, to implement a TIPS
vs UST ASW convergence trade instead. It is possible
to hold on to the trade, earning flat to positive carry and
when the market normalizes, to benefit from the
retracement of the TIPS ASW vs. UST ASW spread back
to its historical level around 30bp. Given the lack of
liquidity in the inflation ASW market, we also suggest a
one-leg trade involving buying the 10Y TIPS ASW outright.
Buy 10Y TIPS ASW (widener trade)
We believe that the 10Y TIPS (Jul-17) ASW presents
an attractive opportunity to implement a spread
widener trade i.e. a trade benefiting from the
continuation of the liquidity crisis in the next few months,
a serious possibility given the disappointment of the
market following the Fed action and its neutral tone this
week.
The 10Y TIPS ASW has typically been much less volatile
than the 10Y nominal ASW and has traded in a very tight
range historically. With the subprime crisis and the
widening of all spreads and risk premia, TIPS ASW also
widened, but very moderately compared to nominal ASW.
Moreover the expectation by the market that the Fed
would commit to inject liquidity and to continue cutting
rates led to a corrective tightening of spreads in the
second half of November and in the first half of
December. In this process, the 10Y TIPS ASW tightened
back to levels that were relatively close to their pre-
subprime crisis levels, particularly when compared to
nominal ASW (see chart below, the chart shows Jan-16
ASW data where substantial history is available but the
picture is the same on the Jul-17 ASW).
Forward 10Y TIPS ASW is very tight
-80
-70
-60
-50
-40
-30
-20
-10
0
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08
TII 2.00% 01/16 ASW
UST 4.50% 02/16 ASW bp
3M
forward
Low downside
risk when buying
TIPS ASW
Interestingly the current disconnection between Repo GC
and 3M Libor creates a positive carry situation for TIPS
ASW wideners. Thus, not only the 10Y TIPS ASW looks
particularly tight compared to its nominal counterpart, but
its 3M forward level is about 3bp tighter. The forward
TIPS ASW is therefore even closer to its pre-subprime
range around 20bp. With the 3M forward ASW close to
24bp, the downside risk of the 10Y TIPS ASW widener
position is limited to 4bp in our view, which is very limited
for a spread widener trade. The 10Y TIPS ASW widener
trade may be one of the cheapest ways to buy some
risk premium today. We also believe that in the long run,
TIPS ASW should converge somewhat towards their
wider nominal UST ASW counterparts as natural payers of
inflation could appear.
Sell TIPS vs. EUR 10Y15Y real yield
TIPS real yields have rallied strongly over the past
couple of months on the back of the continuous
correction in the housing market leading to downward
revisions by the market of the real GDP growth
outlook based on the view that US consumption will
slowdown in the coming months. The rally was
reinforced by the flight to quality engendered by the
liquidity crunch and the lasting effects of the subprime
crisis. As a consequence, the Fed has started easing its
target rate and it is expected to continue as long as
financial conditions remain tense and as long as it sees
downside risk to growth.
Moreover the dollar has already depreciated strongly,
which should support exports and might prevent the US
economy from going into a recession. Further cuts could
continue to weaken the dollar and to improve the
competitiveness of US exports. All in all we expect the
easing of monetary conditions to lead to a resolution
of the liquidity crisis at some point in the months to
come and to support somewhat future US growth.
Interestingly, despite the steepening of the real yield
curve, long TIPS forward real yields richened to low
historical levels at a time when EUR forward real yields
where selling-off, leading to an extreme USD vs EUR
spread (chart below).
Richness of TIPS vs EUR 10Y15Y real yield
-0.60%
-0.40%
-0.20%
0.00%
0.20%
0.40%
0.60%
0.80%
Jun-04 Dec-04 Jul-05 Jan-06 Aug-06 Feb-07 Sep-07
USD vs EUR 10Y15Y real yield spread from Linkers
On the other hand, the economic situation could
deteriorate relatively quickly in Europe. First of all, the
dependence of European real GDP growth on exports is
crucial (see chart below) and the appreciation of the Euro
is likely to be a drag on growth in the next few months.
Strong Euro should affect Eurozone exports and GDP
0
1
2
3
4
5
6
Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07
-3
0
3
6
9
12
15
18 Eurozone real GDP YoY growth (lhs)
Eurozone exports growth YoY (rhs)
Moreover the appearance of worrying inflationary
pressures in Europe has prevented the ECB from easing
monetary conditions despite the liquidity crunch in
financial markets and the stronger Euro, equivalent to
implicit hikes. In this environment, we are likely to observe
a significant turn in economic cycle in Europe in the
months to come and ECB actions might come too late to
mitigate the economic slowdown. Despite this negative
economic outlook in Europe, long dated EUR forward real
yields have remained close to historically high levels due
to the strong steepening of the EUR real yield curve.
As a consequence the spread between USD and EUR
10Y15Y real yields is now historically negative, implying
that the long term equilibrium real GDP growth in the US
will be lower than the equilibrium real GDP growth level in
Euroland. Given the monetary policy and currency
mismatch in the US vs Europe we would expect this
spread to become positive in the months to come. We
recommend selling TIPS vs EUR 10Y15Y real yield.
Trade recommendations

Bullish bias on front breakevens in Q1 08

Mild strategic widening bias on 30Y TIPS B/E

Maintain 10Y-30Y breakeven steepener

Buy TIPS ASW outright or vs. short nominal ASW

Sell TIPS 10Y15Y vs. EUR 10Y15Y real yield
Jerome Saragoussi (1) 212 250 6846

Europe Linkers Outlook 2008

With energy and food prices moving sharply
higher, the HICP increase this autumn looks set to
be the strongest on record. As a result, favourable
carry prospects have benefited short-end
breakevens and rising inflation risk premia have
supported longer-term B/Es; the B/E curve has
flattened. Breakevens are also likely to have been
supported by reduced inflation supply.

We believe this movement may have run its
course. Despite further expected upward
pressures from food prices, a hawkish ECB, an
expected further softening in economic data and
declining year-on-year inflation in early 2008 may
weigh on B/Es, especially since supply is likely to
pick up in Q108. We enter the new year with a
negative bias.

After the upside surprise on French November CPI
OATei/OATi B/E spreads have tightened further.
While the move looks exaggerated from a macro
perspective, the possibility of a significant Livret
A rate reset on 1-Feb and the associated potential
increased hedging needs prevent us from taking
long OATei/OATi positions. We would advocate
B/E steepeners on the OATi curve though.

With risks to the UK economy to the downside
and the RPI/CPI wedge expected to narrow
significantly through 2008 (slowing house price
inflation, BoE rate cuts), UKTi breakevens look
vulnerable. Given the structural demand overhang
at the long-end any cyclical downgrade in
inflation expectations may put some steepening
pressure on the breakeven curve, but a recovery
in corporate inflation supply may mean some B/E
tightening in the long-end too.
EUR inflation outlook
While the first half of this year has been difficult for real
bond markets, linker total return indices have been rallying
since the middle of the year and, except for the very long-
end, total performance indices are in positive territory
year-to-date. Compared to nominal bonds, linkers have
out-performed this year (chart below).

Linkers outperform nominals in 2007
-1.5
-1.0
-0.5
0.0
0.5
1.0
B
T
P
e
i

0
8
B
T
A
N
e
i

1
0
O
A
T
e
i

1
2
B
T
P
e
i

1
4
O
A
T
e
i

1
5
D
B
R
e
i

1
6
B
T
P
e
i

1
7
O
A
T
e
i

2
0
G
G
B
e
i

2
5
O
A
T
e
i

3
2
B
T
P
e
i

3
5
linker out-performance (linker total return -
nominal total return), 2007 ytd

The macro backdrop
Economic growth in the first half of this year surprised to
the upside as the fiscal tightening turned out to be less of
a harm to economic activity than feared. As a result, policy
rate expectations were successively revised higher and
10y real yields increased by 60bp in seasonally adjusted
terms between March and June. With above-trend growth
meaning tightening labour markets and above-average
capacity utilization inflation expectations and breakeven
inflation rates increased in line with real yields (below).
A stagflation scenario?
2.00
2.05
2.10
2.15
2.20
2.25
2.30
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4
2.5
2.6
breakeven
real yield (rhs)
DBRei-16, seasonally adjusted
The re-pricing of credit and liquidity crisis this summer
brought a turning point for linker markets as the re-
allocation of portfolios towards less risky assets and the
parallel downgrading of prospects for growth and central
bank rates led to a rally in real yields and easing breakeven
inflation rates between July and September.
Real rates and breakevens thus moved in sync through
most of this year, but the situation has changed
significantly this autumn. While a re-newed intensification
of credit uncertainties has meant increasing concerns
about the economy and an ongoing rally in real yields, a
sharp rise in energy and foodstuff commodity prices has
pushed headline HICP inflation to 3% in November and
breakeven rates towards new highs (chart above) and has
triggered a discussion of potential stagflationary risks.
While the risks for an extended period of low growth and
high inflation are limited in our view, the macro outlook
remains uncertain. Crude oil prices have very recently
come off their highs and our commodity analysts expect
brent to move towards USD80/b in mid-2008. Barring a
rebound in oil prices consumer energy prices are unlikely
to add to headline inflation in the coming months, even
though gas and electricity prices may be adjusted in
January 2008, while base effect will subtract form the
headline year-on-year rate through most of next year.
Recent survey indicators and producer price trends
strongly suggest that processed food prices will continue
to put upward pressure on HICP inflation at least in the
coming couple of months and we expect processed food
price inflation to move towards 7% y/y early next year and
headline inflation to rise to 3.1% y/y in December. In fact,
the rise in HICP between August and December is
expected to reach 1.9% this year which would be the
strongest price increase between these two months on
record (since 1995, see chart below) and thus mean more
favourable carry prospects than what the typical seasonal
pattern would imply.
Strong price increases at the end of this year
-0.5
0.0
0.5
1.0
1.5
2.0
1995 1997 1999 2001 2003 2005 2007
Rise in HICPxt between August & December
%
Understandably, shorter-end breakevens benefited from
the improved carry outlook, but longer-term spot as well
as forward breakevens also moved towards highs with
5y5y forward and 10y10y forward B/Es trading around
2.50% and 2.60% respectively, i.e. around 25bp above
the level reached on average in H12007. With recent price
developments as such not implying a deterioration in
longer-term inflation prospects, the outlook for inflation
valuations will not least depend on how underlying
inflation trends react to the run-up in food and energy
prices.
HICP pushes B/Es towards highs
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Jan-98 Jan-00 Jan-02 Jan-04 Jan-06
HICPxt current 10y B/E
min B/E max B/E
%
Core HICP inflation has remained more contained this year
than could have been expected given the macro-backdrop
(it has trended sideways at 1.9% since February), but
some indirect effectsi.e. price effects resulting from
higher production costsare in fact likely to be inevitable.
Gas and electricity prices for example are scheduled to be
raised in January 2008 as a result of the recent rise in
crude oil prices, but given the moderate trend in producer
prices of core consumption goods HICP core goods
inflation is unlikely to accelerate strongly in the months
ahead. The risks are somewhat higher for services prices
as cateringrestaurant, caf and canteenprices (7.5%
of the CPI basket) can be expected to be pushed higher
next year as a result of the current (and coming) increases
in food prices (chart below).
Higher food prices on the menu
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
-2
-1
1
2
3
4
5
6
7
catering
food (8M lead; rhs)
% y/y
% y/y
HICP components
A more fundamental inflation risk is the emergence of
second round effects, i.e. that the recent increase in
prices would spill over into expectations of permanently
high inflation, thereby affecting price and wage setting
behaviour. This risk appears to be relatively high in the
current context since food prices typically have a
disporportionally high weight in households inflation
perceptions, growth and labour market trends have
remained robust until recently, inflation has repeatedly
surprised to the upside in recent years (and thus real
wage gains have been less than expected) and there
seems to be some dissatisfaction among households over
trends in purchasing power.
Consumers sensitive to food prices
0
5
10
15
20
25
30
35
40
45
Jan-94 Jan-97 Jan-00 Jan-03 Jan-06
-2
-1
0
1
2
3
4
5
6
7
8 EC consumer inflation expectations
food price inflation, 6m saar (rhs) %
While these risks certainly justify some rise in the inflation
risk premium, several factors argue against a significant
upshift in the longer-term inflation trend: (i) the ECB has
kept a hawkish line, relative to its peers but also relative to
the changes in the economic backdrop, which should
keep a lid on inflation expectations; (ii) growth appears to
be slowing, may be more quickly than expected, and risks
are likely to be on the downside; slowing growth would
make it more difficult to raise output prices and output
price balances in business surveys have recently stopped
rising; (iii) this years moderate core price and wage trends
suggest that it remains very difficult to push through price
and wage increases given stern international competition;
(iv) the exchange rate has appreciated by around 10%
since the middle of last year and by around 5% since the
middle of 2007 in trade-weighted terms; according to
large scale macro models a 10% rise in the exchange rate
could subtract as much as 0.7% from inflation after one
year; (v) low cost producers continue to gain market share
in the euro area, which given the lower price level of the
imported goods means ongoing inflation dampening
effects from trade, especially if import quotas are lifted
further.
Headline inflation to slow in 2008
0.8
1.3
1.8
2.3
2.8
3.3
Jan-01 Jan-03 Jan-05 Jan-07
HICP
core (total excl energy, food, alc, tob)
% y/y
forecast
base effect from
German VAT
On balance, we would argue that the baseline macro
scenario for early next year will be a challenging one for
breakevens, especially given current trading levels. In fact,
a decline in headline year-on-year inflation, more signs of
easing economic growth, the market starting to price in
possible ECB cuts (linkers tend to under-perform in an
environment of a flattening money market curve) could
prove to be a negative for breakevens in Q1 and our
macro model suggests that the inflation risk premium
currently is at exceptionally wide levels (chart below).
However, a slow uptrend in core inflation (excluding the
German VAT effect) should provide some support.
Macro backdrop points to lower B/Es
1.90
1.95
2.00
2.05
2.10
2.15
2.20
2.25
2.30
2.35
2.40
Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07
B/ E 10Y
fit ted
%

Supply & demand trends
With growth surprising to the upside, public finance
consolidation has progressed somewhat more quickly
than expected during the past couple of years. Tax
receipts again were above expectations this year and
issuance plans for H207 were cut half way through the
year. About EUR30bn of the roughly EUR43bn of 2007
sovereign linker supply were issued in the first half of the
year and reduced supply is likely to have been a factor
supporting breakeven levels towards the end of the year,
in particular since the tightening in credit conditions also
meant only very limited non-sovereign issuance.
Sovereign linker issuance to pick up again
0
5
10
15
20
25
30
2003 2004 2005 2006 2007 2008 (e)
20
25
30
35
40
45
50
55
60
FR IT DE
GR EUR (rhs)
linker issuance, EURbn
Slowing economic growth as well as pressures for
increased government spending are likely to mean that
the process of public finance consolidation will lose
momentum next year. Headline government deficits are
projected to show a marginal decline at best in the big3
economies, and a heavy redemption schedule means that
total gross bond issuance is likely to increase. With
breakevens still high from a historical perspective,
conditions remain relatively favourable for linker issuance
and the share of linkers in total bond issuance is expected
to remain high in Italy and France and rise in Germany.
Sovereign supply is likely to be front-loaded into the first
half of the year again and with Germany expected to (tap
the OBLei-13 and) issue a new 30y bond, Greece to re-
open the GGBei-30 and France reported to contemplate a
new 15y or 30y OATi, supply may well be tilted towards
the longer-end which raises the risk of the 30y sector
under-performing on the curve early next year.
Concerning non-sovereign supply the uncertainty remains
high. Press reports suggest that a significant amount of
infrastructure debt placements in particular have been
postponed because of the difficult market conditions. A
normalisation of the latter could hence mean an increase
in non-government supply early next year.
Demand for inflation products has remained robust or
even increased. Assets invested in specialized inflation
funds denominated in EUR have declined slightly this
year, but this was offset by an increase in assets invested
in USD inflation funds (which are often invested globally).
There are also signs that some of the holdings have been
switched to specialized LDI funds which have seen their
volumes grow significantly this year.
Inflation funds
-5
5
15
25
35
45
55
65
75
H104 H204 H105 H205 H106 H206 H107 11/07
assets in USD inflation funds
assets in EUR inflation funds
EURbn
Source: BBG, Deutsche Bank
In general, LDI flows continued to develop with Dutch
pension funds in particular increasing their holdings of
inflation-linked assets and this trend is expected to
continue and intensify next year. Overall, while an
increase in supply may weigh on breakevens temporarily
(and may amplify downward pressure on B/Es from macro
drivers early in the year), more structurally increasing
demand is expected to easily absorb the additional supply.
OATei vs OATi
OATei - OATi spreads have seen another volatile year in
2007. Breakeven spreads tightened significantly in the
wake of this years presidential election on news that the
new French government was contemplating a hike in
value-added tax, but re-widened later during the summer
as it became clear that these plans were put on ice.
Spreads then stabilized at levels slightly below the
average prevailing during the first half of the year, before
tightening again recently, in particular at the shorter-end.
EUR/FRF breakevens spreads
-5
0
5
10
15
20
25
30
35
40
Dec-06 Feb-07 Apr-07 Jun-07 Aug-07 Oct -07 Dec-07
ei12-i11
ei10-i09
bp
B/ E spread, seasonally adjusted
While some of the tightening may be due to expectations
of stronger increases in food prices in France in
December, expectations of a significant increase in the
Livret A rate in February 2008 and the associated
increased hedging needs are likely to also have helped.
The biannual adjustment of the Livret A rate is mechanical
and based on EURIBOR and CPI data registered in
December, although in exceptional circumstances the
BdF may decide not to apply the usual formula. Given
current data trends, the rate may well increase to 4.00%
on 1-February, from currently 3%.
This would be an exceptionally high rate for this type of
risk-free and flexible savings vehicle and could lead to a
significant rise in Livret A deposits (currently EUR116bn
outstanding) early next year and thus increase demand for
French inflation around the 10y point.
Moreover, plans to increase value-added tax have not
been definitively abandoned and more support for OATi
could emerge if the VAT debate re-surfaces once the
regional elections of March out of the way. In all, while
macro arguments would clearly argue in favor of OATei at
current spread levels, the prospects of a significant rise in
Livret A demand as well the possibility of a re-newed VAT
discussion means we prefer neutral EUR/FRF positions
going into the new year.
On the OATi curve, after the upside surprise on November
CPI short-end breakevens widened markedly and the B/E
curve now looks flat in forward space against our CPI
forecasts. In fact, 3M forward breakevens are still at three-
year lows (see chart below). Some pay-back for the sharp
energy price rises in November can be expected in
December and, despite more upside pressures from food
prices, we would prefer B/E steepening positions
(especially OATi-11/13), in particular given the potential
increase in Livret A hedging.
French B/E curve looks flat now
-2
0
2
4
6
8
10
12
14
Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
OATi 13 - OATi 11
cpi x tob, fr
% mom
bp

Credit revaluation & relative value
The revaluation of credit in recent months has led to two
noteworthy relative value trends in inflation markets. For
once, lower credit risk paper has generally fared better
with the DBRei-16 out-performing. For example, the
DBRei-16/OATei-15 B/E spread has tightened since the
spring, despite further evidence of the HICP seasonal
pattern becoming more pronounced, i.e. pointing towards
a widening of the spread. In other words, in seasonally
adjusted terms, the DBRei-16/OATei-15 B/E spread has
widened towards extreme values.
GGBei-25 B/E cheapens vs neighbors
-10
-8
-6
-4
-2
0
2
4
May-06 Sep-06 Jan-07 May-07 Sep-07
50/50
OATei 20/GGBei 25/OATei 32
B/E butterfly
The spread widening has however been most visible
between Italian and Greek linkers on the one hand and
core paper on the other. The GGBei-25 B/E has
cheapened markedly vs its OATei neighbors (chart above)
while the BTPei-17 B/E has reached new lows in the
DBRei-16/BTPei-17/OATei-20 fly or relative to the DBRei-
16 B/E (chart below). The credit component in inflation can
largely be explained by the fact that breakevens compare
real and nominal bonds of similar maturity, but not of
similar duration and that higher duration bonds are
affected more by a steepening in the credit curve.
So does the BTPei-17
1
3
5
7
9
11
13
Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07
BTPei 17 - DBRei 16
B/E spread
bp
The second trend has seen a richening in zero-coupon
breakevens relative to bond B/Es. Indeed, the difficult
credit conditions have meant a reduction in inflation
supply in derivatives format while pension fund demand
for inflation derivatives has at the same time remained
robust. With Banks left to do the cash-derivatives
recycling and balance sheet costs increasing, zero-coupon
swap breakevens have out-performed cash breakevens
since this summer (chart below).
Swap B/Es widen relative to cash B/Es
2
4
6
8
10
12
14
16
18
20
22
Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07
B/E ZC swap - B/E OATei-12 (sa)
bp
Mechanically, this has put cheapening pressure on linker
ASW spreads relative to nominal ASW spreads, which has
been particularly pronounced for BTPeis. As long as
financial market conditions remain difficult and natural
derivatives supply does not pick up, this trend may well
remain in place, particularly if pension fund demand
increases.
and real/nominal ASW differentials widen
5
7
9
11
13
15
17
Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07
BTPei-17
OATei-15
ASW differential, linker - nominal
bp
linker richens
relative to nominal
To recap, from a macro perspective breakevens look high
and first signs of stabilization in headline inflation may put
downward pressures on breakevens early next year,
especially if as expected the ECB sticks to a hawkish line,
growth indicators continue to slow and the euro remains
strong. Until then short-term upward inflation pressures
remain dominant however and upside risks on December
CPI may provide support for B/Es in particular at the short-
end. A pick-up in supply may also be a negative for
breakeven levels in Q108 in particular at the longer-end,
especially if non-sovereign supply recovers as well, but on
balance over next year the risk seems to be that new
demand outstrips additional supply. Still, we would prefer
entering the year with a negative breakeven bias with long
forward B/Es but also short-end B/Es looking particularly
vulnerable.

UKTi outlook
UK linkers had another excellent year with UKTi generating
returns of close to 7% and out-performing their peers
(chart below). Also, in breakeven terms, the UK is likely to
have been the best performer among the major markets
this year.
2007 (ytd) returns of sovereign linker indices
0
2
4
6
8
10
12
gobal US UK EUR SEK
linker total return 2007 (ytd)
%
Source: DBIQ, Deutsche Bank
In fact, after trending higher through the first half of this
year, real yields gradually moved lower since early July on
the back of successive downgrades of expectations for
growth and central bank rates (yields are down more than
40bp for 30y, more than 70bp for 10y) and despite a very
recent rebound, currently still trade close to the cyclical
lows recorded in autumn 2006.
Breakeven inflation rates have trended gradually higher
since mid-2005 and while the move has lost some
momentum over the past few months and long-end
breakevens currently trade just below the highs reached in
late June, they have nonetheless proved remarkably
resilient against the backdrop of a marked rally in nominals
and deteriorating growth expectations (chart below).
Breakevens high
2.80
2.90
3.00
3.10
3.20
3.30
3.40
3.50
3.60
Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07
UKTi 16
UKTi 35
breakeve rates
%
Indeed, while rising energy and food prices have meant
some upward revisions to near-term inflation forecasts,
core inflation has actually surprised on the downside since
this summer and the downgrade in growth prospects has
led to expectations of easing pipeline price pressures.
Core inflation has eased back
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
CPI
Core (total ex energy, food alc & tob)
% y/y
We believe the UK economy will slow quite quickly as a
result of tightening credit standards and that the risks to
consensus growth forecasts are to the downside. With
financial strain on consumers increasing, households will
be sensitive to rises in prices and producers and retailers
are likely to be reluctant to pass-through past cost
increases. In these circumstances we expect the
underlying inflation trend to remain contained next year.
Expected rate cuts point to narrower RPI/CPI wedge
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
3M LIBOR (12M change; lhs)
RPI-CPI (y/y spread; rhs)
While CPI inflation is expected to move broadly sideways,
RPI inflation is projected to slow gradually and a
significant narrowing of the RPI/CPI gap, currently at
2.1pp, seems to be on the cards. First, house price
inflation is slowing and the DCLG measure which the ONS
uses to proxy housing depreciation costs in the RPI may
well slow towards zero at the end of 2008, from over
10% currently. As a result, the contribution to the wedge
from the other housing-component could also quickly
wane, from currently 0.4pp. Moreover, with BoE policy
rates expected 75bp lower in autumn 2008 than in autumn
this year, the contribution to the RPI/CPI gap from
mortgage interest payments could also fade (chart above)
from currently 1.1pp.
RPI to converge towards CPI next year?
0.0
1.0
2.0
3.0
4.0
5.0
6.0
CPI
RPI
% y/ y f orecast
As a result, we expect RPI and CPI inflation to converge
through next year and RPI year-on-year inflation to reach
2% in Q408 (chart above). The expected cyclical
slowdown in RPI inflation may prove to be a negative for
breakevens going forward.
While the level of breakevens thus may look stretched
against the macro backdrop and a BoE target of 2%, the
reduction of non-sovereign inflation supply in the wake of
this summers credit crunch is likely to have been a factor
supporting linkers in the context of a structural demand
overhang. Indeed, while gilt issuance in Q4 was in line
with expectations, corporate supply declined sharply in
the last quarter of this year (chart below).
Non-sovereign supply sharply lower in Q4
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
Q107 Q207 Q307 Q407
sovereign
non-sovereign
GBPm
inflation supply
Total gilt issuance is expected to fall by GBP8bn to
GBP50bn during the next fiscal year, and although the
proportion of linkers may increase somewhat from the
current close to 26%, total linker issuance may end up
slightly below this years GBP15bn.
There remains significant uncertainty about the
development of corporate supply. Clearly there is
potential for some catch-up with deals having been
postponed during the last quarter of this year. While the
effects on corporate issuance of financial difficulties at
monocline insurers remain unclear and markets are far
from normalizing, the timid pick up of activity towards the
end of this quarter (Walsall and Essex hospital PFI, Amey
Lagan Roads) is encouraging. A more meaningful recovery
in corporate supply in the context of decelerating RPI
inflation may mean some downside risks for breakevens
even at the long-end. More generally however, the
structural demand/supply imbalance is likely to continue to
support breakevens in particular at the long-end and any
cyclical downgrade in inflation expectations may put some
steepening pressure on the breakeven curve.
Markus Heider (44) 20 7545 2167

Auction Calendar
Market Ticker/Coupon/Maturity Date Tap/New Issue Size
AUSTRALIA Nothing Expected
AUSTRIA
Nothing Expected
BELGIUM
Nothing Expected
CANADA
Nothing Expected
DENMARK
Nothing Expected
FINLAND
Nothing Expected
FRANCE
BTF
BTF
Mon, 17 Dec 2007
Mon, 24 Dec 2007
Tap
Tap
TBA
TBA
GERMANY
Nothing Expected
GREECE
Nothing Expected
IRELAND
Nothing Expected
ITALY
ICTZ
BOTS 0% 06/08
Thu, 27 Dec 2007
Thu, 27 Dec 2007
Tap
Tap
TBA
TBA
JAPAN
JGB 0% 12/08
JGB TBA% 12/27
JGB 0% 04/08
PORTB 0% 03/08
JGB TBA% 01/10
Mon, 17 Dec 2007
Tue, 18 Dec 2007
Wed, 19 Dec 2007
Wed, 19 Dec 2007
Fri, 21 Dec 2007
Tap
New Issue
Tap
Tap
Tap
JPY
JPY 800 bn
JPY
JPY
JPY
NETHERLANDS
Nothing Expected
NEW ZEALAND
Nothing Expected
NORWAY
NGTB Mon, 17 Dec 2007 Tap TBA
PORTUGAL
Nothing Expected
SOUTH AFRICA
Nothing Expected
SPAIN
SGLT
SGLT
Wed, 19 Dec 2007
Wed, 19 Dec 2007
Tap
Tap
TBA
TBA
SWEDEN
Nothing Expected
SWITZERLAND
Nothing Expected
UK
Nothing Expected
US 4 Month
3 Month
6 Month
Tue, 18 Dec 2007
Mon, 17 Dec 2007
Mon, 17 Dec 2007
Tap
Tap
New Issue
TBA
TBA
TBA
Contacts
Name Title Telephone Email
FRANKFURT
Bernd Volk Covered Bonds/SSA 49 69 9103 1967 bernd.volk@db.com
LONDON
Aditya Challa Euroland & UK RV 44 20 754 51600 aditya.challa@db.com
Alessandro Cipollini Euroland & UK RV 44 20 754 74458 Alessandro.cipollini@db.com
Markus Heider Euroland RV 44 20 754 52167 markus.heider@db.com
Ralf Preusser European Strategy 44 20 7545 2469 ralf.preusser@db.com
Soniya Sadeesh Euroland & UK RV 44 20 7547 3091 Soniya.sadeesh@db.com
Gopi Suvanam Euroland & UK RV 44 20 7545 1600 gopi.suvanam@db.com
Francis Yared Euroland & UK RV 44 20 7545 4017 Francis.yared@db.com
NEW YORK
Ralph Axel US RV 1 212 250 7104 ralph.axel@db.com
Lei Chen US RV 1 212 250 9830 lei.chen@db.com
Mustafa Chowdhury Head of US Rates Research 1 212 250 7540 mustafa.chowdhury@db.com
Marcus Huie US Derivatives Strategy 1 212 250 8356 marcus.huie@db.com
Anish Lohokare US RV 1 212 250 2147 anish.lohokare@db.com
Aleksandar Kocic US Quantitative Strategy 1 212 250 0376 aleksander.kocic@db.com
Jerome Saragoussi US RV 1 212 250 6846 jerome.saragoussi@db.com
SYDNEY
David Plank $ bloc Strategy 61 2 8258 1475 david.plank@db.com
Kenneth Crompton $ bloc RV 61 2 8258 1361 kenneth.crompton@db.com
TOKYO
Christian Carrillo Asia Strategy 81 3 5156-6206 christian.carrillo@db.com
Alexander During Japan & Asia RV 81 3 5156 6199 alexander.duering@db.com

Appendix 1
Important Disclosures
Additional information available upon request
For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see
the most recently published company report or visit our global disclosure look-up page on our website at
http://gm.db.com.

Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the
undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in
this report. Mustafa Chowdhury, Ralf Preusser Francis Yared

Deutsche Bank debt rating key
CreditBuy (C-B): The total return of the Reference
Credit Instrument (bond or CDS) is expected to
outperform the credit spread of bonds / CDS of other
issuers operating in similar sectors or rating categories
over the next six months.
CreditHold (C-H): The credit spread of the
Reference Credit Instrument (bond or CDS) is expected
to perform in line with the credit spread of bonds / CDS
of other issuers operating in similar sectors or rating
categories over the next six months.
CreditSell (C-S): The credit spread of the Reference
Credit Instrument (bond or CDS) is expected to
underperform the credit spread of bonds / CDS of other
issuers operating in similar sectors or rating categories
over the next six months.
CreditNoRec (C-NR): We have not assigned a
recommendation to this issuer. Any references to
valuation are based on an issuers credit rating.

Reference Credit Instrument (RCI): The Reference
Credit Instrument for each issuer is selected by the
analyst as the most appropriate valuation benchmark
(whether bonds or Credit Default Swaps) and is detailed
in this report. Recommendations on other credit
instruments of an issuer may differ from the
recommendation on the Reference Credit Instrument
based on an assessment of value relative to the
Reference Credit Instrument which might take into
account other factors such as differing covenant
language, coupon steps, liquidity and maturity. The
Reference Credit Instrument is subject to change, at the
discretion of the analyst.

Regulatory Disclosures
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consistent or inconsistent with Deutsche Bank's existing longer term ratings. This information is made available only to
Deutsche Bank clients, who may access it through the SOLAR stock list, which can be found at http://gm.db.com
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this report: acting as a financial advisor, manager or co-manager in a pending transaction; 1% or other ownership;
compensation for certain services; types of client relationships; managed/comanaged public offerings in prior periods;
directorships; market making and/or specialist role.
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Hong Kong: See http://gm.db.com for company-specific disclosures required under Hong Kong regulations in connection with
this research report. Disclosure #5 includes an associate of the research analyst. Disclosure #6, satisfies the disclosure of
financial interests for the purposes of paragraph 16.5(a) of the SFC's Code of Conduct (the "Code"). The 1% or more interests
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appraisal or evaluation activity requiring a licence in the Russian Federation.
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Author: As referred to on the front cover. All rights reserved. When quoting, please cite Deutsche Securities Research as the
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their clients. The interpretation and advices herein are submitted on the basis of personal opinion of the relevant interpreters
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GRCM2007PROD012106

David Folkerts-Landau
Managing Director
Global Head of Research
Global Company Research Global Fixed Income
Strategies & Economics
Global Equity Strategies &
Quantitative Methods
Ross Jobber
Chief Operating Officer
Guy Ashton
Global Head
Marcel Cassard
Global Head
Stuart Parkinson
Global Head
Europe Germany Asia-Pacific Americas
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Regional Head
Andreas Neubauer
Regional Head
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Regional Head
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Regional Head
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