Global Directions 063011

June30,2011
THEBIGPICTURE
The Perfect Storm?

AftertheGreekvotes,wethinkfearsofanimmediatesovereigndefaultinEuropehavereceded.Thismightturnintoamore lastingchangeinsentiment,butweneedtoseemorebondmarketnegativeindicatorsemerge,particularlyoutoftheUS,for thistohappen.Wereentertacticalshortsandhighlightanumberofnormalisationtradesthatoughttobewatchedcarefully ifsentimentturnsonamorelastingbasis.IntheUS,thequarterendbalancesheetsqueezelikelyexaggeratedmoves,someof whichwedonotexpectwillbefullyunwound. Cont.onpg.5
The Glorious Summer Returns

Thereliefrallyonbreakeveninflationratessuggestsshiftingpositioningfromselectivelyshorttoneutralandalongstanceon cashvs.swapsineuroinflation.WeretainourpreferenceforUSinflationagainsteuroinflationwhilestrongerthanexpected Canadianinflationcaughtourlong10yTIPSvs.CADbreakeventradewrongfootedweshiftthetradetothe30ysector. Cont.onpg.9
RegionalPerspectives
Page16 Page20 Page23 Page35
UnitedStates
Weremainoftheviewthat thedebtceilingwillget passed,buttheharshreality isratherdaunting.If politiciansdontcometo theirsensesarecession wouldensue. Theincreaseinboth municipalnewissuevolume anddealsizeinJune increasesthelikelihoodthat issuancewillreach$230to $250billionbytheendofthe year.
Canada
AfirmMayCPIprinthasput BoCratehikesbackonthe marketsradar. Withonlyone25bphike pricedinthroughthenext fiveBoCmeetings,thefront endremainsvulnerable. Fornow,welike representingourbearish Canadianratesviewviaa5s 10sflattenerinswaps.
Europe
TheGreekgovernment securedapprovalforits austeritymeasures.Focus nowmovestoSunday's Eurogroupmeeting. Wepresentsome normalisationtradesafter marketslooksettorevert fromtheEuropeanabyss. Thefrontendgetsinthe focusagainandweexpect 25bpratehikesnextweek fromboththeECBandthe Riksbank.
Australia/NewZealand
AUbondstaketheircues fromtheglobalrallybutthe pricinginofaratecutlooks overdone. Soaringunitlabourcosts suggestthatinflationis headinginonlyone direction.AUsabysmal productivityperformanceis largelytoblame. Policysettingswilleventually needtobecomemore restrictive.AH2hikeremains morelikelythannot.
FIXEDINCOMEANDCURRENCYSTRATEGYIRESEARCH
ThisreportispricedasofmarketcloseonJune30,2011. AllvaluesinEURunlessotherwisenoted.
InsideThisWeeksEdition
TradeRecommendations..............................................................................................................................................3 TheBigPicture:ThePerfectStorm? ..............................................................................................................................5 AftertheGreekvotes,fearsofanimmediatesovereigndefaultinEuroperecedes.Whilstthismightturn intoamorelastingchangeinsentimentifUSeconomicdatamanagestobeatexpectations.Weenter tacticalshortpositionsandpresentanumberofnormalisationtradesthatoughttobemonitored. TheGloriousSummerReturns ......................................................................................................................................9 Areliefrallyonbreakeveninflationratessuggestsshiftingpositioningfromselectivelyshorttoanda longstanceoncashvs.swaps.WeretainourpreferenceforUSinflationagainsteuroinflation.Strongerthan expectedCanadianinflationcaughtourlong10yTIPSvs.CADbreakeventradewrongfootedweshiftthe tradetothe30ysector. WhattoWatchFor .....................................................................................................................................................13 Data&EventsCalendar ..............................................................................................................................................14 RBCEconomics&YieldForecasts................................................................................................................................15 U.S.Perspectives ........................................................................................................................................................16 TheDebtCeilingfrom30,000Feet:Weremainoftheviewthatthedebtceilingwillgetpassed,butthe harshrealityisratherdaunting.Ifpoliticiansdontcometotheirsensesarecessionwouldensue......................17 MunicipalsAstrongersecondhalf:MunicipalnewissuevolumepickedupappreciablyinJunefrom thelevelsprintedearlierintheyear .......................................................................................................................19 CanadaPerspectives...................................................................................................................................................20 Somerespiteforthebears:FirmMayCPIputstheBoCbackontheradar ...........................................................21 EuropePerspectives ...................................................................................................................................................23 Morethanaliveafterthevote:Wehighlightanumberofnormalisationtradesthatshouldscorewellif sentimentturnsonamorelastingbasis .................................................................................................................24 PeripheryMonitor:Greekpoliticiansthisweekvotedinfavourofthelatestbatchofausteritymeasures. WethinktheeurogroupmeetingonSundaywillthereforeapprovedisbursementofthenexttrancheof funding,withIMFapprovallikelytofollowonFriday.............................................................................................27 ECBpreview:WefirmlyexpecttheECBtopressaheadwithtighteningmonetarypolicynextweek,despite theweakereuroareaactivitydataoverthepastmonth.WeanticipateabroadlyneutralIntroductory StatementwhichwillkeepopenallfutureoptionsfortheGoverningCouncil ......................................................28 UK:AsummarypreviewofGiltsupplyinfiscalQ2. ................................................................................................30 RiksbankPreview:WefullyexpecttheRiksbanktoraiseitsreporate25bpto2.00%.Ourviewisthatthe frontendhaspricedouttoomuchinthewaytighteningandweseeopportunitiesforpositioningaheadof nextweek'smeeting................................................................................................................................................31 Australia/NewZealandPerspectives...........................................................................................................................35 Australiasabysmalproductivity:SoaringunitlabourcostswillkeeptheRBAstighteningbiasintact................36 SupplyOutlook...........................................................................................................................................................39 Contacts.....................................................................................................................................................................43 Disclosures .................................................................................................................................................................44
RBCCapitalMarketsGlobalDirections
June30,2011
OurTradeRecommendations
SellRXU1(pg.5)
Entry(30Jun11) 125.73ticks Current 125.73ticks Target 123.5ticks CutOut 126.2ticks 3mthCarry P&L
TNoteandBundfuturesthathavebothtakenouttheiruptrendsinplacesinceApril.Crucially,theyhavealsotakenout theJunelowswheremarketsattemptedtoselloffthelasttime.10yUSyieldsstartedtheirdescentinFebruaryaround 3.75%anddeclinednearly90bpbeforestagingaturnaroundthisweek.A50%correctioncouldsee3.30%andourQ3/11 forecastsevenpencilin3.65%.Infutureterms,technicalssuggestevenaselloffinthelow120areaintheTNoteand 123.50intheBundfuture.Whileitisbynomeansadonedeal,weprefertradingthemarketfromtheshortsideandrec ommendsmalltacticalshortsinBundfutures.
Long5yBTPvs.50%2yBTP&50%10yBTP(pg.24)
Entry(30Jun11) 21bp Current 21bp Target 14bp CutOut 24bp 3mthCarry 2.5bp P&L
TheBTPcurvestillholdsdistressedtradeopportunities,whichhardlymoveddespitethereliefinperipheryversuscore spreads.Forinstance,the510yASWcurveisstilltradingatextremelyflatlevelstherebyimplyingagloomypictureforthe Italiancreditwhilethe5ysegmentoftheItaliancurveistradingextremelycheapinthe2y5y10yASWfly.Withabrighter spreadpictureforthenearterm,wealsoexpecttheItalian510ycreditcurvetosteepenandthe2510yBTPflytore treatfromitselevatedlevels.Werecommendbuyingthecurrent5ybenchmarkBTP3.75%Apr16vs.50%BTP2%Jun13 and50%BTP3.75%Mar21.
Tactical2ySpainvs.Germanyspreadtightener(pg.24)
Entry(30Jun11) 200bp Current 200bp Target 165bp CutOut 220bp 3mthCarry +30bp P&L
Therisksstemmingfromthekeydriversoftheextremetier2spreadwideninginthepastfewweeks,animminentGreek default,andthehugeuncertaintyabouttheprivatesectorinvolvementforanewGreekbailouthavebeensubstantially reduced.Withinthetier2space,thefrontendoftheSpanishcurveshowedthestrongestperformanceversusGerman paperamidthisweeksspreadtightening.Weseeagoodopportunityforthetighteningtolastfortheneartermsup portedbythecarryadvantage.We,therefore,recommendbuyingtheSPGB4.2%Jul13vs.theDBR3.47%Jul13onatacti calbasisandinasmallsize.
CAD5s10sswapflattener(pg.21)
Entry(24Jun11) 95bp Current 90bp Target 75bp CutOut 105bp 3mthCarry 0.5bp P&L +5bp
WeenteredaCAD5s10sswapflattenerat95bp(target75bp,stop105bp)basedonanentrylevelsuggestedonJune9 (seeCanadaPerspectivesarticleBellyofCanadascurvelookingstretched).Canada's5ysectorcontinuestolookoverex tendedonthecurvebothonanequalweightedandaprincipalcomponent(PCA)weightedbasis.
June30,2011
OpenTradeRecommendations
Trade Entrydate Entrylevel 510yRAGBsteepenerboxedvs.FRTR/BTNS 20Jan11 9.5bp FRTR2.5%Oct20vs.BTNS2%Jul15andRAGB3.9%Jul20vs. RAGB3.5%Jul15 Tactical2y10yEURswapflattener 28Apr11 124bp 2yRAGBvs.OATwidener SellRAGB3.8%Oct13vs.FRTR4%Oct13 Sweden1041assetswapwidener 1041SGB6.75%2014 PayDecemberBoCmeetingOIS Long6yNLvs.50%6yGEand50%6yFR BuyDSL4.5%Jul17vs.50%Bund4.25%Jul17and50%OAT 4.25%Oct17 CAD5s10sswapflattener SEKDec11Dec12FRAsteepener SellRXU1 Long5yBTPvs.50%2yBTP&50%10yBTP BuyBTP3.75%Apr16vs.50%BTP2%Jun13and50%BTP 3.75%Mar21 Tactical2ySpainvs.Germanyspreadtightener BuySPGBJul13vs.DBRJul13 *accountingforcostofcarry 18May11 19May11 26May11 20Jun11 0bp 65.5bp 1.25% 11bp
Current 5bp
Target 4bp
Stoploss 13bp
3mthcarry 0.5bp
P&L* +4.5bp
Status Hold
124bp 3bp 74.0bp 1.08% 9bp
110bp 4bp 80bp 1.60% 5bp
130bp 2.5bp 58bp 1.08% 14bp
12bp +0.5bp 4.5bp 12bp +0.5bp
8.5bp +3bp +6.5bp 20bp +2bp
Hold Hold Hold Stopped Hold
24Jun11 30Jun11 30Jun11 30Jun11
95bp 20bp 125.73 21bp
90bp 20bp 125.73 21bp
75bp 40bp 123.5 14bp
105bp 10bp 126.2 24bp
0.5bp 2.5bp
+5bp
Setup Setup Setup Setup
30Jun11
200bp
200bp
165bp
220bp
+30bp
Setup
Source:RBCCapitalMarkets
June30,2011
TheBigPicture
The Perfect Storm?

LifeaftertheGreekvoteharboursrisksofabondmarketnegativeoutcome
PeterSchaffrik+44(0)2070297076peter.schaffrik@rbccm.com MichaelCloherty+12124372480michael.cloherty@rbccm.com
AftertheGreekvotes,fearsofanimmediatesovereign defaultinEuropereceded.Whilstthismightturnintoa morelastingchangeinsentiment,wecautionthatwe needtoseemorebondmarketnegativeindicators emerge,particularlyoutoftheUS. Thespotlightturnstobreadandbutterbondmarket drivers,namelyUSeconomicdata.Therearedecent chancesthatthedownbeatexpectationsaresurpassed, addingpressureonbondmarketsglobally. Onecouldevenimaginethatahostofotherbond marketnegativetopicsmayhavearevivalsoon,suchas ECBratehikes,theendofQE2anddiminished pessimismsurroundinggrowthprospectsintheUS.A perfectstormmightbebrewingup. Wehighlightanumberofnormalisationtradesthat oughttobewatchedcarefullyifsentimentturns. IntheUS,thequarterendbalancesheetsqueezelikely shiftedreservesfromforeigntoUSbanks,exaggerating pricemovesasUSbanksscrambledtoreducetheir balancesheets. Whileweexpectsomeofthesemovestobeunwound, otherfactorsatplaygiveusdifferingdegreesof confidenceinthemovesof30yrswapspreads,the 10s/30sbreakevencurve,and2yrswapspreads. Achangeinsentiment Byallmeans,marketswilljudgethisweekasamilestonein theEuropeandebtcrisis.AftertheGreekvote(s),the likelihoodishighthatthisweekendwillseetheEuropean leadersapprovethenexttrancheofaidandmighteven decideonthedetailsforthenextbailoutpackage.That meansthattheimmediatethreatofadefaultwithall potentialcascadingeffectsisremoved.Marketshaveand
shouldcontinuetotakeheed.Tobefair,webelievethatits tooearlytoexpectafullfledgedreliefrallytounfoldonthe backoftheGreekvotealone.Toomuchtrusthasbeenlost inthemeantimeincontrasttothereliefralliesseenin JanuaryandMarch.Yet,thereisadecentchancethatthe votesmightbethemereharbingerofawholehostofbond marketnegativestocome.Attentionshouldnextturnto 'breadandbutter'fixedincomedrivers,suchas(US)data releases,markettechnicals,etc.Todaysreactiontothe ChicagoPMIreleasealreadyindicatedhowvulnerablethe marketisandFriday'sISMfigureaswellasnextweeksUS NFPdatawillbecrucial.Importantly,technicalsalsolook poor. ThechartsBP1.1andBP1.2showtheTNoteandBund futurethathavebothtakenouttheiruptrendsinplace sinceApril.Crucially,theyhavealsotakenouttheJunelows wheremarketsattemptedtoselloffthelasttime.How steepcouldthereversallast?10yUSyieldsstartedtheir descentinFebruaryaround3.75%anddeclinednearly90bp beforestagingaturnaroundthisweek.A50%correction couldsee3.30%andourQ3forecastsevenpencilin3.65%. Usingthe10yBundasayardstick,yieldsdropped approximately72bpfromthehighat3.49%inApril.A50% correctionwouldstillrepresenta20bpyieldincreasetoan equivalentof3.18%inthecurrentbenchmark.Infuture termstechnicalssuggestevenaselloffinthelow120area intheTNoteand123.50intheBundfuture.Andwhileitis bynomeansadonedeal,weprefertradingthemarket fromtheshortsideandaddasmalltacticalBundfuture shortat125.73inourtradelistonpage3.
June30,2011
TheBigPicture
ThePerfectStorm?
ExhibitBP1.1:TNoteonthewaydown...
126
ExhibitBP1.2:...andBundfuture,too!
130
124 50% correction
128
122
126
50% correction
120
124
118
122
116
120
114 Jan-11
Apr-11
Jul-11
118 Jan-11
Apr-11
Jul-11
Source:RBCCapitalMarkets,Bloomberg
Sources:RBCCapitalMarkets,Bloomberg
Frontendandcurveshape Withnextweeklikelybringinganotherratehikeoutof Europe(seealsoourECBpreviewonpage28),thefront endoftheEuropeancurveispronetobeinthespotlight again.Infact,ithasseensomeofthemostpronounced stressmovesoverthelastweeksnotonlyinmarket pricingbutalsoinbehaviourintheECBtenders.ECB liquiditydemandssurgedasfundingstressincreased,just tobeunwoundagainthisweek.Excessliquiditymoved ExhibitBP1.3:AverageexcessliquidityvsEONIArepobasis
EONIA over repo rate (RMP average 0 -0.1 -0.2 -0.3 -0.4 -0.5 -0.6 -0.7 -0.8 0 100 200 300 400 excess reserves (average over RMP) averages over last RMPs
Source:RBCCapitalMarkets,ECB
current value (not RMP average)
highertostandaboveEUR50bnforthefirsttimesince May,puttingdownwardpressureonEONIAs.Thequestion mustbewhetherthissetsaprecedentforthecoming periodswhichinturnwouldjustifysignificantlylower forwardEONIAratesforanygivenreporatewedoubtit! ChartBP1.3showstheaverageEONIArepospreadover thelasttwoyearsinrelationtotheaverageexcess liquidity.Unlessweseeasustainedincreaseinliquidity demands,theassumptionmustbethatthisfigureretreats backtowardstheEUR20bnrangeitcamefromandthus EONIAsshallremainataround1520bpbelowtherepo rate. Withthatinmind,1.54%forDecEONIApricesjustabout onefullhikeafternextweekslikelyincreaseto1.50%in theECBsreporateatbest.AgainstourviewthattheECB willnotstopincreasingrates,wethinkthereisadecent chancethatforwardEONIAswillriseagainandthatthe EURyieldcurveresumesitsflatteningtrend.Wehave beenholdingfirmtoourEUR2y10yflatteningexposure overthelastweeksandseenoreasontochangethatview overthecomingdays. Euroareaspreadstighterbutcautiously ThemostobviousnormalisationtradeinEuropeis probablytheintraeuroareaspreadmarket,though.
June30,2011
TheBigPicture
ThePerfectStorm?
SpreadsofItalianandSpanishbondshavealready tightenedagreatdealandwethinkthereismore potential.Yet,weareawarethatalotoftrustandfaith hasbeendestroyedmostrecentlyandthusdoonly recommendtacticaltradesatthefrontendoftheSpanish curve,whichalsooffersabout30bpofpositivecarryover thenextcoupleofmonths(seepage24fordetails). Europeinthespotlight,USinthedrivingseat AndwhilethemajornewshasbeencomingoutofEurope, thecurveandspreadmovementshavebeenevenmore dramaticintheUS.Anumberofcurvesegmentsthathad simplybeentrackingthelevelofrates,like5s30sand 2s5s10s,movedfarmorethanjustifiedbythemovein yields.Shorterswapspreadswidened10+bpandthen tightened5+bpatthesametimethatlongermaturity swapspreadsinvertedalmost10bpandthenwidened 3bp.Also,the10y30ybreakevencurvesteepened14bp andthenflattened9bps. Recentmovesexaggeratedbybalancesheetsqueeze Wethinktheseexaggeratedmovementsarerelatedtothe balancesheetsqueezethatwediscussedinlastweeks GlobalDirections.Asarecap:Oneofthedownsidesof havingamassiveamountofliquidityinthesystemisthat cashcanquicklyslosharoundthesystem,rapidly expandingsomebanksbalancesheets.Foreignrelated banksintheUSaccumulatedmorethanUS$900bnof ExhibitBP1.4:Therecentflushouthasleft5s/30slook ingsteeptothelevelofrates.Overall,welikeforward steepenersbutcurrentlevelsdonotoffertheidealentry point.
2.90 2.80 2.70 5s30s 2.60 2.50 2.40 2.30 2.20 1.30 1.50 1.70 1.90 5y r UST 2.10 2.30 R2 = 0.8838 Since March 31st Since June 15th Last
cashassets(nearly90%ofcashassetsofUSbanksare reservesattheFed).JustasthestressintheEURmoney marketindicated,aportionofthatreservesholdingis presumablyaliquiditycushionincasestressinEurope intensifies.Yet,US$900bnistoobigforaliquidity cushionalargepercentageispresumablyforeignbanks arbitragingthedifferencebetweenshortratesandthe interestrateonreserves.SincethenewFDICfeelimitsUS banksabilitytoarbitrageinterestonreserves,foreign banksnowholdthemajorityofreservesattheFed. Yet,giventhestressinEurope,weexpectthatsome foreignbankswillaggressivelytrytoshrinktheirquarter endbalancesheets,inpartbynolongerarbingintereston reserves.Thosereservesdonotdisappearinsteadthey flowtoanotherbank,withlargeUSbanksbeingthelikely recipients.ThatmeanstheseUSbankssuddenlyseetheir balancesheetinflated,andtheytrytooffsetthis expansionbycuttingthebalancesheetinotherareas. Thetradesthatreducethebalancesheetmoveprices, whichthentriggersstoplossesinamarketwithlittle balancesheetroom.Accordingly,pricemovementsare significantlyexaggerated. Thismeanswethinkthebulkoftherecentprice movementsarelikelytounwind,althoughwehave ExhibitBP1.5:30yrswapspreadsthelatestmovehas presumablyflushedoutsomeoftheweaklongs.
-20 -22 -24 -26 -28 -30 -32 -34 -36 31-Mar-11 21-Apr-11 12-May-11 2-Jun-11 23-Jun-11 30yr swap spreads (bps)
June30,2011
TheBigPicture
ThePerfectStorm?
differentdegreesofconfidenceinthosemovements.A detailedviewoneachfollows. 30yrspreads IntheJune9thGlobalDirectionswewrotethatbeinglong 30yrspreadsistherighttradeforthosewithalong horizon,butwethoughttherewastoomuchriskofa flushingoutofbadlongpositionstogetlong30yrspreads immediately.Thislatestmovehaspresumablyflushedout someofthosebadlongs,providingagoodentrypoint.In addition,aggregateopeninterestintheultralong contracthascontinuedtogrowandthelongsremain primarilyrealmoneyinvestors,whichisconsistentwitha migrationfromaddingdurationwithswapstoadding durationwithfutures. 10s30sbreakevencurve Fundamentally,wethinktheTIPSbreakevencurveshould besteeper,astheweakeconomyandsofteroilprices shouldweighonshorterbreakevens,whilelonger breakevensshouldbesupportedbyconcernabouta perceiveduptickintheFedinflationtarget(aftertwo deflationscaresinadecade),heightenedpoliticalscrutiny oftheFed,andrisksaroundtheinflatedFedbalance sheet.Accordingly,wedonotthinkwewillseeafull reversaloftherecentsteepening. 2yrspreads Whilewethinkthemassiveamountofreservesheldby foreignbankswillkeepLIBORextremelystable,weare worriedthatinvestorswillmisinterpretwhatislikelytobe adramaticdropincashassetsofforeignbanksthatthe FedwillpublishonthenexttwoFridays.Aswediscussed earlier,foreignbanksarelikelytocontinuetoscaleback ontheirarbitrageinextremelyshortratesinorderto shrinktheirbalancesheets.
WealreadysawaUS$123bndropincashassets(reserves) heldbyforeignbankslastFriday(thatdatawasasofJune 15th).Weshouldseesignificantdeclinespublishedthis weekandnextweek,andsomeinthemarketarelikelyto misinterpretthismoveandextrapolatethetrendbeyond quarterendinaflawedforeignbankswillexhausttheir reserveholdingsinthreeweeksanalysis.Accordingly,we thinktherewillbeapronouncedintraweeklypatternin shortspreadsinvestorswillbebiasedtobelong2yr spreadsonFridays(particularlybeforelongweekends) andthatmovewillbeamplifiedbythesignsofforeign bankcashassetsdecliningrapidly.Afullreversalofthe2yr spreadwideningisunlikelyuntiltheFedshowsapost quarterendriseincashassetsofforeignbanksinthedata publishedonJuly15thand22nd. Summaryandmarketconclusions Marketslooksettohaveturnedandoutrightyieldsare rising.WebelievethataftertheEuropeandebtcrisis hastakenastepback,USdatawillbedrivingoutright moves.Weliketacticalshortsatthisstageandentered Bundfutureshortstoexpressthatview. WitharatehiketocomenextweekinEurope,wealso believethatthefocusislikelytoturntotheEuropean frontendagain,leavingthecurveexposedtocurve flattening. IntheUS,thebeginningofanewquartershouldbring somebalancesheetreliefandreversesomeofthe moredramaticmovesseenoverrecentweeks. However,wedonotbelieveafullreversaliswarranted insomepricemovements.30yrswapspreadsmay widenasrealmoneyinvestorsmigratetowardsfutures, butmarketsentimentshouldkeepthebreakevencurve steepandafullreversalofthemovein2yrspreadsis unlikelyuntillaterinJuly.
June30,2011
TheBigPicture
The Glorious Summer Returns

ThediscontentedGreekWinterpauses
ChristopheDuvalKieffer+44(0)2070290184christophe.duvalkieffer@rbccm.com
Reliefrallyonbreakeveninflationratessuggestsshifting upwardrepricingofinflationexpectationsand/orupside positioningfromselectivelyshorttoneutral(althoughnotlong) riskstoinflation. andalongstanceoncashvs.swaps. WeretainourpreferenceforUSinflationagainsteuroinflation. Seasonalimbalances StrongerthanexpectedCanadianinflationcaughtourlong10y Onereasonwhywerefrainfromalongstanceon breakeveninflationfornowisthatthecarryonshort TIPSvs.CADbreakeventradewrongfootedweshiftthetrade inflationpositionsremainsverypositive.Withdifferent tothe30ysector. magnitudesacrossinflationmarkets,thefirsthalfofthe Summerusuallyexhibitsverynegativeseasonalinflation Correctionandreliefrallyonbreakeveninflationrates seeExhibitBP2.1.Ifanything,seasonalinflationinJulyis Inflationvaluationscorrectedsharplytotheupsideafter thereleaseoftheoutlineofadebtrolloverproposalfor moremarkedintheeuroareathanintheUS,theUK,or Greeceandthevoteoffurtherfiscalconsolidation Canada.Interestingly,Augustisalsolargelynegativefor Canadawhichisnotthecaseelsewhere. measures.TheincreaseinnominalyieldsincoreEuropean countriespermeatedtoothernominalyieldsworldwidebut ExhibitBP2.1:monthlyseasonalinflation,% alsotobreakeveninflationrates.Indeed,flighttoquality, Canada US 0.60% flighttoliquidity,andtheabsolutepreferenceforcore UK France 0.40% conventionalbondsareoftenaccompaniedbyan Euro area underperformanceofrealyieldsILbondsaresomewhat 0.20% lessliquidthannominalbondsand,therefore,contracting 0.00% breakeveninflationrates.Anothersignoftheflightto -0.20% qualityonconventionalbondmarketsiswideningswap spreadsananalogyoninflationmarketsisthe -0.40% underperformanceofcashbreakeveninflationratesagainst -0.60% inflationswaps. -0.80% Thereliefrallyfollowingstepstowardacredible managementoftheGreekissuesproducedthereverse outcomeoninflationvaluations.Itisenough,inourview, Source:Bloomberg tosuggestashiftinourstanceoneurobreakevenrates fromshorttoneutral.Wepositionforfurtherreliefby Theotherreasonistheoutlookonoilprices,whichisnot gainingexposuretocashbreakeveninflationratesagainst unambiguouslypositive.Thepassthroughofloweroil inflationswapslong10ybreakevenratesonbundsor pricesintomotorfuelsinpriceindicesgreatlyvariesacross OATeisvs.10yinflationswaps.Ourtakeonthepriceaction areas;itismuchfasterintheUSthanintheeuroareafor isthatmostofthepriceactionremainsattributabletothe instance.Contractionsinoilpricestakeroughlytwomonths unwindingofflighttoqualityandnotyettoagenuine tobefullypassedthroughintheUSsothesharpdropof
%
Se pt em be r
Ju ne
M ay
Ju ly
Au gu st
June30,2011
TheBigPicture
TheGloriousSummerReturns
MayaffectsJuneandJulyindices,whileitmaytakeupto fourorfivemonthsintheeuroarea. Tothatextent,intheabsenceofasignificantoilpricerally, euroinflationwillcontinuetobeaffectedbythesharpdrop inpricesinMayandthroughouttheSummer.Therelease oftheeuroHICPflashestimateforJuneshowedinflationat 2.7%,unchangedfromMayinyearonyeartermsand slightlybelowexpectations.Ourquantitativemetric,which doesnotembedtheeffectofflighttoqualitybutusesthe flashestimate,remainsontheshortside,itisworthnoting. Asaresult,weseetherallyineuroareabreakevenratesso farasacorrectionfromexcesspessimismandflightto quality. DoesflighttoqualityaffectTIPSaswell? ItisratherintuitivetounderstandwhyEuropeaninvestors confrontedwiththeGreekcrisiswouldoverweighsafer assetsintheirfixedincomeportfoliosandshiftfromshort datedperipheralbondsintolongerdatedBunds.Yetthe sharpreactionofUSbondmarketstotheprogressmade towardarealisticmanagementoftheGreekissuesuggests thatglobalinvestorsalsoshiftedtheirportfolioallocation awayfromeurodenominatedassetsintoUSD denominatedassetsduringthefirstweeksofJune.The reboundinyieldsthatfollowedtheconfidencevotein GreecewasofequivalentmagnitudeintheUSandon Bunds20bpforTreasuriesfromtheir24Junetroughand 15bpforBunds. Withasharpincreaseinnominalyields,USbreakeven inflationwidenedandwidenedasfastaseurobreakeven
inflationratesby13bpon10yTIPSsincethe24June against14bpfor10yBundei.Inotherwords,the outperformanceofrealyieldscomparedtonominalyields wasasmarkedintheUSasitwasincoreEurope.Giventhe discrepancyintermsofinflationcarryprofilebetweenUS andeuroinflationlinkedbonds,weseethisconvergencein thepriceactionasfurtherevidencethatthesharpfallin breakeveninflationrateswasdrivenbyflighttoquality andthatthisflighttoqualityequallyaffectedGermanand USassets. Indeed,duringthepullbackinvaluationsinJune10yUS breakeveninflationresistedmuchbetterthaneuro breakevenrates;theinflationmarkethaspricedinthe realityofamuchmorefavourablecarryonUSinflationthan oneuroinflationduringthenextthreemonths.USinflation swapshaveoutperformedmuchmoreconsistentlythan euroinflationswapssincethebeginningofthemonth, losinggroundonlyduringtheunwindingoftheflightto quality. We,therefore,retainalongbiasonUSinflationvs.euro inflationafocusontheinflationviewimmunefromflightto qualityeffectswoulduseinflationswaps. Also,theUSrealcurveflattenedin5y10yaneffectofthe strongdemandfor30yTIPSduringlastweeksauctionandalso oftheflighttoquality,whichessentiallyflattensthenominal curveandtherealcurve,althoughlessso,therebyleavingthe breakevencurvesteeper.Wecloseourrealflatteningstanceon 5y10yandexpectthenextstepofthepricingoutofflightto qualitytoflattenthebreakevencurve.
ExhibitBP2.2:10yUSbreakevenratesoutperformanceover ExhibitBP2.3:10yinflationspread,US/euro,cashandswaps eurobreakevenratessincesecondweekofJune 100 80 10Y US/euro spread on BE,

10Y US/euro spread on BE, RHS 50 290 270 250 bps 230 210 190 170 150 TIPS 21 Bundei 20 45
90 80
RHS 10Y US/euro spread on sw aps
70 60 50 40 30 20 10
40
bps
35 30 25 20 15
70 60 50 40 30 01/04/2011 08/04/2011 15/04/2011 22/04/2011 29/04/2011 06/05/2011 13/05/2011 20/05/2011 27/05/2011 03/06/2011 10/06/2011 17/06/2011
01 /0 4 08 /20 /0 11 4 15 /20 /0 11 4/ 22 20 /0 11 4 29 /20 /0 11 4 06 /20 /0 11 5/ 13 2 /0 01 5 1 20 /20 /0 11 5 27 /20 /0 11 5 03 /20 /0 11 6 10 /20 /0 11 6/ 17 2 /0 01 6 1 24 /20 /0 11 6/ 20 11
Source:Bloomberg
24/06/2011
10
Source:Bloomberg
10
June30,2011
TheBigPicture
Canada:CPIsurprisestotheupside CanadianconsumerpricessurprisedtotheupsideinMay, withtheheadlineincreaseup0.7%(consensus0.3%)anda coreincreaseof0.5%(consensus0.2%).Giventhe0.4% worthofseasonalinflationinMay,thesurpriseon seasonallyadjustedinflationwaslarge:0.3%insteadofthe 0.1%expected.Theyearonyearinflationratemovedup to3.7%forheadline(from3.3%inApril)and1.8%forcore (from1.6%inApril)headlineyearonyearinflation,which wasexpectedtoprintbelowUSinflationinMay,wasinfact stillhigherby0.1pp. Asaresult,10ybreakevenratesonCanadianinflation widenedmorethanTIPSbreakevenrates,outperformingby around5bp.OurpositioninglongUSbreakevenversusCAD breakevenon10ywaspremisedonamuchweakerreading oftheCanadianCPIinMayandhas,therefore,provedill timedweusethesteepeningeffectofthe30yTIPS auctionontheUSbreakevencurvetoshiftourexposureto the30ysector,TIPS2041vs.RRBs2041onabreakeven basis. UK:DMOlaunchesconsultationonRPIandCPI On29JunetheUKDebtManagementOffice(DMO) launcheditsconsultationontheissuanceofCPIlinkedIL bonds.Thisconsultationfollowsimportantstepstaken previously:inJuly2010,theUKgovernmentannouncedits intentiontousetheCPIasthemeasureofpriceinflationfor determiningthestatutoryminimumincreasefor revaluationandindexationofprivatesectoroccupational pensions,alsoaffectingthePensionProtectionFundand theFinancialAssistanceScheme.InDecember2010,the DepartmentofWorkandPensionpublishedaconsultation ExhibitBP2.4:shiftinglongTIPSBEexposureto30y
290 280 270 bps RRB 2041, BE TIPS 2041, BE
ontheuseoftheCPI.InJune2011,theUKgovernment decidedthatitwouldnotintroducelegislationoverriding theexistingrulesofpensionschemesandwouldfavoura softtouchapproachtoindexation. Acrucialfactorunderpinningtheseissuesisthedifference betweenCPIandRPInumbersitisonlytotheextentthat thereisasubstantialdifferencebetweenthesemeasures thatthechangeinindexationandrevaluationhas implications.Needlesstosay,thechangetoalower measureofinflationdecreasespensionliabilitiesinthe future. TheissueoftheCPIandRPIwedgeiswellknown:thetwo indiceshavedifferentpurposesandtheoretical underpinnings.TheRPIincludesnotionalspendingsuchas costsassociatedwiththemaintenanceofaproperty (housingcostssuchasmortgagepaymentsand depreciation);whereas,theCPIexcludessuchcosts.Asa result,itemweightsaredifferent.Also,lowerlevel aggregationmethodsaredistinctandarereferredtoasthe formulabias. Themeandifferenceover20052011ontheyearonyear ratesisaround50bpRPIrate50bphigher.Therangeof possibleoutcomesonthisdifferenceiswide,froma minimumof230bptoamaximumof340bp(i.e.,CPI340bp higherthanRPIasinmid2009).Asfarasthecontribution tothevarianceoftheoveralldifferenceisconcerned,90% ofthevarianceisaccountedforbythehousingcomponent, 6%bytheformulaeffect,2%forthecoverage,and1.5%for theweights. ExhibitBP2.5:CPI/RPIwedge,yoy,%
4.0 3.0 2.0 pp 1.0 0.0 -1.0 -2.0 -3.0 2005 Jan Difference betw een CPI and RPI Housing component, total Difference in coverage Formula effect Other differences incl. w eights
260 250 240 230
17 /0 2/ 20 03 /0 11 3/ 20 17 11 /0 3/ 20 31 11 /0 3/ 20 14 /0 11 4/ 20 28 11 /0 4/ 20 12 11 /0 5/ 20 26 11 /0 5/ 20 09 11 /0 6/ 20 23 11 /0 6/ 20 11
2005 Nov
2006 Sep
2007 Jul
2008 May
2009 Mar
2010 Jan
2010 Nov
Source:Bloomberg
Source:Bloomberg
11
June30,2011
TheBigPicture
ExhibitBP2.6:BreakdownofthedifferencebetweenCPIandRPIrates,y/y,contribution/component
Mean Median Maximum Minimum Std.Dev.
Source:ONS
TOTAL 0.47 0.95 3.44 2.29 1.59
MIP 0.01 0.25 2.76 1.51 1.17
HD 0.33 0.44 0.61 0.99 0.39
COVERAGE 0.12 0.13 0.34 0.15 0.11
FORMULA 0.60 0.55 0.43 1.03 0.15
WEIGHTS 0.33 0.36 1.01 0.18 0.30
Thehousingcomponent,therefore,isthemostimportant factorintermsofvariance,althoughitisnotintermsof averagecontribution.Inotherwords,whiletheRPIdoes notdepartmuchfromtheCPIinthelongrunbecauseof thehousingcomponent,theaverageofthehousing contributiontothespreadissmallitisbecauseofthe housingcomponentthatitcandepartalotfromtheCPIin theshortrunthecontributiontothevarianceofthe spreadishigh.Tocomplicatethematterfurther,thereare planstoincludenotionalhousingcostsintheCPIinthe mediumtermnotbefore2014,however,accordingto ONS. Followingtheconsultation,after22September,theDMO willdecideontheopportunityofissuingCPIlinked instruments.ItwillassesswhethertheILmarketcan stomachfurthersegmentationtherearealreadytwo differentsortsofILGiltswiththreemonthandeightmonth indexationschemeswithaslightlyhighershareforthree monthlinkersatpresent.Itwillalsoassessthedemandfor specificCPIindexationfrompensionfunds.Needlesstosay, thedecisionmadeafterSeptemberwillbeofgreat importanceforthefutureoftheUKILmarket.
12
June30,2011
WhattoWatchFor
UnitedStates
EmploymentReport(Fri):Theemploymentreportisthe obvioushighlightinanotherwiselight,holiday shortenedweek.Whileweanticipatesome improvementfromthedreadfulMayreport,wesuspect theJunenumberswillbenothingtowritehomeabout. Thefactisthatemploymenthaslaggedtheoverallsoft patchthathasbeenwithusforthebetterpartofthe lastthreemonths,andwebelieveatleastanotherpoor payrollreportisinstore.WethinkheadlineNFP advancesjust85,000inJune,withprivatepayrolls increasingby110,000(governmentrelatedlayoffs shouldcontinuetorunatarounda25,000clipforthe foreseeablefuture).Thiswouldleavethesixmonth averageforprivateNFPat170,000.Weanticipate payrollgrowthwillremainrelativelymodestandright aroundthatzoneinH2/11,anumberconsistentwitha 2.53.0%realconsumptionbackdrop.Intermsof unemployment,thereisagoodchance(giventhe declineinconfidenceasitrelatestojobs)thatthelabor forcecontractsslightlyanddrivestheratedownto9.0% from9.1%previously.
unanimouslyexpectedtobeleftonholdat0.50%,and theAPTunchangedat200B. Riksbankinterestratedecision(Tues):Weexpectthe Riksbanktoraiseitsreporateby25bpto2.00%,andwe lookfortheRiksbank'sratepathtobelittlechanged. EurogroupandIMFmeetings:Thespeciallyconvened eurogroupmeetingonSundayisexpectedtoapprove disbursementofthenexttrancheofbailoutfundingfor Greece.WealsoexpecttheIMFtofollowsuit(Fri). UKJuneservicesPMI(Tue):TheUKservicesPMIhas falleninthepasttwomonths,butiftheJunereadingis stable,thentheQ2/11readingswouldstillmechanically implyrelativelysolidservicesectorgrowthof0.6%q/q. Mayindustrialproductiondata:IPdataforMaywillbe publishednextweekforanumberofeconomies, includingSpain(Wed),theUKandGermany(Thu),and Italy(Fri).
Australia/NewZealand
RBAJulyRBABoardMeeting(Tue)WeexpecttheRBA toleavethecashrateat4.75%,yetatighteningbias remainsclear;however,givenEuropeandevelopments havedominatedthelastmonth,theriskisfora balancedstatementhighlightingcontinuedglobal uncertaintyandriskstogrowth. AUJuneLabourForce(Thu)Employmentgrowth moderatedinrecentmonthsfollowinganunsustainably strongpacein2010,consistentwithsofteninginactivity andweaknessintheinterestratesensitivesectors.We seelittlechangetothistrendinJune(RBC15,000). Watchthefulltimecomponent,whichhasbeenweakin thelasttwomonthsamodestbounceislikely.Thekey unemploymentrateshouldholdaround5%(RBC4.9%) withthelabourmarketremainingnearfullcapacity. NZQ1/11GDP(Thu)Whilesomeofthepartialshave beenslightlystronger,thesecondlargeChristchurch earthquakehitinFebruaryandwillunderpinanother sluggishquarterofgrowth.Weexpectanearflat outcomeinQ1.Thenumbersaredatedwithmore timelydatasomewhatfirmer.TheRBNZisexpectinga 0.3%riseinGDP(P)inQ1.
Canada
EmploymentReport(Fri):RBCislookingfora18,000 increaseinemploymentduringJune,whichwouldbring totalH1/11jobsgainstoahealthy180,000.Theservice sector,onceagain,isexpectedtodrivejobgrowth,while manufacturingemploymentwilllikelyremainflatdueto lingeringglobalsupplychainissues.Areboundinthe labourforceshouldseetheURtickupto7.5%inJune. Thepositiveemploymentshouldhelpallaysome concernsattheBoCoverafurtherdeteriorationin consumptionamidelevatedhouseholddebtlevels.
Europe
ECBinterestratedecision(Thurs):WelookfortheECB toraiseitsrefirateby25bponThursdayto1.50%.We expectabroadlyneutralaccompanyingStatement, whichwillkeepopentheGoverningCouncilsoptions. BoEinterestratedecision(Thurs):BankRateis
13
June30,2011
DataandEventsCalendar
Region EDT
SunJul03 Euroarea MonJul04 Australia Australia Australia UK Spain UK UK Euroarea Canada Canada Tue05 Global Australia Australia France Spain Italy Sweden France Germany Euroarea Euroarea Euroarea Germany UK Euroarea Euroarea Wed06 Germany Spain Euroarea Germany Canada US Thu07 NZ Australia France Netherlands Sweden Norway Norway UK UK Greece Germany Ireland UK UK Euroarea US Euroarea US Canada Canada UK Fri08 UK Australia Greece Germany France Netherlands Sweden Italy UK UK UK Ireland Canada US US Euroarea US 11:00
Time BST
Period AEDT
Data/Event
RBC
Consensus
Prior
16:00 01:00#
ExtraordinaryeurogroupmeetingtodiscussdisbursementofnexttrancheofGreekbailoutfunding USMarketsClosedIndependenceDay RetailSales,m/m(%) BuildingApprovals,m/m(%) ANZJobVacancies,m/m(%) Halifaxhousepriceindex,m/m,3m/y(%) Unemployment,m/mnsa(000s) ConstructionPMI BoEhousingequitywithdrawal,bn PPI,m/m,y/y(%) IndustrialProductPrices,RawMaterialPrices,m/m,y/y(%) RBCPurchasingManagers'Index
21:30 21:30 21:30 tba 3:00 4:30 4:30 5:00 8:30 9:30
2:30 2:30 2:30 tba 8:00 9:30 9:30 10:00 13:30 14:30
11:30 11:30 11:30 tba 17:00 18:30 18:30 19:00 22:30 23:30
May May May Jun Jun Apr Apr May May June
0.3 2.0
50.0
0.0,6.3
0.0,6.5
1.1 11.5 6.5 0.1,4.2 79.7 54.0 7.0 0.9,6.7 0.5,6.8 54.8
21:30 0:30 tba 3:13 3:28 3:30 3:48 3:53 3:58 3:58 4:00 4:00 4:30 5:00 13:30 tba 3:00 5:00 6:00 8:30 10:00 18:45 21:30 2:45 3:30 3:30 4:00 4:00 4:30 4:30 5:00 6:00 6:00 7:00 7:00 7:45 8:00 8:30 8:30 8:30 10:00 10:00 21:45+ 22:45 tbc 2:00 2:30 3:30 3:30 4:00 4:30 4:30 4:30 6:00 7:00 8:30 8:30 13:30 15:00
2:30 11:30 5:30 14:30 tba tba 8:13 17:13 8:28 17:28 8:30 17:30 8:48 17:48 8:53 17:53 8:58 17:58 8:58 17:58 9:00 18:00 9:00 18:00 9:30 18:30 10:00 19:00 18:30 03:30# tba 8:00 10:00 11:00 13:30 15:00 tba 17:00 19:00 20:00 22:30 0:00#
May Jul Jun Jun Jul Jun Jun Jun Jun
Jun May
ChristineLagardebeginsworkasIMFManagingDirector TradeBalance,A$bn 2.0bn 1.6bn RBAratedecision,% 4.75% 0.0 4.75% BanquedeFranceGovernorNoyerspeaksinParis ServicesPMI 47.5 50.9 ServicesPMI 47.5 50.1 Riksbankratedecision,% 2.00 2.00 1.75 ServicesPMI('flash':56.7) 56.7 62.5 ServicesPMI('flash':58.3) 58.3 58.3 56.1 ServicesPMI('flash':54.2) 54.2 54.2 56.0 CompositePMI('flash':53.6) 53.6 55.8 ECBExecutiveBoardmemberBiniSmaghispeaksatanECBconferenceonemergingEurope FederalConstitutionalCourthearschallengeagainstGermanparticipationintheeuroareabailoutfundandrescueofGreece ServicesPMI 53.8 Retailsales,m/m,y/y(%) 1.2, 1.0,0.6 0.9,1.1 ECBExecutiveBoardmemberStarkspeaksatanECBconferenceonemergingEurope IMFBoarddiscussesArticleIVconsultationwithGermany Industrialproduction,y/ywda(%) GDP,q/q,y/y(%)(preliminary:0.8,2.5) Factoryorders,m/m,y/y(%) BuildingPermits,m/m(%) ISMNonManufacturing
May Q1F May May Jun
0.8,2.5 0.1 52.0 0 15,4.9 0.5,2.6 53.5
1.6 0.3,1.9 2.8,10.5 21.1% 54.6 0.2 7.8,4.9 7.1 0.1,2.4 0.3,5.6 1.7,8.7 1.1,0.6 1.7,1.2 1.5,1.3 0.2,3.1 0.6,9.6 0.0,1.2 0.50 200 1.25 46.7 428 0.3,1.9 69.1 0.4
23:45 8:45 Q1 GDP,q/q(%) 2:30 11:30 Jun LabourForce,'000,% 7:45 16:45 May Tradebalance,bn 8:30 17:30 Jun HICP,m/m,y/y(%) 8:30 17:30 May Servicesproduction,m/m,y/y(%) 9:00 18:00 May Industrialproduction,m/m,y/y(%) 9:00 18:00 May Manufacturingproduction,m/m,y/y(%) 9:30 18:30 May Industrialproduction,m/m,y/y(%) 9:30 18:30 May Manufacturingproduction,m/m,y/y(%) 10:00 19:00 Jun HICP,m/m,y/y(%) 11:00 20:00 May Industrialproduction,m/m,y/y(%) 11:00 20:00 Jun HICP,m/m,y/y(%)(to12July) 12:00 21:00 Jul BoEBankRatedecision,% 12:00 21:00 Jul BoEAssetPurchaseTarget,bn 12:45 21:45 Jul ECBrefiratedecision,% 13:00 22:00 Jul RBCConsumerOutlookIndex 13:30 22:30 Jul ECBmonetarypolicypressconference 13:30 22:30 01Jul InitialJoblessClaims(Thous.) 13:30 22:30 May NewHousingPriceIndex,m/m,y/y(%) 15:00 00:00# Jun IveyPMI 15:00 00:00# Jun NIESRGDPestimate,3m/3m(%) 2:45 3:45 11:45 12:45 May Jun May May May Jun Jun Jun May Jun Jun Jun May BankofEnglandInterimFPCmemberAndyHaldanespeaksinBeijing RBA'sAGDebelle'sspeech"InDefenceofCurrentAccountDeficits"
0.7,7.0 0.50 200 1.50 0.50 200 1.50
435
tbc tbc 7:00 16:00 7:30 16:30 8:30 17:30 8:30 17:30 9:00 18:00 9:30 18:30 9:30 18:30 9:30 18:30 11:00 20:00 12:30 21:30 13:30 22:30 13:30 22:30 18:30 03:30# 20:00 5:00#
(Tentative)IMFBoardmeetingtodiscuss4threviewofbailout,incl.disbursementofnexttrancheoffunding Tradebalance,bn 10.5 10.9 BdFbusinesssentiment,index 102 103 Industrialproduction,m/m,y/y(%) 0.3,0.8 Industrialproduction,m/m,y/y(%) 0.7,12.0 Industrialproduction,m/m,y/y(%) 0.3,0.8 PPIinputprices,m/m,y/y(%) 2.0,15.7 PPIoutputprices,m/my/y(%) 0.2,5.3 PPIcoreoutputprices,m/my/y(%) 0.2,3.4 Industrialproduction,m/m,y/y(%)(to12July) 1.4,2.7 EmploymentChange,UnemploymntRate 18k,7.5% 10k,7.4% 22.3k,7.4% Chng.innonfarmpayrolls,privatepayrollsm/m(Thous.) 85,110 85,110 54,83 UnemploymentRate(%) 9.0 9.1 9.1 ECBExecutiveBoardmemberBiniSmaghispeaksinGreeceon"Adjustingtothecrisis:policychoicesandpoliticsinEurope" ConsumerCredit(Bn.$) 5.0 6.24
*Variablereleasedate,#Followingday,+Previousday; Source:Bloomberg,ReutersandRBCCapitalMarketsestimates
14
June30,2011
RBCEconomicsandYieldForecasts
RealGDP Q111 Q211 Q311 Q411 US RBC(Mar) Fed(Apr) Canada RBC(May) BoC(Apr) Euroarea RBC(Jun) ECB(Jun) UK RBC(Feb) BoE(May)
USD Fedrate 3mTbill 2yTSY 5yTSY 10yTSY 30yTSY 2yASW 10yASW 30yASW EUR ECBreporate 3mEONIA 3mEURIBOR 2ySchatz 5yOBL 10yBund 30yBund 2yASW 5yASW 10yASW 30yASW AUD RBARate 3mBankBill 2yTSY 5yTSY 10yTSY SEK Reporate 3mSTIBOR 2ySwap 5ySwap 10ySwap
2010 2011 2012 2.9 2.5 3.2 3.2 2.9 2.0 1.9 1.5 1.4
Q212 0.50 0.65 1.60 3.05 4.25 4.95 7 15 15 Q212 2.25 2.25 2.30 2.60 3.15 3.75 3.85 40 40 35 10 Q212 5.25 5.40 5.40 5.60 5.85 Q212 3.00 3.60 4.30 4.35 4.40
Headlineinflation(avg),%y/y Q111 Q211 Q311 Q411 US RBC(Mar) Fed(Apr) Canada RBC(May) BoC(Apr) Euroarea RBC(Jun) ECB(Jun) UK RBC(Jun) BoE(May)
CAD BoCrate 3mCTB 2yCAN 5yCAN 10yCAN 30yCAN
2011 2012 3.1 2.5 2.6 2.5 2.7 2.6 4.5 4.6 2.3 1.6 2.1 2.1 2.2 1.7 2.1 2.9
1.8
2.2
3.1
3.1
3.0 3.9 3.1 2.6 1.8 1.7 2.4 2.1
2.1
3.4
3.6
3.1
3.9 3.9 0.8 0.8 0.5 0.5

30Jun 0.25 0.02 0.46 1.76 3.16 4.37 24 11 31 30Jun 1.25 1.34 1.55 1.61 2.28 3.03 3.77 54 47 38 6 30Jun 4.75 4.96 4.74 4.87 5.21 30Jun 1.75 2.42 2.97 3.26 3.51
2.8 2.0 0.3 0.3 0.3 0.1

Q311 0.25 0.20 0.90 2.30 3.65 4.60 20 15 25 Q311 1.50 1.50 1.65 2.00 2.70 3.50 3.75 50 35 25 5 Q311 5.00 5.15 5.10 5.25 5.65 Q311 2.25 3.00 3.90 4.10 4.20
3.8 2.7 0.4 0.3 0.7 0.9
3.3 2.7 0.5 0.3 0.6 0.5

Q411 0.25 0.25 1.10 2.60 4.00 4.85 15 20 25 Q411 1.75 1.80 1.90 2.25 2.85 3.60 3.80 45 35 30 5 Q411 5.00 5.20 5.20 5.40 5.75 Q411 2.50 3.25 4.00 4.20 4.30
3.2 3.1 1.7 1.7 1.3 1.3

Q112 0.25 0.35 1.25 2.80 4.15 4.90 13 20 20 Q112 2.00 2.00 2.10 2.45 3.05 3.75 3.85 45 40 30 5 Q112 5.25 5.40 5.30 5.50 5.85 Q112 2.75 3.50 4.20 4.30 4.40
2.6 2.4 2.5
3.2 2.7 2.7
2.7 2.5 2.8
2.1 2.5 2.7
4.1 4.1
30Jun 1.00 0.93 1.59 2.34 3.11 3.55
4.4 4.5
Q311 1.25 1.70 2.15 3.00 3.50 4.00
4.7 5.0
Q411 1.75 2.15 2.40 3.30 3.80 4.30
4.8 5.0
Q112 2.25 2.40 2.80 3.50 3.95 4.45
Q212 2.50 2.65 3.00 3.65 4.05 4.50
GBP BoErate 3mSONIA 3mLIBOR 2yGilts 5yGilts 10yGilt 30yGilt 2yASW 5yASW 10yASW 30yASW NZ RBNZRate 3mBankBill 2ySwap 5ySwap 10ySwap NOK DepositRate 3mNIBOR 2ySwap 5ySwap 10ySwap
30Jun 0.50 0.54 0.83 0.83 2.07 3.38 4.29 53 31 5 21 30Jun 2.25 2.92 3.36 4.38 5.16 30Jun 2.25 2.92 3.62 3.99 4.37
Q311 0.50 0.60 0.85 1.50 2.35 3.70 4.20 55 40 25 15 Q311 2.50 2.85 3.60 4.85 5.50 Q311 2.50 3.00 4.20 4.60 4.90
Q411 0.75 1.00 1.20 1.80 2.60 3.85 4.30 55 40 25 15 Q411 2.75 3.00 3.85 5.10 5.65 Q411 2.75 3.10 4.40 4.80 5.00
Q112 1.00 1.25 1.40 2.00 2.75 4.00 4.40 50 45 30 10 Q112 3.00 3.15 4.10 5.30 5.75 Q112 3.00 3.30 4.65 4.90 5.10
Q212 1.25 1.35 1.45 2.20 2.90 4.10 4.40 50 30 15 10 Q212 3.25 3.50 4.30 5.35 5.80 Q212 3.25 3.50 4.75 4.95 5.10
Sources:ECB,BoE,RBCCapitalMarkets
15
June30,2011
U.S.Perspectives
QE2,quarterendintherearviewmirror,betterdataahead?
Intherecentweek,severalviolentselloffsensuedfollowingbothpoorauctionsandabetterthanexpectedChicagoPMIprint,providing someevidencethatratesareinfactvulnerableatthecurrentlevels.AnyprogresstowardashortertermsolutioninEuropewillonly increasethisvulnerability.AsJulyprogresses,webelievethedataflowwillcontinuetoimprovemuchaswewitnessedwithdatainthe backhalfofJune.Ofcourse,nextweekspayrollreport,whichweexpecttobemodestatbest,willbeasignificanthurdletowardhigher yields. After140purchaseoperations,QE2hasfinallycometoanend.WecontinuetobelievethebiggesteffectofQE2sendwillbeseeninthe cheapeningofofftherunsrelativetoontheruns.Afterastringofthreepoorauctions,however,webelievemorevolatilitysurrounding auctionsmaylieaheadastheprimarydealercommunitynolongerhasabuyerofunwantedinventories.TheFedhaspurchased$288B ofissuessettlingsinceQE2began,morethanonethirdoftheallocationsprimarydealersreceivedduringthatsametimeperiod. AsdiscussedinTheBigPicture(page5),theendofQ2shouldrelievesomestressinthefrontend. TheincreaseinbothmunicipalnewissuevolumeanddealsizeinJuneincreasesthelikelihoodthatissuancewillreach$230250billion bytheendoftheyear.
QuickView
Product Rates View Higher
Europeansovereigndebtissueswillprovidesomeresistancebuttheselloffs, whichensuedfollowingpoorauctionsandstrongerthanexpecteddata affirmedthatratesareveryvulnerable. Directionalitywillpersistinthenearterm,butthecurveshouldsteepengiven supplydynamicsandtheFedsunconventionaltighteningpath. Aftertherecentflushout,wethinkthecurrentlevelsprovideagoodentry pointforlongspreadwideners(SeeBigPictureonpage5).Wearewaryof overreactionstodeclinesinforeigndollarreserveshavinganeffectonfront endspreads. Afterrecentsteepening,fundamentalsshouldsupportasteepbreakeven curve,withconcernsoveraweakereconomyandsofteroilpricesweighingon shorterbreakevensandinflationriskspushinglongerbreakevenswider. Lackofsupplyoutsideofthefrontendshouldkeepagencieswellbidinanysell off.OnaLiborbasis,wecontinuetoexpectagenciestoperformwellifspreads widenonanyrenewedfearsoutofEurope. Dislocationsshouldebbafterquarterendwithrepocheapening. Withratesclosertothezerobound,directionalitywillremainsignificant,but wethinkdeliveredswillremainrelativelyhigh. Shortterm,weareneutralbutstillseevaluehereoverasomewhatlonger horizon.
Curve
Steeper
Spreads
30yrspreadswider
TIPS
Neutral
Agencies
Neutral
FrontEnd Vol MBS
Repocheapening Slightlyhigher Neutral
16
June30,2011
U.S.Perspectives
Debt Ceiling from 30,000 Feet

TomPorcelli(212)6187788tom.porcelli@rbccm.com JacobOubina(212)6187795jacob.oubina@rbccm.com
Letuswrapsomecontextaroundthedebtceilingnotbeing passed.Aswediscussbelow,itwouldalmostcertainly resultinarecession.Inotherwords,wequiteliterallyview notraisingthedebtceilingasanimpossibilityonlymade possiblebypoliticiansnotgraspingtheramifications highlightedbelow.Westillthinktherearegreateroddsitis passed,butyoucannotruleoutthepossibilitythatthe braintrustinDCinventsanotheraccountinggimmicktobuy moretime.Remember,whentheyfirststartedthisdebt ceilingdancemanyyearsago,itoccurredtofewpeople thattheywouldtaptheGfund,asanexample,tobuytime. Itwasanovelapproachatthetime,andsuchnovelty cannotberuledoutthistime.Barringanyadditional accountingshenanigans,themusicstopsonAugust2. Tosaythattheeffectfromasharpcontractionin obligationstothebroadereconomywouldbequitesevere
mightbeanunderstatement.Weestimatethegovernment needsnetissuanceofmarketablenotesandbondsofabout $109BpermonthfromAugustuntiltheendof2011to meetitsspendingobligations.Throwinanother$24Bper monthincreaseinthenonmarketablesliceandyouare dealingwithaprojectedexpansioninTreasurydebt outstandingof$133Bpermonthonaverageforthatfive monthspan. Totaloutlays(exinterestpayments)haveaveragedroughly $290Bpermonthforthepastyear.Inotherwords,even excludinginterestpayments,thegovernmentwouldneed toreducespendingonobligationsbyabout46%acrossthe boardtoavoidpiercingthroughthedebtceiling.Ona dollarfordollarbasis,thecutsthatwouldbeneeded wouldequatetoabout5%ofannualGDP.Withthe economybarelyclockinginabove2.5%sincetherecession
ExhibitUS1.1:Themagnitudeofcutsthatwouldbeneededtobridgethefundinggapisstaggering
Net Treasury I ssuance Energy General Government Agriculture Community and Regional Development Science, Space and Tech I nternational Affairs Natural Resources and Environment Administration of Justice Transportation Veterans Benefits and Services Education, Training, Social Services Health Medicare I ncome Security National Defense Social Security 0 20 40 60 80 100 120 140 $b, projected monthly average from Aug-11 to Dec-11
$b, monthly average outlay last 12 months
Source:RBCCapitalMarkets,Haver
17
June30,2011
U.S.Perspectives
ended,anotherseveredownturnwouldbejustabouta donedeal. Thismassivecontractioninspendingwouldnecessarily emanatefromreductionsinSocialSecurity,Medicare, NationalDefense,andthesocalledIncomeSecurity.These arethelargestcategoriesofspendingbyfarandgiventhe sizeofthefundinggap(netissuance),itwouldbenecessary toparethemback.Frankly,thereisnotenoughmeatinthe othercategoriestobridgethegap.Giventhesensitivityof thoseitemsonbothsidesoftheaisle,itishardtothinkany politicianwouldrisknotraisingtheceilingandpotentially creatingafundingcrisisinthosecategoriesandthelossof votesthatwouldfollow.
18
June30,2011
U.S.Perspectives
Municipals: A Stronger Second Half

Junesnewissuevolumesuggestsabettersecondhalffor2011
ChrisMauro(212)6187729chris.mauro@rbccm.com
MunicipalnewissuevolumepickedupappreciablyinJunefrom thelevelsprintedearlierintheyear.Additionally,thesizeofthe individualdealscomingtomarkethasincreasedsignificantly withseveralverylargeissuespricedthismonth. Theserecentsignsoflifeinthenewissuemunicipalmarket pointtoamoreactivecalendarforthesecondhalfoftheyear. Thisincreasesthelikelihoodthatissuancewillreach$230250 billionbytheendoftheyear. TheUSmunicipalmarket,whichhadbeensufferingunder anaemicnewissuevolumethroughoutmostofcalendar 2011,enjoyedahealthypickupinissuanceinJune.Weekly municipalbondissuance,whichhadbeenaveraging between$24billionallyeartickeduptothe$67billion rangeduringthemonth.Monthlyvolume,whichhadbeen aslowas$12billioninJanuaryandhadbeenstuckinthe $1520billionrangefromFebruaryuntilMay,isexpected tototalapproximately$27billioninJune.WithJunes beefiercalendar,H1/11volumewilltotal$110billion,still about50%ofH1/10volumeandthelowesttotalforfirst halfissuancesince2000.Nevertheless,therecentsignsof lifeinthenewissuemarketbodewell,wethink,forthe volumeinH2/11. Wethinkthepickupinissuanceinthepastfewweeksis duetoanumberoffactors.First,theheavyoversupply fromQ4/10,whenissuersrushedtomarkettotake advantageoftheexpiringBuildAmericaBondprogram,has finallybeendigested.Second,statebudgetissues,which haddominatedthefiscallandscapeduringthefirstfive monthsoftheyear,therebyovershadowingcapital programsandalmostallotherstatefiscaland administrativeissues,finallybegantorecedeinimportance. TheNovember2010electionresultedintheturnoverof morethanhalfofthenationsgovernors.Manyofthese newgovernorswereelectedonanausterityplatform, forcingthemtofocusexclusivelyonbudgetmattersduring thefirstseveralmonthsoftheiradministrations.Withthe budgetyeardrawingtoaclose,thesefiscalissuesare slowlybeingresolved,andbudgetsarebeingadopted.
Additionally,recentdatafromtheUSCensusconfirmsthat statetaxcollectionsarebeginningtoimprove.Thisis providingissuerswithasmalldegreeoffinancialbreathing roomandallowingthemtorefocussomewhatontheir capitalprograms. Inadditiontotheencouragingincreaseinweeklynewissue volume,weareparticularlyenthusiasticaboutthemore constructivecompositionofthisvolume.Junesnewissue calendarsawadiscernableincreaseinthenumberoflarger dealscomingtomarket.Theweeklycountofissuesof$100 millionorlargerreached20forthefirsttimethisyearlast week.Additionally,weestimatethatthenumberofissues of$200millionorlargerwilltotal27inJune.Thisstatistic hadbeeninthe10to15permonthrangefromJanuary untilMay.IfthistrendcontinuesandH2/11volume averages$5billionaweek,total2011issuanceshould reach$230billion.Anincreaseinaverageissuanceto$6 billionaweekwouldbring2011volumeto$250billion.Asa result,wearestickingwithourvolumecallof$250billion fortheyear,realizing,however,thatthisfigureisprobably onthehighsideoftherangeoflikelyoutcomes. ExhibitUS2.1:Municipalnewissuevolumeanddealsize haveincreasedinrecentweekswithanotablepickupin thenumberofissuesof$100millionandlargercomingto marketperweeksincemidMay2011.
$8,000 $7,000 $6,000 $5,000 W eekly I ssuance Volume 100MM+ Deals (rhs) 20 18 16 14 12 10 8 6 4 2 0 Jan
Source:Bloomberg
$ MM
$4,000 $3,000 $2,000 $1,000 $0 Feb Mar Apr Apr May Jun
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Somerespiteforthebears
AfirmMayCPIprinthasputBoCratehikesbackonthemarketsradar,withcoreCPInowonly0.2ppawayfromthemidpointofthe Banksinflationtarget.ThereportrepresentsthefinalinflationreadingaheadoftheJulyratedecisionandMPR,and,attheveryleast, shouldforcetheBanktomaintainitstentativetighteningbias. Withonlyone25bpratehikepricedinforthenextfiveBoCmeetings,thefrontendremainsvulnerableoncemarketattentionshiftsback tofundamentals. Fornow,welikerepresentingouroverallbearishCanadianratesviewviaa5s10sflattenerinswaps,withthe5ysectorstilllooking overextendedonthecurve,bothonanequalweightedandaprincipalcomponent(PCA)weightedbasis.Thepositionoffersanearflat carryandhasthepotentialtobenefitfromanyunderperformanceatthebellyofthecurveasQE2intheUScomestoanend.
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TheBoCrecentlyswitchedtoatentativehikingbias,suggestingthatmonetary stimuluswillbeeventuallywithdrawn.Fornow,theunderlyingglobalrisk aversiontoneshouldkeepthesafehavenbidinGoCsintact.Withthemarket pricinginonlyone25bpratehikeuntilQ1/12andGovernorCarneyrecently firingashotacrossthebowonundesiredhouseholddebtlevels,thefrontend remainsvulnerableinourview. WhileaneventualrefocusingonfundamentalsshouldpushshortertermGoC yieldshigher,Canadasgenerallypositivedebtdynamicsandanchoredinflation expectationswillprovidesomeshelterforlongtermyields.Wecontinuetolook fortheGoC2s10scurvetoflattento105bpbyQ2/12,ledbythefrontend. Therecenttentativemovewiderinswapspreadscouldgainsomesteamasthe spreadbetweenfixedrateandfloatingratemortgagesnarrows,potentially enticingsomeadditionalratelockingactivity.Giventhatwearenowbeyond peakmortgageseason,however,wedonotexpecttoseeamovemuchbeyond 20bpinfiveyearspreads. OngoingmonetarypolicydivergencebetweenCanadaandtheUSleavesroom forshorterdatespreadstopushwiderbyatleast25bporsointhemedium term.Atthelongerendofthecurve,Canadianratesareexpectedtotrade throughUSratesofthesametenorgiventhemorepositivedebtanddeficit dynamicsinCanada,althoughtherecentriseinriskaversioncoulddelaythe move. RRBbreakevenrateshavecollapsedsincehittingafiveyearhighof270bpin April,withrisingglobalriskaversionandlowercommoditypricesbeingthe catalystforthemove.Untilsignsofdomesticwagepressuresappear,breakeven ratesnear250bpseemmoreappropriatetous.
Rates
Higher
Curve
Neutral/flatter
Swap Spreads
Neutral/Wider
CADUSD Spreads
FrontEndWider/ LongEndTighter
RRBBreak evens
Neutral
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CanadaPerspectives
Some respite for the bears

FirmMayCPIputstheBoCbackontheradar
KamBath4168426362kam.bath@rbccm.com PaulBorean4168422809paul.borean@rbccm.com
AfirmMayCPIprinthasputBoCratehikesbackonthemarkets ExhibitCAD1.2:Ratehikeexpectationsmoderate radar,withcoreCPInowonly0.2ppawayfromthemidpointof Implied policy rate expectations through June 2012 (bp) 42 theBanksinflationtarget. Mkt Expectations (as at Apr 29, 2011) Australia Withonlyone25bpratehikepricedinoverthenextfiveBoC -5 Mkt Expectations (current) meetings,thefrontendremainsvulnerableoncemarket Eurozone 101 46 attentionshiftsbacktofundamentals. 80 Fornow,welikerepresentingouroverallbearishCanadianrates U.K. 37 viewviaa5s10sflattenerinswaps,withthe5ysectorstill 59 U.S. lookingoverextendedonthecurvebothonanequalweighted 44 andaprincipalcomponent(PCA)weightedbasis.
Canada 46 -10 10 30 50 70
84
FirmMayCPIdataputsBoCratehikesbackontheradar ThereleaseoffirmMayCPIdatahasputBoCratehikes backonthemarketsradar,fullyreversingthedeclinein expectationsseenafterlastFridaysWallStreetJournal article,whichemphasizedsomedovishcommentsfrom GovernorCarney.Bothheadlineandcoreinflation resoundinglysurprisedtotheupside,pushingtheannual ratesupto3.7%and1.8%,respectively.Someofthemove canbeattributedtoseasonalfactors,whichadded0.5ppto theheadlinemonthlyincreaseand0.2pptothecore measure,butpressureswerealsoreasonablywidespread, andtheoveralltrendpointshigher(seeCAD1.1). ExhibitCAD1.1:CanadianInflationtrendinghigher
8 6 4 2 0 -2 -4 -6 Jan- May- Sep- Jan- May- Sep- Jan- May- Sep- Jan- May- Sep- Jan- May07 07 07 08 08 08 09 09 09 10 10 10 11 11 % Core CPI 3-mth saar pace Headline CPI 3-mth saar pace
90
110
Source:Bloomberg,RBCCapitalMarkets
The1.8%y/yprintoncoreleavestheQ2/11averageat 1.7%,0.3pphigherthanexpectedbytheBoCattheApril MPR,andonly0.2ppawayfromthemidpointoftheBanks inflationcontroltarget.Coreinflationcouldmoderate slightlyinJuneassometransitoryincreasessuchastherise inautoprices(whichcouldbeduetosupplyconstraints causedbytheJapaneseearthquake)areunwound.The spikeduringMay,however,stillhighlightstheriskofthe BoCfallingbehindthecurve,especiallygivenitscurrent expectationfortheoutputgaptocloseandcoreCPItohit 2.0%inQ2/12. TheMayCPIreportrepresentsthefinalinflationreading headingintotheJuly19ratedecisionandsubsequentMPR, and,attheveryleast,shouldforcetheBanktomaintainits tentativetighteningbias.TheflatprintonAprilGDPleaves somewoodtochoponQ2/11growth,butmodestgainsof 0.2%inMayandJunewouldstillleaveit1.8%upatan annualrateoverQ1/11.Thismeansthereisafighting chancethattheBoCs2.0%Q2/11GDPforecastmightstill beachieved(whichwouldalsobealittlebrighterthan recentcommentsfromGovernorCarneypointingtoan advanceinthe1%range).NextweeksCanadian
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employmentreportwilllikelyreinforcethepositivelabour ExhibitCAD1.4:BellystillrichonaPCAweighted2s5s10sfly marketbackdrop,withtheeconomyexpectedtoadd 3.0 PCA Weighted Fly Residual Z-Scores % 18,000jobsinJune,bringingtheH1/11totaltoavery 2.0 respectable180,000.Theunemploymentrateisexpected totickupto7.5%asthelabourforceexpands,thereby 1.0 leavingitonly0.3ppabovethe10yearaverage. 0.0 WeweretakenoutofourpaidpositioninDecember (1.0) meetingOISlastFridayasthemarketreactedtosome (2.0) reportedlydovishcommentsfromGovernorCarney.The BoCGovernorreportedlydownplayedtheroleofmonetary (3.0) policyinahousingbubbleandsuggestedthatthecentral Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 bankdoesnothavetopushtheshorttermratebackto neutralastheeconomynearsfullcapacity.Withrespectto Source:Bloomberg,RBCCapitalMarkets thelatter,assumingaconservative3.00%estimatefora neutralovernightratebyQ2/12(theBankscurrent suggestedonJune9(seeGlobalDirectionsarticleBellyof forecastfortheclosingoftheoutputgap),wecaneasilyget Canadascurvelookingstretched).Canada'sfiveyearsector continuestolookoverextendedonthecurvebothonan backtosomethingwellabovewhatispricedinforward equalweightedandaPCAweightedbasis1.ThePCA marketsandstillbeconsideredcomfortablyinstimulative territory.Onthesecondpoint(thequestionabouthow weightedflyhasonlyrecentlybouncedbackfromlevels monetarypolicyshouldrespondtoahousingbubble),the overtwostandarddeviationsrichrelativetothe2s10s remarksmayhavebeentakenoutofcontext.Thisdebateis swapcurve(seeExhibitCAD1.4).Atthetimeofourinitial recommendation,theflywasroughlyonestandard alsolonginthetooth,andtheBank'spolicyisprettyclear: deviationrichtothecurveandhadjustbeguntowiden. ifitisjustahousingissue,thenusedirectmeasuresasa firstdefence.However,aswehavearguedrecently(seelast week'sCanadaPerspectivesarticleonhouseholddebt TheCADswapcurvecarryprofileisalsorelativelyflatoutto issues)thatapproachdoesnotappeartobeworkingaftera the10yearsectoratpresent,whichfavours5s10s flatteners(0.2bp/monthcarry)overlongerdatedpositions fewkicksatthecan,andmonetarypolicymaynowhave (5s10spositionoffersabetaadjusted0.3bpimprovement toplayacomplementaryrole. overa5s30sflattener).Canadasfiveyearsectorhas outpacedmostinternationalmarketssincethebeginningof CA5s10sswapflattenerremainsanattractiveplay WeenteredaCAD5s10sflattenerinswapsat95bplast April,havingralliedalmostlockstepwiththeUS.Thisweek, week(target75bp,stop105bp)basedonanentrylevel thebellyofCanadascurveunderperformedintandemwith theUSasthemarketprovedtobelessthanenthusiasticfor ExhibitCAD1.3:Stillroomforbellyunderperformance shortandintermediateTreasurysupply.Thehistorically bp 2s5s10sswapfly 80 elevatedcorrelationbetweenCanadianandUSfiveyear USD EUR GBP CAD 60 ratesshouldhelptheCanadian5s10scurveflattenfurther astheFedsdisproportionatesponsorshipofthebellyvia 40 QE2comestoanend.Wewouldalsoexpecttoseeapick 20 upinmortgagefixingactivityastheBankofCanadamoves closertohikingrates,whichwouldputadditionalpressure 0 onthebellyofCanadasswapcurve.
20 40 60 Jan10 Mar10 May10 5yrraterich relativeto2sand10s
Jul10
Sep10 Nov10 Jan11 Mar11 May11
1 NotesonthePCAweightedfly:Aftercomputingtheprincipalcomponentweightedbutterflyseries,thisseriesisregressedontheslopeofthecurveovertheanalyzedperiod.Therelativerichnessor cheapnessofthebellyisthenassessedbythedivergenceofthePCAweightedflyfromthefittedvalue(i.e.,thenumberofdeviationsofthezscorefromzero).Apositiveornegativezscoreindicatesa cheaporrichbelly,respectively.
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EuropePerspectives
Disasteraverted...fornow
EURLifeafterthevote:Whilewethinkitistooearlytoassumethatafullyfledgedtrendreversalsetsin,wehighlightanumberoftrades thatshouldworkinanormalTacticalSPGBBundtighteneratthefrontend,2y5y10yBTPfliesandcashbondB/Ewidenersversusthe swapcurvelookattractive. PeripheryMonitor:Greekpoliticiansthisweekvotedinfavourofthelatestbatchofausteritymeasures.WethinktheEurogroup meetingonSundaywill,therefore,approvedisbursementofthenexttrancheoffunding,withIMFapprovallikelytofollowonFriday. WefirmlyexpecttheECBtopressaheadwithtighteningmonetarypolicynextweek,despitetheweakereuroareaactivitydataduring thepastmonth.WeanticipateabroadlyneutralIntroductoryStatementthatwillkeepopenallfutureoptionsfortheGoverningCouncil. WealsopresentasummarypreviewofGiltsupplyinfiscalQ2/11. WefullyexpecttheRiksbanktoraiseitsreporate25bpto2.00%.Ourviewisthatthefrontendhaspricedouttoomuchintheway tightening,andweseeopportunitiesforpositioningaheadofnextweek'smeeting.
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Outright
Sidewaystohigher
Tacticallyshorttechnicallevelshavefallenandmarketslooksettoturn directionforlonger.
Curve Cross currency spreads ASW
Flatter
Intheearlyphasesofahikingcycle,curvestendtooutflattentheforwards.We expecttheflatteningtoresumegoingintonextweeksECBratehike. WecontinuetolikeGiltBundtightenersfrom5yonwardand,ingeneral, expectBundstounderperformmostotherfixedincomemarkets. Ingeneral,weexpectamoreneutralASWenvironmentinEurope,butduringa correctionofthecrisismode,tighteningshouldsetin.
Tighter Bunds/Giltsneutral totighter,Sweden wider
IntraEMU spreads
Tighter/RVplays
Strategicallyneutral,tacticallytighterSPGBBundspreadsin2y,2y5y10yBTP flies.
Inflation Money markets
Wider Short/Steeper
Welikeb/ewidenersincashversustheswapcurve. Moneymarketpricingappearsexpensiveonallcounts,andwelikeshortsfrom Dec11onward.Themoneymarketcurveshouldresteepen.
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More than alive after the vote

EGBspreadtradestowatchifnormalisationtakeshold
NorbertAul+44(0)2070290122norbert.aul@rbccm.com PeterSchaffrik+44(0)2070297076peter.schaffrik@rbccm.com
AftertheGreekvotes,fearsofanimmediatedefaultreceded. Weseegoodsigns(outrightandinspreads)thatthismightturn intoalastingchangeinsentiment. Wehighlightanumberofnormalisationtradesthatoughttobe watchedcarefullyifsentimentturns. Thetradesthatwelikebestatthemomentare2ySPGBvs. Bundtighteners,buyingthebellyin2y5y10yBTPflyand2y 10yflatteners,10yb/elongsvs.theILswapcurve. 1)Assetswapspreads Oneofthemorevisiblesignsofstresshasbeenthe significantwideninginBundassetswapspreadsduringthe lastfewweeksfromthelow30bpareato45bpinthe10y partofthecurve.Asshouldbeexpected,thereisagood chancethatthisretreatssayinthehigh30bparea.Yetit isherewhereweseegoodentryopportunitiesinwideners again.SaythatgrowthandGreekdefaultfearstrulyrecede, theimplicitassumptionshouldalsobethatGermanywill growsignificantly,therebyreducingdeficitsandgovie ExhibitEUR1.1:2ySpainvs.Germanyand10yItalyvs.Ger many(ASWspreadsinbp)
300 280 260 240 220 200 180 160 140 120 100 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 10y IT vs. GE 2y ES vs. GE
supply,whichshouldsupporttheBundASWspread.Inthe oppositescenariowherestressresumes,theflightto qualitytradesshouldalsokeepBundsindemand.Inshort, weseelittlereasontoexpectBundASWtoretreattoo significantly. 2)Intraeuroareaspreads Wemakeoutbetteropportunitiesforrelieftradesat presentintheeuroareagovernmentspreaduniverse.The risksstemmingfromthekeydriversoftheextremetier2 spreadwideninginthepastfewweeks,animminentGreek default,andthehugeuncertaintyabouttheprivatesector involvementforanewGreekbailouthavebeen substantiallyreduced. Fromthisperspective,weprefertobetacticallylongtier2 spreadsgoingintothisSundaysEurogroupmeeting,where thepotentialforadisappointingoutcomeshouldbe limited.Withinthetier2space,thefrontendofthe Spanishcurveshowedthestrongestperformanceversus Germanpaperamidthisweeksspreadtightening.The2y ESversusGEspreadtightenedover50bpgoingintoand afterthefirstGreekausterityvoteonWednesday(Exhibit EUR1.1).Althoughthisperformanceholdssetback potential,weareconfidentthatthespreadreliefcould persistforthenearterm.Furthermore,thecarryadvantage forthenextmonthsislargelyinfavourofSpainversus Germanyspreadtightenersatthefrontendofthecurve (ExhibitEUR1.2).We,therefore,recommendbuyingthe SPGB4.2%Jul13vs.theDBR3.47%Jul13atayieldspread of200bponatacticalbasisandinasmallsize.Thetrade offersanattractivepositivecarryofaround30bpoverthe nextthreemonths,andweareaimingforaperformance potentialofsome35bp.Wesetatargetatthespreadlow ofmidMay(165bp),andastopataspreadlevelat220bp.
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ExhibitEUR1.2:1mand3mcarryof2yEGBspreadtighten ersoverGermanpaper(inbp)
35 30 25 20 15 10 5 0 2y ES vs. GE 2y IT vs. GE 2y BE vs. GE 2y AT vs.GE 2y FR vs. GE 2y NL vs. GE 2y FI vs. GE 3m Carry 1m Carry
Source:RBCCapitalMarkets
Furtheroutonthecurve,weprefertoexpressperiphery versuscoretighteningexposureviathe10yBTPvs.Bund spread.Despitethepoliticalpressuresurrounding Berlusconi,todayspassofthepotential47bnindeficit cuttingmeasure(tryingtobalancethebudgetby2014)has beenanencouragingsignforthemarket. Againstthisbackdropthe10yBTPvs.Bundspreadholds,in arelativecomparison,stillthemostreliefpotentialacross tier2curves.Atacurrentlevelofaround170bpfortheBTP 4%Sep20vs.DBR2.25%Sep20,theyieldspreadstilltrades ExhibitEUR1.3:Cheapbellyinthe2y5y10yBTPfly(ASW over23bpaboveitslowon3June(ExhibitEUR1.1)and levelinbp) offersaround7bpofpositivecarryforthenextthree 25 80 months. BTP 2-5-10y fly (50/50) 70 BTP 5-10y (rhs) 20 BTP 2-5y (rhs) 60 3)OntheItaliancurve:CheapbellyintheBTP2y5y10yfly BTP 2-10y (rhs) StayingwithItalianpaper,theBTPcurvestillholds 15 50 distressedtradeopportunities,whichhardlymoveddespite 40 10 thereliefinperipheryversuscorespreads. 30 Forinstance,the510yASWcurveisstilltradingcloseto 5 20 flatoreveninvertedlevels(dependingontheissuesusedin thecurvespread),therebyimplyingagloomypicturefor 10 0 theItaliancredit.TheBTP3%Nov15vs.BTP3.75%Mar21 0 spreadinASWterms(ExhibitEUR1.3)iswidelydetached -5 -10 fromits25yand210ypeersontheItaliancurveand -10 -20 hardlysteepenedduringthecourseofthepastweek, Dec-10 Feb-11 Apr-11 Jun-11 despitethatperipheralpaperswitchedbackinriskon Source:Bloomberg,RBCCapitalMarkets mode.
Theunderperformanceofthe5yBTPsegmentbecomes evenmoreapparentwhenfocusingonthe2y5y10yBTP flywitha50:50riskweightinginthewings(greylinein ExhibitEUR1.3).ThebellyoftheItaliancurve underperformedconsistentlyintheASWflyalongside wideningBTPvs.BundspreadssincelateApril,and currentlystilltradesataround18bpusinglongBTP3% Nov15vs.50%BTP2%Jun13and50%BTP3.75%Mar21as depictedinExhibitEUR1.3.Withabrighterspreadpicture forthenearterm,wealsoexpecttheItalian510ycredit curvetosteepenandthe2510yBTPflytoretreatfromits elevatedlevels. Withrespecttothelatter,werecommendbuyingthe current5ybenchmarkBTP3.75%Apr16vs.50%BTP2% Jun13and50%BTP3.75%Mar21atayieldspreadof21bp aimingataperformanceof510bp.Wefavourbeinglong theBTPApr16alsofromasupplyperspectivebecausethe bondisgettingclosertotheendofitsontheruncycle (potentiallyonlytwomoretapstocomeon14Julyand12 August)and,therefore,holdsthepotentialtorichenonthe BTPcurve. 4)Cashb/einflation Oneofthenotmostintuitivegaugesofstressinthe systemisthedevelopmentofcashbondb/einflationrates. Notonlydoinflationexpectationsretreatoncemarkets priceinascenariothatcouldhavepotentialnegative ramificationsforeconomicactivity(suchasaGreek
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EuropePerspectives
default),butalsothesafetyandliquidityifnominalcash ExhibitEUR1.4:10yBundb/eandILswap bondsareindemand.Withcashbondb/ebeingdefinedas (%) 2.6 thespreadbetweena(liquid)nominalanda(lessliquid) realbond,intimesofstress,cashbondsb/econtractmore 2.4 thantheyotherwisewould.Thiscanbedepictedquite 2.2 clearlyinthedifferencebetweenthecashb/erateandthe 2 ILswapcurve,asExhibitEUR1.4does.Ifmarketscontinue toreturnfromthestresspricedin,thenb/eshouldrise 1.8 andthedifferencebetweencashbondb/eandswaps 1.6 shoulddecline.Onpage9,weelaborateonthis relationshipinmoredetailandrecommendholdingb/e 1.4 widenerversustheswapcurveusingthe10yBUNDeior 1.2 OATeicurve. 1 Jun-10 Sep-10 Dec-10 Mar-11
10y Bund b/e 10y IL sw ap
(bp)
40 35 30 25 20 15 10 5 0
Jun-11 spread (rhs)
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Periphery Monitor
Greekparliamentbacksausteritymeasures,nowforPSIpressure
JamesAshley+44(0)2070290133james.ashley@rbccm.com GustavoBagattini+44(0)2070290147gustavo.bagattini@rbccm.com
TheGreekparliamentvotes TheGreekgovernmentsecuredapprovalthisweekonthe latestausteritymeasuresrequiredtobringtheexisting bailoutprogrammebackontrack.OnWednesday,MPs passedtheausteritypackageby154votesto138,while Thursdaysimplementationbillalsopassedwiththevotes similarlysplitbroadlyalongpartylines.Separately,Greece metitsendJuneprivatisationtarget. FrenchbankproposalforGreekdebtrollover AFrenchproposalforavoluntaryrolloverofGreekdebt providedtwooptions.Onewouldseebanksrollingover 70%oftheirGreekholdings50ppwouldgointoanew30 yearbond(withpotentialincentiveslinkedtoGreekGDP growth)and20ppintoahighqualityzerocoupon instrument;theotherproposalwouldhavebanksrolling over90100%ofholdingsintonewfiveyearbonds.The formerproposalappearstohavebeengarneringmore supportinrecentdays,andtherehavebeenmediareports thatGermanbanksarealsoreceptivetothisidea.Indeed, GermanFinanceMinisterSchubleusedapressconference onThursdayafternoontoannouncethatanagreementhas beenreachedwiththeGermanbankstorolloverdebt holdingsmaturingupto2014.Butmediareportsalso suggesttheplaniscontingentonratingsagenciesnot deemingittoconstituteaselectivedefaultatthetimeof writing,theagencieshavenotyetgivenanyindication. Italy:politicalcrisisinthemaking? FinanceMinisterTremontipreparedanausteritypackage withmeasuresworthupto47B(1.8Bthisyear,5.5B nextyear,and20Binboth2013and2014).Thepackage wasscheduledtobepassedbycabinetdecreeonThursday afternoon(nonewsatthetimeofwriting),beforegoingto parliamentforconfirmationpriortothesummerrecess. ButUmbertoBossi,leaderoftheNorthernLeague(PM Berlusconismaincoalitionally),warnedthatthisplanhad thepotentialtocauseacollapseofthegovernment.
Portugal:focusonstickingtobailoutconditions ThenewPortuguesegovernmentpresenteditsfouryear fiscalprogrammetoparliamentthiswasinlinewiththe conditionssetoutintheIMF/EUbailoutpackageagreedto inMay.FiscaldataforQ1/11wereweakerthanexpected. Ourviews Thetraindidnotderailthisweek,yetthedirectionoftravel hasnotchangedalongtermsolutionisstillrequiredto theGreekfiscalcrisis.Animmediatedisasterhasbeen avoided,andthefocusnowshiftsbacktoEuropeanpolicy makersandtheirnegotiationsonSunday.WiththeGreek parliamenthavingfulfilleditssideofthebargain,weexpect theEurogrouptoapprovedisbursementofthenexttranche offunding(withIMFapprovallikelytofollowonFriday). SundaysEurogroupmeetingisalsoexpectedtooutlinethe scopeofprivatesectorinvolvement(PSI)insupporting Greekpublicfinances.TheFrenchrolloverproposalappears tohavebeengainingtractioninrecentdays,with policymakersreportingpositivefeedbackfrominitial soundings.Inourview,suchaproposalcouldbepotentially beneficialforGreecesshorttermliquidityandforanew bailoutpackage,provideditisstructuredinawaytoavoida crediteventoraratingdefault. Onthehorizon July3:Eurogroupfinanceministersmeet. July8(tbc):IMFBoardmeetingonGreece;fourthreviewto bepublishedshortlythereafter. July1112:EurogroupandECOFINfinanceministersmeet. July13:Europeanbankstresstestresults. BymidJuly:planned12BdisbursementtoGreeceunder currentprogramme,before7Bincouponandbill repaymentsaredueduringJuly1522. Aug1219:Greece:3.7Bincouponandbillrepayments aredue. Aug20:Greece:6.6Bbondredemptionaredue.
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ECB preview: Keep calm and carry on

WeexpecttheECBtoraiseitsrefirateby25bpnextThursday
JamesAshley+44(0)2070290133james.ashley@rbccm.com
withareminderthattheGoverningCouncilwillcontinue TheECBsJuneStatementclearlysignalleda25bpratehikeat tomonitorverycloselyalldevelopmentswithrespectto nextweekspolicymeeting.DespiteworriesoverGreeceand upsideriskstopricestability.Butthat(probable) signsofabroaderslowdowninactivity,weexpectThursdays continuedreferencetoupsideriskstopricestabilityin meetingtoresultintheGoverningCouncilraisingitsrefirateto conjunctionwithlikelyreferencestotheaccommodative 1.50%,aspreviouslysignalled.Weexpectabroadlyneutral natureofthecurrentpolicysettingandampleliquidity accompanyingStatementtogivetheECBmaximumflexibility. TheGoverningCouncilmayalsotaketheopportunitynextweek willservetonotifythattheGoverningCouncilretainsa clearhikingbias.Whilethegeneralorientationofthe tonormalisethestandingfacilitycorridorto100bp. GoverningCouncilwillremainperfectlyclear,wedonot Junesstrongvigilance=25bprefiratehikenextweek expectanystronghintsinnextweeksStatementasto WefullyexpecttheECBtoraiseitsmainpolicyrateby25bp whenthenexthikeislikely. nextThursday,to1.50%,despitetheelevateduncertainty Morelikely,inourview,isthatifthereweretobeanysuch stemmingfromtheongoingGreekdebtcrisis.Lastmonths hints,theywouldappearinPresidentTrichetsresponses IntroductoryStatementhadtheGoverningCouncil duringthesubsequentQ&A.Eventhere,wedonotexpect declaringitselftobeinapostureofstrongvigilancethe clearestpossiblesignalthatcouldhavebeengivenofaJuly tobegivenastrongsteeronthespecifics.Inpart,thatde rigueur:thefirstwordutteredbyinfantcentralbankersis ratehike1.Lestanyoneshouldthinkthattheintervening conservative,andPresidentTrichetsregularmantrais marketvolatilityhadweakenedtheGoverningCouncils thattheECBneverprecommits.SounlesstheGoverning resolve,PresidentTrichetrepeatedtheVwordagainthis CouncilintendstoraiseratesagaininAugust(which,inour week.AndwiththeGreekparliamentaryvoteshavingbeen negotiatedthisweekwithoutprovokingdisaster,wesee view,ishighlyimprobable),theneveninnormaltimes,we littleprospectoftheECBnotdeliveringonlastmonthscall ExhibitEUR2.1:EuroarearealGDPgrowthversusourPMI toarms.Insofarasitispossibletoinferanythingfromthe basedGDPindicator volatileeuromoneymarketsatpresent(giventhevolatility 1.5 ofshortdatedmoneymarketrates,andthecurrentwedge betweenEONIAandtherefirate),a25bphikenextweek 1.0 seemstobefullypricedsothelikelydecisiontotighten 0.5 policyshouldnothaveanymajoreffectonthemarket. 0.0 -0.5 Q2: Whattoexpectfromthepressconference 0.45% q/q WeexpecttheIntroductoryStatementatnextweekspress -1.0 PMI-based indicator conferencetoleavetheGoverningCouncilwithmaximum -1.5 Euro area GDP, % q/q flexibility.Or,inotherwords,wethinktheStatementwill -2.0 avoidgivinganystrongguidanceonthetimingoffuture -2.5 ratehikes.Thereferencetostrongvigilancewillbe 00 01 02 03 04 05 06 07 08 09 10 11 droppedfromnextweekstext,mostlikelytobereplaced
1
ForadetailedanalysisoftheECBskeywordsandphrases,pleasesee Kremlinology...orhowtounderstandtheECB,publishedearlierthisweek.
Sources:Haver,RBCCapitalMarkets
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wouldnotnecessarilyexpectstrongguidanceatthisstage ExhibitEUR2.2:ECBmainpolicyrates,% (i.e.,anabsoluteminimumoftwomorelikelythree 7 Marginal lending rate monthsbeforethenextratehike). EONIA (5-day moving average) 6 Refi rate Butinadditiontosuchinnatecentralbankconservatism, Deposit rate 5 thereisheighteneduncertaintyovertheoutlookforthe euroareaeconomy,whichsurelydictatestheneedforeven 4 greatercautionthanusual.Unquestionably,theworries 3 overhowtheGreekdebtcrisiswillunfoldinthemonths aheadareimportantconsiderations.YettheECBwillbe 2 thinkingofthatasarisktoitscentralmacroprojections 1 ratherthansomethinghavingamaterialeffectonthe centralprojectionsthemselves.Forsure,itisariskfactor 0 withthepotentialtocausehugedisruption,butsofara 99 00 01 02 03 04 05 06 07 08 09 10 11 riskiswhatitis.Fornow,theECBwillseenopressingneed Sources:Haver,Markit,RBCCapitalMarkets toreviseitsviewonthegrowthandinflationoutlookfor theeuroareaasawhole. theECBsstandingfacilitycorridor(fromthecurrent75bp above/belowtherefiratebacktotheprecrisis100bp). Bycontrast,thegeneralweakeningofthe(core)economic TheECBultimatelyleftthecorridorwidthunchangedin datainthepastmonthissomethingthatshouldfeedin April,butsubsequentcommentsfromofficialssuggestthat directlytotheGoverningCouncilsviewofhowthe atleastsomeoftheGoverningCouncilmemberssupporta recoveryisprogressing.Fornow,thesofterdatawillnotbe normalisationofthecorridor.Particularlynotableremarks undulytroublingaslowdowningrowthispreciselywhat sincetheAprilmeetinghavebeenmadebyGovernor theECBandEurosystemstaff(andourselves)hasbeen Orphanides(Iwouldargueinfavourofnormalisingthe forecasting(weexpect2011growthof2.0%,andthe widthofthecorridorsoonerratherthanlater.Inmyview, Eurosystemstaffexpects1.9%).Buttheconcernisthepace itisincreasinglyhardertojustifythenonstandardwidthof atwhichtheactivityindicatorshavesoftenedifthatpace thecorridorastimegoesby")andbyGovernorBonello ofslowdowncontinuesinQ3/11,thentheriskstogrowth (Therearesignsthatthemarketfundingconditionsare willbecometiltedtothedownside(ExhibitEUR2.1). improving,andonewouldwanttoencouragethat.One Allofwhichistosay,thatwhiletheGoverningCouncilwill wayofdoingitwouldbebywideningthecorridorand besanguineabouttheslowdownobservedsofar(hence makingitlessattractiveforbankstousethedepositfacility theveryhighprobabilitythatweattachtoaratehikeon andinsteadgototheinterbankmarket). Thursday),thereisacaseforproceedingwithextracaution untilthegrowthoutlookinQ3/11andbeyondhasbeen Intheory,theECBcouldamendthestandingfacility clarified.Againstthatbackdrop,wedonotexpectstrong corridoratanypointthereisnoobligationornecessityto guidancefromtheECBnextweek.Itmaybethatthe waitfortherefiratetobechangedbeforetweakingthe GoverningCounciliscurrentlymindedtoraiseratesagainin depositand/ormarginallendingrates.Butinpractice,it October(whichisourforecast),butthereislittleobvious wouldbesomewhatpeculiarforsuchadecisiontobe advantagetobegainedfromdeclaringsoatthisstage.A announcedataseeminglyarbitraryandrandomtime.In Statementreferencingveryclosemonitoring,in ourview,itmakesfarmoresenseforthecorridor conjunctionwithaneutralQ&AgivestheGoverningCouncil normalisationtocomeatthesametimeasachangeinthe maximumflexibilityavaluablecommodityintimesof refirate.Hence,witha25bphikeintherefiratealllinedup uncertainty. fornextweek,wethinkthereisafairchancethatthe GoverningCouncilmightalsotakethisopportunityto Revisitingthestandingfacilitycorridor normalisethestandingfacilitycorridor(i.e.,backto IntheleaduptotheGoverningCouncilsratehikeinApril, 100bp). wearguedthecasefortheGoverningCouncilrewidening
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Gilt Issuance Calendar: Fiscal Q2/11

SummarypreviewofDMOGiltmarketoperationsforJulytoSeptember
SamHill,CFA+442070290092sam.hill@rbccm.com
NextweekisthestartofthefiscalQ2/11Giltsalesprogramme. Q2issuanceshouldcomeinatjustover38B(excludinga plannedbutunspecifiedminitenderandanyproceedsfromthe postauctionoptionfacility).Thiswouldbesomewhatlower thanthe45.4BraisedinQ1/11excludingPAOFproceedsofjust over1B.ThissplitwouldseetheDMOraisec.27%ofitstarget inQ1versusc.23%inQ2. ThetableshowstheDMOsplannedscheduleofoperations. TheevenflowsizecolumnshowsthecashthattheDMOshould plantoraisefromeachoperation.Expectednominalsizesare alsoshown,althoughtheseRBCestimatesaresubjecttomarket levelsandtheDMOsdiscretion.Thefinalcolumnshowsthe durationtobeissued,asmeasuredbytheequivalentnumberof futurescontracts(GU1)forthenominalsizesshown(basedon currentmarketlevels). Indesigningthiscalendar,theDMOhasagainspreadthe issuanceveryevenlyovertheperiod,bothincashandduration terms.
Anew5yGiltwillbelaunched.Thiswillmatureon22January 2017.Thisnew2017bondwillbebuiltupfromAugustonward tobethenext5ybenchmark. ThefirstoftwosyndicationsthattheDMOhasconfirmedwill beatapofthenewUKTI0.75%2034thatwaslaunchedinMay. Bydesign,thetimingofthistransactionfulfilstheappetitefor durationthatwillexistasaresultoftheindexextensioninthe FTSEOver5yearIndexlinkedGiltIndexon26July.Onthat date,UKTI2.5%2016becomesasub5ybond.Aportfolio trackingchangesinthecompositionofthisindexwillseeits neutralduration(calculatedonthebasisofamarketweighted averageofthedurationoftheconstituents)extendby1.45 yearswhenUKTI2.5%2016isexcluded.Thissyndicationshould catertothedemandfordurationbutnotexacerbateittoo much. ThesecondsyndicationinlateSeptember,weknow,willbea longdatedconventional.Eitheranew30yoranew40y benchmarkisexpectedtobelaunched.
ExhibitGB1:JulySeptemberplannedGiltoperationsandestimatedsizes
No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 -
Date
Bond
Sector Medium Index-linked Long Short Index-linked Long Index-linked Short Index-linked Medium ? Index-linked Short Long
05-Jul-11 3T21 06-Jul-11 IL27 14-Jul-11 4Q40 19-Jul-11 2%16 w/c 25 Jul IL34 02-Aug-11 4H34 11-Aug-11 IL42 18-Aug-11 new 5yr 23-Aug-11 IL22 01-Sep-11 3T21 w/c 5 Sep ? 15-Sep-11 IL47 22-Sep-11 new 5yr w/c 26 Sep ? Total
Evenflow size, mn 3,425 1,215 2,100 4,740 3,620 2,100 1,215 4,740 1,215 3,425 ? 1,215 4,740 4,500 38,250
RBC Expected nominal, mn 3,250 1,100 2,000 4,750 3,600 2,000 950 4,750 1,200 3,250 ? 850 4,750 4,500
Duration (equivalent no. of futures contracts)* 30,786 23,099 36,762 22,607 82,401 16,680 32,646 27,500 17,563 30,786 ? 35,564 27,500 83,000 466,894
*estimatesareshownforthenew5year,andtheestimatefortheSeptembersyndicationassumesanewcurrentcoupon30year. Sources:DMO,RBCCapitalMarketsestimates
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Rate Raising Riksbank

TheremaybesignsofslowingbutSwedenisstillstrongandthemarkethas gonetoofarinpricingouthikesweseeopportunitiesinthefrontend
ChristianLawrence+44(0)2070297085christina.lawrence@rbccm.com WefullyexpecttheRiksbanktoraiseitsreporate25bpto2.00% upside,wenowseetheriskasbeingmoreskewedtothe downside,thatistosay,three25bphikesbyyearendisour onTuesdayofnextweek. basecasescenario,buttworatehikeswouldsurpriseus SvenssonandEkholmarelikelytocontinuedissentinginfavour lessthanfour.Sowhythechangeofheart? ofnochange.WeexpectthatObergwillnolongervoicehis preferenceforaratehikeateverymeetingthisyearandthat ExhibitSE1.1Riksbankprojectedreporatepath talkofthepossibilityofa50bphikeislikelytosubside. 8 Wemaintainourcallforthreefurther25bpratehikesin2011 % Riksbank projected repo rate path 7 takingthepolicyrateupto2.50%byyearend,butwenowsee from the April MPU, % theriskasskewedtolessratherthanmore. 6 ThemacrobackdropinSwedenisstillstrongdespitesomesigns 5 thatthepaceofrecoverymayhavepeaked. 4 Wethinkthefrontendhaspricedouttoomuchintheway 3 tighteningandseeopportunitiestopositionourselvesinlightof thisaheadofnextweeksratedecision. 2 1 TheRiksbankwillcontinueraisingrates 0 TheRiksbankwillannounceitslatestratedecisionon -1 Tuesday,5July,andweexpecttoseea25bpincreasein '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 Swedishpolicyrates,whichwouldtaketheRiksbankrepo Source:Riksbank,RBCCapitalMarkets rateupto2.00%.Thiswouldbetheseventhconsecutive Swedenisstillstrong meetingatwhichtheBankhasdecidedtohike25bpsince Wecertainlyhavenotundergoneafundamentalshiftin rateswereraisedoffthecyclelowof0.25%inJulyoflast year.TheSTINA(SEKOIS)marketisreflectingthisviewwith viewasourbasecasescenarioonthetighteningpathis forwardsimplyinga90%chanceofa25bphikenextweek. unchanged,andweremainbullishoftheSwedisheconomy. TheRiksbankitselfhasalsosignalledthelikelihoodofa Butdevelopmentsinthelastfewmonthssuggestthatthe moveinJuly,withtheprojectedratepathoutlinedinthe rapidriseoutofrecessionisbeginningtotemper.This MonetaryPolicyUpdate(MPU)thataccompaniedthelast comesaslittlesurprise,andindeed,wehighlightedthatthe ratedecision(25bphiketo1.75%)on20Aprilpointingtoa SwedishrecoverywouldlikelyslowsomewhatinH2/11 25bphikeinJulyasthemostlikelyoutcome. whenwereleasedourGlobalDirections2011Outlookat thetailendoflastyear. Sonextweeksdecisionlooksasclosetoadonedealasone couldhopeforinaglobaleconomicandfinancialclimateas IntermsofhowtheSwedishmacrodatahavedeveloped uncertainasthis,butwhatofSwedenstighteningcycle sinceAprilcomparedtotheRiksbanksprojections,wesee beyondtheJulymeeting?Tobeclear,wethinkthe thatthedivergencehasbeenrelativelysmall.Indeed, Riksbankisstillfirmlyontheratenormalisationpath;and inflationonbothaheadlineCPIandunderlyingCPIFbasis indeed,wemaintainourcallthatrateswillberaisedto (whichassumesafixedrateofinterestforhouseholdsand 2.50%byyearend.Withthatsaid,whereasatthelast thusisnotdirectlyaffectedbyratehikes)hasprintedinline meeting,wesaidthattherisktoourrateprofilewastothe withtheRiksbanksforecastgiveortakelessthan0.1ppin
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bothAprilandMay.At3.3%y/y,headlineCPIinflationis AnotherkeypointisthatSEKhasweakenedsignificantly wellabovetheBanks2%target,andthelastsetof sincetheAprilMPR,andonaverageinQ2/11,thecurrency Riksbankminutesmadeitclearthatthereareconcernsthat wasaround2%softerthantheRiksbanksforecastona ifheadlineCPIinflationremainsabovetarget,thenthis TCWbasis.Indeed,theSEKTCWindexshowsthatSEKhas gainedaround4.4%sincethatjuncturewhileEUR/SEKhas increasesthedangerofrisinginflationexpectationsthe rallied3.9%andNOK/SEKisup3.1%.Thiscomesfollowinga TNSProsperasurveycommissionedbytheRiksbankhas sustainedperiodofcurrencystrengtheningfrom highlightedagradualupwarddriftininflationexpectations. undervaluedlevels. Turningtoactivity,GDPgrowthinQ4/10stoodat7.6%y/y, ExhibitSE1.3SEKhasweakenedsincetheAprilMPR whichwas0.8ppfirmerthantheRiksbanksforecastand wellaboveprecrisislevels.InQ1/11,thisslowedto6.5%y/ NOK/SEK (LHS) 1.26 9.4 SEK TCW (/100) (LHS) y,0.1ppbelowtheRiksbankforecast.GDPgrowthislikely 1.24 EUR/SEK (RHS) tohavepeakedinSweden,buttheoutlookforgrowth 9.2 1.22 remainspositive,andweexpectGDPgrowthofaround 1.20 0.6%q/qor5.0%y/yinQ2/11. 9.0
1.18
ExhibitSE1.2RiksbanksResourceUtilisationindicator
2.50 2.00 1.50 1.00 0.50 0.00 -0.50 -1.00 -1.50 -2.00 -2.50 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11
Source:Riksbank,RBCCapitalMarkets
1.16 1.14 1.12 1.10

8.8 8.6 8.4
Riksbank RU indicator of resource utilisation
03Jan 28Jan 22Feb 19Mar 13Apr 08May 02Jun 27Jun
OtherindicatorsthattheRiksbankfocusescloselyonwhen makingmonetarypolicydecisions,suchasitsownmeasure ofresourceutilisation,theRUIndicator,haveproven firmerthanexpectedwiththisrisingintopositiveterritory inQ4/10at0.09(Riksbankforecast0.01)andfurtherin Q1/11at0.34.TheRiksbankislikelytosignalthatresource utilisationisnowbacktonormallevels,althoughEkholm andSvenssonmaydisagreegiventheirongoingstancethat thelabourmarketactsasabettergauge;anditisthis concept,atleastinpart,thatdrivesourviewthatboth memberswillenterreservationsagainstthedecisionto raiserates.Atthemargin,weseesomeriskofasmall downwardrevisiontoneartermGDPforecastsandasmall upwardrevisiontonearterminflationforecasts.
1)FormoreinformationontheRiksbank'sRUindicatorpleasesee:http:// www.riksbank.com/upload/Dokument_riksbank/Kat_publicerat/Ekonomiska% 20kommentarer/2010/ek_kom_nr4_10eng.pdf
AlthoughwewouldarguethatGovernorIngveshas appearedcomfortablewiththecurrency,therecentselloff inSEKwillcomeassomecomforttotheRiksbankasa wholeandinparticulartothemoredovishmembers,with Ekholmhavingpreviouslyvoicedconcernsthatraisingrates toorapidlycouldleadtoconsiderablestrengtheningofSEK. Forasmallopeneconomy,whichisheavilyrelianton exports(around50%ofGDP),thepotentialforcurrency strengthtohampercompetitivenessandgrowthisclear. Wenotethatuptothisjuncture,therehasbeenrelatively littleevidenceofthis,althoughsignsarebeginningto appear,andinthelatestreleaseoftheRiksbankcompany interviews,itwassuggestedthatthecurrentkrona exchangeratehasanegativeeffectontheirprofitability. Itisimportanttonotethat,whileweareawarethat negativeinternationaldevelopmentswilllikelytakemore prominenceintheMPRthanbackinApril,owingtothe softeningofUSdataandtheongoingwoesfacingtheeuro areaperipherycountries,weexpectthattheRiksbankwill largelyfocusonthestrongSwedishfundamentals.Wesaw thislastyearwhentheBankcontinuedraisingratesdespite heightenedtalkofapotentialglobaldoublediprecession. Indeed,weexpectthattheRiksbankwilladoptasimilar
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approachtotheNorgesBanksinitsMPRlastweekwhenit notedalongsidethisforecastthatthemakeupofthe RiksbankExecutiveBoardwillresultinincreased explicitlystatedthatitsprojectionswerebasedonthe uncertaintyastothepathofmonetarypolicynextyear assumptionthatthedebtproblemsfacingGreecewillbe andonward.Thereasonbeingthattwooftheboards resolvedwithoutsignificantspillovereffectsonothereuro mosthawkishmembers,ObergandNyberg,willleavethe areacountries. Riksbankatyearend,andgiventhatIngvessixyearterm Insummary,withinflationandgrowthbroadlyinlinewith asgovernorendsattheendofthisyear,therewasdoubt theRiksbanksforecastfromitsAprilMPRandtherecent astowhetheranotheroftheboardsmosthawkish selloffinSEKleavingthecurrencyweakerthanprojected, memberswouldstillbepartoftheratedecisionprocess. weexpecttheBanktocontinuealongitscurrenttightening cycleandraiseratesto2.50%byyearend2011.Withthat TheconcernsoverIngvesleavinghavenowbeenquashed; said,wenowseetheriskasskewedmoretowardfewer however,itwasannouncedthisweekthatIngveswill ratehikesthanmoreratehikes,andweexpecttalkofthe remainchairmanoftheexecutiveboardforanothersix possibilityof50bpmovesanda2.75%yearendratefrom yearterm.Withthatsaid,clearlythisdoesnotchangethe themorehawkishmembersoftheboardtobesilenced. factthatthetwomosthawkishmemberswillnotbeonthe LookingtotheRiksbankspolicyrateprojection,wedonot boardnextyear,andwedonotyetknowwhotheir foreseeanysubstantialrevisions,andthepathislikelyto replacementswillbeandinturnhowthedovehawk remainunchanged. balancewillbeadjusted. Themarkethasgonetoofar ExhibitSE1.4FRAspricinginlessthanonehikein2012 Althoughweareconsciousthatthedownsiderisktoour 100 SEK Dec 11 Dec 12 FRA spread, bp yearendcallforthepolicyrateat2.50%hasincreased,we 90 arefirmlyoftheviewthatthemarkethasgonetoofarin 80 pricingoutratehikesintheremainderofthisyear. 70 AlthoughtheSTINAforwardsarenearlyfullypricingina 60 hikenextweek,theimpliedlikelihoodofahikeatthe7 50 Septembermeetingnowstandsatjust50%,whilethe 40 probabilityofafurtherratehikeon27Octoberispricedat 30 36%andonDecember20ataround15%.Thismeansthe 20 STINAforwardsarecurrentlypricinginaround40bpby 20th April - last Riksbank rate decision and MPU yearend2011. 10 0 Themarketisclearlyoftheviewthatthedomestic headwindsandinternationaldevelopmentswillseethe Riksbanktonedownitshawkishstanceinnextweeks Source:Riksbank,RBCCapitalMarkets MPR.Whilewehavesympathywiththeviewthatthe Repricing2012 RiksbankmaybelesspositivethanitwasinApril,wedo InlightoftheuncertaintysurroundingtheRiksbank notthinkashiftinstanceofthatextentwillbe forthcoming.Assuch,wethinkthemarketwillbesurprised ExecutiveBoarddynamics,aswellastheeasingofthepace oftheSwedishrecoveryandthecontinueduncertainty bythehawkishnessoftheMPRandexpectthemarketto priceinagreaterriskoffurtherhikes. surroundingtheglobaloutlook,weseetherisktoourcall for100bpoftighteningin2012asskewedtothedownside. Fourmore,Sixmore WefeeltherecentpriceactionintheSEKfrontendhas Lookingtonextyear,wemaintainourcalltheRiksbankwill gonetoofarinpricingintheserisks.Indeed,sincethestart raiserates25bponfouroccasionsin2012takingthepolicy ofJunetheDec2011Dec2012SEKFRAspreadhas rateupto3.5%byyearend2012.Wehavepreviously narrowedmorethan25bp,andsincetheAprilmeeting,it
02-Apr 17-Feb 24-Apr 04-Jan 26-Jan 07-Jun 16-May 11-Mar 29-Jun
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hasflattened40bpandnowstandsataround20bpwe thinkthisisfartooflatandseelittleriskoftheRiksbank hikingratesjustoncenextyear(pleaseseeExhibitSE1.4). Welikeplayingthisasasteepeningtrade,butmomentum hasleftuswatchingonthesidelinesduringrecentsessions withpriceactionmeaningthatenteringthetradewould havebeenakintocatchingafallingknife.Therecentbid toneseenintheDec12FRAhascausedamodest steepening;however,wethinknowisthetimetoenterthe tradeataspreadofaround20bp(pleaseseepage3)with atargetof40bpandalossat10bp.Thethreemonthroll downofthispositioncurrentlystandsat+7bp.
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Australia/NewZealandPerspectives
MarketpricingofRBAcutsmisplaced
Fuelledbytheglobalbondrally,AUyieldstestednear12monthslowsthisweek.Wewerenotsurprisedbythemoveand,indeed,have longarguedthat3yearbondyieldscantradethroughcashinamaturetighteningcycle.Despitealikelyneartermimprovementinglobal riskappetite,theseyieldscouldstaysubcashorprettyclosetoitinthecomingmonths. Moresurprisingisthemarketsexpectationsfora25bpratecutbyyearend.Historysuggeststhatthisismostunlikelyandtheultrafront endofthemarketlooksexpensive.PaidbackmonthOISpositionscontinuetolooklikevalueattheselevels. Waningcapacityandasharpaccelerationinunitlabourcostssuggestinflationisonlyheadinginonedirection.Thisaloneislikelytostop theRBAfromdeliveringanykindofeasing,emergencyorotherwise.Weexpecttheupcoming7Julyboardmeetingtoconfirmits tighteningbias,butwhetherthemarketwilllistenismoredebatable.DiscussionofintensifiedEuropeandebtconcernsandrisksislikely todominatepolicydeliberationsresultinginaratherbalancedstatementpostmeeting. AstilluncertainglobaloutlooksuggeststhattheRBAmaywellstayonthesidelinesforlongerthanweexpect.Weawaitkeyretailsales andlabourmarketdatanextweekwithQ2/11CPIscheduledforreleaseon27July,buttheriskremainsskewedtowardourAugusthike occurringlaterinQ4/11.
QuickView
Product AURates View Neutral
Ultrafrontend(<2y)rateslooklow,andweseelimitedvaluein3yearsat5bp throughcashgivenourexpectationofaH2/11ratehike.10yearyieldsremain towardthelowerendofawellestablished56%rangewithUSTscontinuingto dictatedirection. Thecurveshouldremainrangebound.Somerecoveryinriskappetitehas pushedthecurveflatter,butwithUS10yearsstillexpensive,wedonotlookfor significantflattening. WeexpectamatureRBAcycleandgreaterglobalstabilityinthemediumterm tobringspreadstighter.Riskon/riskoffsentimentwillseesomevolatilityamid agenerallynarrowingbias. Thebenchmark10yAUUSspreadremainsdirectional,andweareneutralat currentlevelsinthemiddleofa200230bprange.ThematureRBAtightening cycleandsuperiorfiscalpositionshouldhelpAUdollarblocspread compressioninthemediumterm. Expectationsoffurthersemisupplyasthenewfiscalyearkicksoffhave weighedonthissector.Weremainpositiveonthisassetclasslongertermand viewcurrentlevelsasattractive.Semisacrossthecurvearecurrentlyat3 monthwidestoACGBs.Guidancetodatefromregulatorsconfirmssemiswillbe animportantassetclassforliquiditybooksinlocalbanks.Demandwillfar outweighsupplyandpressurespreadstobondandswap. Eventualpolicynormalisationbeckons,withtheJuneMPSsuggestingtheRBNZ isinplayin2011.Withthisoutlook,2yrateshavebeendraggedtoolowby globaleventsandthemostrecenttremors. Eventualnormalisationarguesformodestflattening.Somefalsestartsarelikely butthedatarunisbeginningtoturnmodestlymorepositive. 35 June30,2011
AUCurve
Neutral
AUSwap Spreads
Neutral/Tighter
AUDUSD Spreads
Neutral/Tighter
Semis
Positive
NZSwap
Higher
NZCurve
Flatter
Australias poor productivity

SoaringunitlabourcostswillkeeptheRBAstighteningbiasintact
SuLinOng(612)90333088sulin.ong@rbccm.com
next18months,wehavelongarguedthatthreeyearbond OffshoredevelopmentscontinuetodictateAntipodeanbond yieldscouldeasilytestbacktowardcashandthroughthe markets. cashrateinamaturetighteningcycle. Wearenotsurprisedbytheextentoftherallyand,in particularly,havelongarguedthatthreeyearACGByieldscan Thecurrent4.75%cashratecoupledwiththedefacto tradethroughcashinmaturetighteningcycles.Despitesome tighteningfromthebankshaspushedlendingratesinto likelyrecoveryinrisk,theseyieldscouldstaysubcash,orcloseto modestlyrestrictiveterritoryandequatestopolicyratesof it,inthecomingmonths. 2006.Thecurrentparallelsto2006remainstark, Wearemoresurprisedbymarketpricingofanemergencycut particularlythetermsoftradeshockandaccompanying bytheRBA.Historysuggeststhatthisisunlikely,although implicationsfortheeconomy.Despitethis,threeyear EuropeanandglobaluncertaintycouldwellseetheRBAstayon yieldsaveraged10bptocashduring2006,whichwitnessed thesidelinesforlonger. threehikesandfurthertighteningin2007andtradedas Ifthereisonepieceofdatawhichdebunkstheratecutmyth,it muchas30bp.Thiswasdespitethecontinuedmarch istheaccelerationinunitlabourcostsinthelastyear.Theyare higherinUSTyieldswithtwoyearyieldsrisingby currentlyrunningattheirfastestpaceintwodecadesdrivenby approximately150bpduringthecourseof2006.Withonly verylowlabourproductivityinAustralia.Inflationisonlyheading one25bphike,atmostfromtheRBAinthenextsixmonths inonedirection. anduncertaintyoverEuropelikelytolingerasheadwinds, Accordingly,theRBAislikelytoremindmarketsofitstightening threeyearbondyieldscouldeasilystaywellthroughcashin biasattheupcoming7Julyboardmeeting.Whethertheylisten, thecomingmonths,orprettyclosetoit. ornot,isanotherstory. Butmarketsaregettingoverexcitedaboutratecuts AUbondstaketheircuesfromoffshore Whatsurprisesusmoreistheextentofthemoveinthe Amidanearemptydomesticdataandeventscalendar, ultrafrontend.DespiteclearsignalsfromGovernorStevens Antipodeanmarketsremainatthewhimofinternational developmentswithGreeceandEuropecentrestage.The ExhibitAU1.1:3yrACGByieldstostayclosetocash? relentlessrallyinglobalbondmarketshastakenAUyields 8 8 downtonear12monthlowswithAUlargelykeepingpace withmovesinUSTs.Thebenchmark10yAUUSspreadhas 7 7 remainedinits200230bprange,spendingmostofthe weekaroundthemiddleofthisrangewithAUcontinuingto 6 6 benefitfromongoingoffshoredemandamidincreased uncertaintyandturmoilelsewhere.Notsurprisingly,the 5 5 bellyoftheAUcurvecontinuestooutperform,withmid 4 4 curvebondserringontheexpensivesideandpushingthe2 3 years (% LHS) 510sflytoathreemonthlowearlyintheweek. 3 3 Cash Rate (% As3yearbondyieldstest20bpthroughcash RHS) 2 2 TheextentoftherallyinAUfixedincomedoesnotsurprise us.Indeed,despiteourlongheldviewthatwearelikelyto M ay-99 M ay-02 M ay-05 M ay-08 M ay-11 seefurthermodestpolicyactionfromtheRBAduringthe Source:RBA,Bloomberg
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June30,2011
andAssistantGovernorLowe(Economic)inspeeches duringthelasttwoweeks,themarketmovedtofullyprice ina25bpcutbyyearendthisweek.Whilepricinghas correctedsomewhatafterWednesdayssuccessfulGreek inprinciplevoteonitsausteritypackage,themarket continuestotoywiththepossibilityofacutbyyearend. WenotethattheRBAhasneverengagedinanemergency movewiththethreeepisodesofpolicyeasingsincethe introductionoftheinflationtargetinthemid1990s consideredanddeliberateandusuallyinconjunctionwith similarpolicyactionglobally.Themostrecentepisodesof monetaryeasingoccurredamidstglobalrecessions,andwe looktobealongwayfromaglobaldoubledipdespitethe Europeanchallenges.Whilewethinkthatthereisaclear riskthattheEuropeansovereigndebtcrisis(aswellas someuncertaintyovertheoutlookfortheUSeconomy) keepstheRBAonthesidelinesforlonger,wedonotexpect anykneejerkcutfromGovernorStevens.Globalgrowth prospects,especiallyinAsia,wouldhavetodeteriorate markedlyforratecutstobeontheRBAspolicyagenda. Withsoaringunitlabourcostsconfirmingtheinflation trajectory Regularreaderswillknowthatweremainverymuch weldedtoourmediumtermviewshistoricallyhigher termsoftrade,animpendingsurgeinbusinessinvestment, andwaningcapacityinbothgoodsandlabourmarkets whichargueformodestlyhighercashratesforthemedium term.Thetimingmaybedebatable,butifthereisasingle ExhibitAU1.2:RecenteasingcyclesfromtheRBA
8.5 7.5 6.5 5.5 4.5 3.5 2.5 30/06/95 30/06/02 30/06/09
Asian Crisis Tech Wreck/9/11 GFC Cash Rate (% LHS) Terms of Trade (Index RHS)
chartthatshouldquashmarketexpectationsforratecuts, emergencyorotherwise,itistheonebelowthathighlights thesharpaccelerationinunitlabourcosts. Unitlabourcostsjumpedbyalmost3%inQ1/11withy/y growthacceleratingto7.5%,itsfastestpaceintwo decades.Wagesgrowthhaspickedupalittleinthelasttwo quartersandisrunningcloseto4%withwagesinmining, construction,financeandinsurance,andprofessional servicesrisingbymorethantheindustryaverage.However, therealculpritinthesoaringunitlabourcoststoryisAUs poorproductivityperformanceinrecentyears,andindeed, formuchofthelastdecade.Duringthedecadetofiscal 20092010labourproductivityaveragedalittleover1%, approximatelyhalftheaverageofthe1990sdecade. Furthermore,withtheexceptionof20092010,labour productivitywasrunningatbarely0.5%perannuminthe previousfiveyears.AUspoorproductivityperformance leavestheeconomyparticularlyvulnerabletoany downturninthetermsoftradeorexternalshock. Thelackofreformformuchofthelastdecade,combined withtheunderinvestmentincapitalandinfrastructure,has exacerbatedthisworryingtrend.Disappointingly,the currentminorityLaborGillardGovernmentlookssetto remainhamstrungforremainderofitsthreeyearterm, whichendsinlate2013.Thelikelyconsequenceinthenear termwillbeapickupininflationifpasthistoryisanyguide. ExhibitAU1.3:Soaringunitlabourcosts
40.0 35.0
6.0 5.0 4.0
Headline CPI (% y/y LHS) RBA's Core M easures (% y/y LHS) Unit Labour Costs (non-farm, t d 4 t % / RHS) RBC's
8.0 6.0 Forecasts 4.0 2.0
30.0 25.0 20.0 15.0
3.0 2.0 1.0 0.0 -1.0 Dec-95 Dec-98 Dec-01 0.0 -2.0 -4.0 DecDec-04 Dec-07 Dec-10 Dec-12
Source:RBA,ABS
Source:RBA,ABS
37
June30,2011
Accordingly,weremainreasonablycomfortablewithour longheldexpectationforanother25bphikeinH2/11but concedethattheriskisforourAugustcalltobepushed backtoouroriginalQ4/11hike.Historyhasshownthatin timesofuncertainty,theRBAtendstostayonthesidelines awaitingfurtherdataanddevelopments.Thislookstobe thecaseatthemoment.WhentheRBAconvenesforits monthlyboardmeetingnextTuesday,5July,Europeanand globaldevelopmentsarelikelytodominateitsdiscussions. Atighteningbiaswillremainintact,butitwillbedifficultto exercisethisbiasagainstastillratheruncertainglobal backdrop.
38
June30,2011
USSupplyOutlook
Thecomingweekssupplyannouncementisexpectedtobringnochangestothesizesofauctions:$32B3s,$21B10s, and$13B30s(finalreopeningofthe5/21sand5/41s). Instead,thefocuswillbeonhowthemarketadjuststotheendofQE2.Goingforward,thetotalsizeofpurchaseswill dropsubstantially(estimatedat85%),andoperationswillbemuchmorespreadoutastheFedwillpurchasejust seventimespermonth,comparedto18operationspermonthduringQE2. TheTreasuryhadthreeconsecutivepoorauctions.Thequarterendbalancesheetissue(seeTheBigPicture,page5, formore)definitelyplayedarole,butwethinkthattheendofQE2willbeafactorinauctionsinthebellyofthecurve incomingmonthsasmarketsarelosingoneverylargebuyerthatwaswillingtotakeunwantedinventoriesoffthe handsoftheprimarydealercommunity.TheFedhaspurchased$288BofnewissuesthathavesettledduringQE2 morethanonethirdtheamountprimarydealershavebeenallocatedthroughauctionsduringthesameperiod.Inpar ticular,theFedhasbeenawelcomebuyerinthe3,5,and7yearsectors.Withratespinnedbeneathlevels,whichwe believewouldbeconsistentwithfundamentals,theauctionprocesscouldremainsomewhatsloppy. ExhibitSO1.1:USTEventCalendar
4 JULY 5 6 2.5- to 4-yr $2.5 $3.5 bn 12 4- to 5.5-yr $2.5 $3.5 bn 3yr Auction 13 2PM Purchase Schedule Released 10yr Auction 30yr Auction 14 7 Auction Announc.: 3yr,10yr,30yr 15 8 MARKET CLOSED Independence Day 11
*Fed Purchases are scheduled for 11AM and auctions are scheduled for 1PM unless otherwise noted
Sources:NYFed,USTreasury,RBCCapitalMarketsestimates
ExhibitSO1.2:USTreasurydurationflowsin10yequivalents
UST Duration Flows in 10yr Equivalents (Bn.$)
25 20 15 10 5 0 -5 1-Jul 5-Jul 6-Jul 7-Jul 8-Jul 11-Jul 12-Jul 13-Jul 14-Jul 15-Jul Duratio n Entering Mkt Duratio n Leaving Mkt. Cumulative Net Duration Entering (Leaving) Mkt. (rhs) 55 45 35 25 15 5 -5
Sources:NYFed,USTreasury,RBCCapitalMarketsestimates
39
June30,2011
EuropeanSupplyOutlook
Intheupcomingweekweexpect15.517.5BofEGBsupplyoutofAustria,Germany,Spain,andFrance.Thiswillbe accompaniedby1519BofbillissuanceoutofFrance,theNetherlands,Belgium,andPortugal. Thenetcashflow(differencebetweenEGBgrossissuanceversusredemptionsandcoupons)willturnnegativeforthe nexttwoweeksamidsignificantGermanandDutchredemptions,andcouponpayments(ExhibitSO2.1).Thesewill evenbeexceededbythesubstantialcouponpaymentsandredemptionoutofItalyandSpain(30Julymaturities)on1 Augustwherealmost54B(IT:20Bredemptionsand10Bcouponpayments,ES:15.5Bredemptions,andalmost 8Bcouponpayments)areflowingbacktothemarket.Thesefunds,potentiallybeingreinvestedinSPGBsandBTPs, shouldsupportthecurrentriskonmodeintier2paper(outrightandinspreadtermsoverBunds). Thenextsupplyweekwillbeverycoreheavy(ExhibitSO2.3).Austriawillkickofftheweekwithtapsofits10yonthe runbenchmarkRAGB3.65%Apr22andtheRAGB3.8%Oct13offtheruninacombinedsizeof1.65BnextTuesday(5 July).Austriasfrontendsupplysupportsourwideningviewofthe2yAustrianspreadoverFrenchpaper.There,we generallyconsideravaluationoftheRAGBOct13vs.FRTROct13yieldspreadclosetoflatlevelsastootightlookingfor some3bpspreadwidening(seealsoourOpenTradeRecommendationsonpage4). Germanywillreopenitscurrent2ybenchmarkBKO1.75%Jun13by4BforthelasttimenextWednesdaybeforeits successorBKOSep13willbelaunchedon17August.Fromthisperspective,theFinanzagnetur(DFA)publisheditsfund ingoutlookforQ3/11.TheDFAplanstoissueatotalof60Bnextquarterinbills(21B)andbonds(39B).Thisrepre sentsanoverall11Bfundingreductioncomparedtothe2011sfundingoutlookpublishedinDecember2010.The betterpartofthereductioncomesoutofthebillspacewith9Blessissuance.InQ3/11,allthree9mBubilltaps(3B each)havebeencancelledwhilethesizeofthethree6mBubilllauncheshasbeenreducedby1Beach.Intheconven ExhibitSO2.1:UpcomingEGBgrossissuance,redemptions, couponpayments(B)
30 20 10 -10 -20 -30 -40 -50 -60
week 27-Jun to week 04-Jul to week 11-Jul to week 18-Jul to week 25-Jul to 01-Jul 08-Jul 15-Jul 22-Jul 29-Jul week 01-Aug to 05-Aug
ExhibitSO2.2:FundingcompletionofmainEMUsovereign issuers(ofmainbondprogramme)
( bn) 250 200 150 100 50 0 GE FR IT ES NL BE AT PT FI
YTD (abs, lhs) target* (lhs) YTD (in %, rhs) average over the last two years (in %, rhs)
RBC expectations
(%) 195 189
100 80 60
184
94 50
40 34 20 0
18
19
16
gross issuance
coupon payments
bond redemptions net cash flow Source:Nationaldebtagencies,RBCCapitalMarketsestimates
*EGBfundingtarget,netofbuybacksforFrance,ItalyandPortugal Sources:NationalDebtAgencies,RBCCapitalMarketsestimates
40
June30,2011
SupplyOutlookForTheUpcomingWeek
ExpectedgrossEGBsupplyintheweekcommencing04Jul11(inB)andDV01equivalent(inMn/bp) ExhibitSO2.3:AcrossIssuers
9 8 7 6 5 4 3 2 1 0 FR in bn (lhs) GE ES AT dv01 equivalent in mn/bp (rhs) 8 7 6 5 4 3 2 1 0 3 2 1 0 2y/3y 5y 10y 15y 30y IL Floater in bn (lhs) dv01 equivalent in mn/bp (rhs) 2 1 0
ExhibitSO2.4Acrossthecurveandfundingtypes
7 6 5 4 3 6 5 4
Source:NationalDebtAgencies,RBCCapitalMarketsestimates
Source:NationalDebtAgencies,RBCCapitalMarketsestimates
tionalbondspace,theDFAjustreducedtheBKOissuanceby2Bwith1BlowerreopeningsoftheBKOJun13(on6 July)andtheBKOSep13(on14September).AreductioninbillissuancesignificantlyandlowerfundinginBKOsmakea lotofsenseinouropinion.Itisquiteprudenttoextendthedurationofthedebtprofileamidthecurrentlowinterest rateenvironment. ThebetterpartofnextweeksEGBsupplywillbecomingoutofFrance.Weexpectsome89Bsplitbetweenthecur rent10ybenchmarkFRTR3.25%Oct21,the15yFRTR3.5%Apr26,andoneortwoofftherunlines.TheFrenchTresor willasusualoutlinebondsandsizeindicationfornextThursday'sauction(7July)thisFriday(1July)at10:00(BST). Onthesameday,Spainscheduledatapofits5yontherunSPGB3.25%Apr16.WhiletheTesorowillpublishitsissu ancesizerangenextMondayaround13:00(BST),additionalofftherunlinecouldbeaddedtonextThursdaysauction thisFriday(1July).Forasinglelineonoffer,weexpect23Btobeissuedand34Bfortwolines.
41
June30,2011
SupplyOutlookForTheUpcomingWeek
ExhibitSO2.5:Europeansovereigngovernmentbondandbillauctioncalendarfortheupcomingweeks
Time (GMT)
Fri:01Jul 10:00 Mon:04Jul 10:00 Netherlands Netherlands 13:00 13:50 Netherlands Spain France France France Austria Austria Belgium Belgium Germany Portugal Tap New 3mDTC 8mDTC 30Sep11 29Feb12 29Jun12 29Sep11 29Dec11 28Jun12 20Oct13 20Apr22 20Oct11 15Dec11 14Jun13 21Oct11 23bn 1.52.5bn 12bn 4.5bn 1bn 2.5bn
Issuer
Tap/ newissue/ buyback
Bond/Bill
Maturity
Expectedvolume
Avg.b/cratioYTD*
France
AnnouncementFRTRauction(07Jul)
New 12mDTC SizeannouncementSPGBAuction(07Jul) Tap 12wBTF Tap 25wBTF New 51wBTF Tap Tap Tap Tap Tap Tap RAGB3.8 RAGB3.65 3mBGTB 6mBGTB BKO1.75 6mPORTB
Tue:05Jul 10:00 10:30 Wed:06Jul 10:00 10:00 Thur:07Jul 09:30 09:50
1.65bn 22.5bn(e)
2.57
4bn 0.751bn 1.88 2.54 2.04 2.74
Spain France France France 16:30 Italy afterCOB Spain Mon:11Jul 10:00 Germany 10:00 SlovakRepublic 13:50 France 16:30 Italy Tue:12Jul 09:00 Netherlands 10:00 Italy 10:30 Belgium 10:30 Belgium 11:45 Slovenia Wed:13Jul 10:00 Germany Thur:14Jul 10:00 Italy Italy Fri:15Jul 10:00 France
23bn(e) Tap SPGB3.25 30Apr16 Tap FRTR3.25(e) 25Oct21 89bn(e) Tap FRTR3.5(e) 25Apr26 Tap FRTR4.25(e) 25Oct18 BOTannouncement(12Jul)andbondannouncementforBTPauction(14Jul) MonthlyBondAnnouncement 6mBubill 12mSLOVTB BTFAuction BTPAuctionSizeAnnouncement(14Jul) Tap New Tap New New Tap Tap Tap Nether3.25 12mBOTS 3mBGTB 12mBGTB 91dSLVNTB DBR3.25 BTPS3.75(e) BTPS4.5(e) New New 11Jan12 11Jul12 4bn 2bn 8bn(e)
15Jul21 16Jul12 20Oct11 19Jul12 13Oct11 04Jul21 15Apr16 01Mar26
1.52.5bn 8bn(e) 22.5bn(e) 30mn 4bn 1.61 1.38 1.57
4.55.5bn(e)
AnnouncementBTNSandlinker(21Jul)
*Averageb/cratioofauctionsintherelevantmaturitybracketpercountry;(e)indicatesRBCCapitalMarketsestimates Source:NationalDebtAgencies,RBCCapitalMarketsestimates
42
June30,2011
Contacts
RBC Capital Markets Fixed Income & Currency Strategy

RBCCapitalMarkets,LLC:
StevynSchutzman GlobalHeadofFICStrategy&Researchand ChiefMacroStrategist (212)6182553 stevyn.schutzman@rbccm.com
Europe
JamesAshley NorbertAul GustavoBagattini AdamCole SamHill JensLarsen ChristianLawrence ElsaLignos PeterSchaffrik
SeniorEuropeanEconomist EuropeanRatesStrategist EuropeanEconomist GlobalHeadofFXStrategy UKFixedIncomeStrategist ChiefEuropeanEconomist FixedIncomeStrategist G10CurrencyStrategist HeadofEuropeanRatesStrategy
+442070290133 +442070290122 +442070290147 +442070297078 +442070290184 +442070290092 +442070290112 +442070297085 +442070297077 +442070297076
james.ashley@rbccm.com norbert.aul@rbccm.com gustavo.bagattini@rbccm.com adam.cole@rbccm.com christophe.duvalkieffer@rbccm.com sam.hill@rbccm.com jens.larsen@rbccm.com christian.lawrence@rbccm.com elsa.lignos@rbccm.com peter.schaffrik@rbccm.com
RoyalBankofCanadaEuropeLimited:
ChristopheDuvalKieffer GlobalInflationLinkedStrategist
AsiaPacific
SuLinOng MichaelTurner
RoyalBankofCanadaSydneyBranch:
HeadofAustralianandNewZealandFICStrategy FixedIncome&CurrencyStrategist +61290333088 +61290333088 sulin.ong@rbccm.com michael.turner@rbccm.com
RoyalBankofCanadaHongKongBranch:
SueTrinh SeniorCurrencyStrategist +85228485135 sue.trinh@rbccm.com
NorthAmerica
RBCDominionSecuritiesInc.:
MarkChandler DavidWatt KamBath GeorgeDavis PaulBorean MichaelCloherty TomPorcelli JacobOubina ChrisMauro DanGrubert HeadofCanadianFICStrategy SeniorCurrencyStrategist FixedIncomeStrategist ChiefTechnicalAnalyst Associate HeadofUSRatesStrategy ChiefUSEconomist SeniorUSEconomist HeadofUSMunicipalsStrategy Associate
(416)8426388 (416)8424328 (416)8426362 (416)8426633 (416)8422809 (212)4372480 (212)6187788 (212)6187795 (212)6187729 (212)6187764
mark.chandler@rbccm.com david.watt@rbccm.com kam.bath@rbccm.com george.davis@rbccm.com paul.borean@rbccm.com michael.cloherty@rbccm.com tom.porcelli@rbccm.com jacob.oubina@rbccm.com chris.mauro@rbccm.com dan.grubert@rbccm.com
RBCCapitalMarkets,LLC:
43
June30,2011
RequiredDisclosures
Conflictsdisclosures
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Conflictspolicy
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Alloftheviewsexpressedinthisreportaccuratelyreflect thepersonalviewsoftheresponsibleanalyst(s)aboutany andallofthesubjectsecuritiesorissuers.Nopartofthe compensationoftheresponsibleanalyst(s)namedherein is,orwillbe,directlyorindirectly,relatedtothespecific recommendationsorviewsexpressedbytheresponsible analyst(s)inthisreport.
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44
June30,2011
Disclaimer
RBCCapitalMarketsisthebusinessnameusedbycertainsubsidiariesofRoyalBankofCanada,includingRBCDominionSecuritiesInc.,RBCCapitalMar kets,LLC,RoyalBankofCanadaEuropeLimitedandRoyalBankofCanadaSydneyBranch.Theinformationcontainedinthisreporthasbeencompiled byRBCCapitalMarketsfromsourcesbelievedtobereliable,butnorepresentationorwarranty,expressorimplied,ismadebyRoyalBankofCanada, RBCCapitalMarkets,itsaffiliatesoranyotherpersonastoitsaccuracy,completenessorcorrectness.Allopinionsandestimatescontainedinthisreport constituteRBCCapitalMarketsjudgmentasofthedateofthisreport,aresubjecttochangewithoutnoticeandareprovidedingoodfaithbutwithout legalresponsibility.Nothinginthisreportconstituteslegal,accountingortaxadviceorindividuallytailoredinvestmentadvice.Thismaterialisprepared forgeneralcirculationtoclientsandhasbeenpreparedwithoutregardtotheindividualfinancialcircumstancesandobjectivesofpersonswhoreceiveit. Theinvestmentsorservicescontainedinthisreportmaynotbesuitableforyouanditisrecommendedthatyouconsultanindependentinvestment advisorifyouareindoubtaboutthesuitabilityofsuchinvestmentsorservices.Thisreportisnotanoffertosellorasolicitationofanoffertobuyany securities.Pastperformanceisnotaguidetofutureperformance,futurereturnsarenotguaranteed,andalossoforiginalcapitalmayoccur.RBCCapital MarketsresearchanalystcompensationisbasedinpartontheoverallprofitabilityofRBCCapitalMarkets,whichincludesprofitsattributabletoinvest mentbankingrevenues.EveryprovinceinCanada,stateintheU.S.,andmostcountriesthroughouttheworldhavetheirownlawsregulatingthetypes ofsecuritiesandotherinvestmentproductswhichmaybeofferedtotheirresidents,aswellastheprocessfordoingso.Asaresult,thesecuritiesdis cussedinthisreportmaynotbeeligibleforsaleinsomejurisdictions.Thisreportisnot,andundernocircumstancesshouldbeconstruedas,asolicita tiontoactassecuritiesbrokerordealerinanyjurisdictionbyanypersonorcompanythatisnotlegallypermittedtocarryonthebusinessofasecurities brokerordealerinthatjurisdiction.TothefullextentpermittedbylawneitherRBCCapitalMarketsnoranyofitsaffiliates,noranyotherperson,ac ceptsanyliabilitywhatsoeverforanydirectorconsequentiallossarisingfromanyuseofthisreportortheinformationcontainedherein.No matter containedinthisdocumentmaybereproducedorcopiedbyanymeanswithoutthepriorconsentofRBCCapitalMarkets.
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June30,2011

The Perfect Storm?

The Glorious Summer Returns

WeenteredaCAD5s10sswapflattenerat95bp(target75bp,stop105bp)basedonanentrylevelsuggestedonJune9 (seeCanadaPerspectivesarticleBellyofCanadascurvelookingstretched).Canada's5ysectorcontinuestolookoverex tendedonthecurvebothonanequalweightedandaprincipalcomponent(PCA)weightedbasis.

124bp 3bp 74.0bp 1.08% 9bp

110bp 4bp 80bp 1.60% 5bp

130bp 2.5bp 58bp 1.08% 14bp

12bp +0.5bp 4.5bp 12bp +0.5bp

8.5bp +3bp +6.5bp 20bp +2bp

Hold Hold Hold Stopped Hold

24Jun11 30Jun11 30Jun11 30Jun11

95bp 20bp 125.73 21bp

90bp 20bp 125.73 21bp

75bp 40bp 123.5 14bp

105bp 10bp 126.2 24bp

Setup Setup Setup Setup

The Perfect Storm?

124 50% correction

current value (not RMP average)

The Glorious Summer Returns

ExhibitBP2.2:10yUSbreakevenratesoutperformanceover ExhibitBP2.3:10yinflationspread,US/euro,cashandswaps eurobreakevenratessincesecondweekofJune 100 80 10Y US/euro spread on BE,

RHS 10Y US/euro spread on sw aps

01 /0 4 08 /20 /0 11 4 15 /20 /0 11 4/ 22 20 /0 11 4 29 /20 /0 11 4 06 /20 /0 11 5/ 13 2 /0 01 5 1 20 /20 /0 11 5 27 /20 /0 11 5 03 /20 /0 11 6 10 /20 /0 11 6/ 17 2 /0 01 6 1 24 /20 /0 11 6/ 20 11

260 250 240 230

TOTAL 0.47 0.95 3.44 2.29 1.59

MIP 0.01 0.25 2.76 1.51 1.17

HD 0.33 0.44 0.61 0.99 0.39

COVERAGE 0.12 0.13 0.34 0.15 0.11

FORMULA 0.60 0.55 0.43 1.03 0.15

WEIGHTS 0.33 0.36 1.01 0.18 0.30

May Jul Jun Jun Jul Jun Jun Jun Jun

May Q1F May May Jun

0.8,2.5 0.1 52.0 0 15,4.9 0.5,2.6 53.5

0.7,7.0 0.50 200 1.50 0.50 200 1.50

3.0 3.9 3.1 2.6 1.8 1.7 2.4 2.1

3.9 3.9 0.8 0.8 0.5 0.5

2.8 2.0 0.3 0.3 0.3 0.1

3.8 2.7 0.4 0.3 0.7 0.9

3.3 2.7 0.5 0.3 0.6 0.5

3.2 3.1 1.7 1.7 1.3 1.3

2.6 2.4 2.5

3.2 2.7 2.7

2.7 2.5 2.8

2.1 2.5 2.7

Q212 2.50 2.65 3.00 3.65 4.05 4.50

FrontEnd Vol MBS

Repocheapening Slightlyhigher Neutral

Debt Ceiling from 30,000 Feet

$b, monthly average outlay last 12 months

Municipals: A Stronger Second Half

Some respite for the bears

Sep10 Nov10 Jan11 Mar11 May11

Curve Cross currency spreads ASW

Tighter Bunds/Giltsneutral totighter,Sweden wider

Inflation Money markets

Welikeb/ewidenersincashversustheswapcurve. Moneymarketpricingappearsexpensiveonallcounts,andwelikeshortsfrom Dec11onward.Themoneymarketcurveshouldresteepen.

More than alive after the vote

Jun-11 spread (rhs)

ECB preview: Keep calm and carry on

Gilt Issuance Calendar: Fiscal Q2/11

Rate Raising Riksbank

1.16 1.14 1.12 1.10

8.8 8.6 8.4