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1. Fixed Income research
Global
5 March 2009
Ahead of the curve
EMU: Make or break?
The financial and economic crisis is exposing flaws in the set-up of EMU, inviting
speculation about break-up, default or at least a buyers’ strike. We evaluate the
various options available and conclude that there is no easy way out. Bond and
CDS spreads appear fundamentally elevated but the risk is for tensions to
increase before things can improve.
► Highlights of the Week Ahead: Industrial production should show that the slump in the
Eurozone continued at the start of the year at an unrelenting pace. Order intake offers a
shimmer of hope but further setbacks cannot be ruled out in coming months. In the US,
retail sales should show that private households are still putting off making purchases. (p. 9)
► Relative value:
€: Zooming in on 2y swap spreads: we present a fair value model for the Schatz ASW and
conclude that short-end ASWs stand at risk to re-widen over the coming weeks. Tactical 2y
ASW wideners – outright or via conditional setups – should score! (p. 12)
€: While acknowledging drawbacks when modelling money market spreads, our formal
approach underscores the suspicion that, in particular, longer-dated Euribor spreads are
too low. (p. 14)
€: Some EMU bailout hopes are pointing towards the EIB. Yet, providing help would go
hand in hand with certain disadvantages for the institution, in our view. (p. 16)
£: Conventional and unconventional measures from the BoE – what does it mean for
markets? (p. 18)
► Derivatives Dimension:
Flow Derivatives, Correlation, Volatility: Slope options may be superior to conditional
steepeners when directional risks rise relative to curve exposure. (p. 20)
Structured Products: Corporates may reduce their funding costs through a structured
swap including a hedge against possibly higher CMS yields later this year. (p. 23)
Inflation Dimension: Despite the ongoing y/y downtrend of Eurozone inflation, the
seasonal pattern in the m/m rates is likely to change the negative carry environment for
linkers soon. (p. 25)
Key fixed income views
Last
Segment View update/publication
Outright Strategy (1-3m) Long duration positions in EUR, small longs in US$, GBP and JPY via 8-Jan/AotC
swaps and government bonds.
Outright Tactic (<1m) Long 12-Feb/AotC
Curve Small Steepeners in the Eurozone, First small flatteners in the US and UK, 26-Feb/AotC
box trades between the Eurozone and the US/UK.
Cross Market Spreads Overweight Eurozone versus US and UK. 19-Feb/AotC
EUR Swap Spreads Tighteners. Overweight larger solid EMU credits. 5-Feb/AotC
Short Term Products Strategic longs via EONIA and IRS. Schatz shorts against EONIA. 26-Feb/
Tactically and strategically neutral Short Sterling. Strategically neutral STP Weekly
Eurodollars and short gamma strategies.
Research Analysts
Inflation Linked Products Receive long dated GBP, USD, EUR IL swaps, buy cash bond b/e versus 19-Feb/AotC
Christoph Rieger
+49 (0)69 713 19029 swaps, receive EUR IRS versus USD/UK real rates.
Volatility Short ultra-long tenored € gamma. Short US$ and £ gamma (also versus 29-Jan/AotC
christoph.rieger@dkib.com
longer dated tenor). Neutral € and US$ vega.
Peter Schaffrik
Source: Dresdner Kleinwort Research
+44 (0)20 7475 3229
NOT FOR DISTRIBUTION IN THE UNITED STATES, CANADA, JAPAN OR AUSTRALIA
peter.schaffrik@dkib.com
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3. Ahead of the curve 5 March 2009
The Big Picture
Christoph Rieger The financial and economic crisis is exposing flaws in the set-up of EMU, inviting
+49 (0)69 713 19029
speculation about break-up, default or at least a buyers’ strike. We have evaluated
christoph.rieger@dkib.com
the various options that are on the table and conclude that there is no easy way
out. At the same time, we hold a high degree of confidence that investors in any
EMU sovereign will get repaid at face value and in EUR. This leaves bond and CDS
spreads appearing elevated. However, we believe fundamental and funding risk ia
likely to get worse before getting better in a number of countries, so we prefer
keeping overweights in the larger and more liquid countries and still expect new
historical lows in Bund yields this summer.
Creative destruction of EMU – One positive feature about any recession is that it exposes structural flaws, fostering a
a risk that needs to be priced
process of ‘creative destruction’ as Schumpeter pointed out more than one hundred
years ago. Applied to EMU, the current crisis inexorably exposes structural deficiencies
that have been simmering below the surface and could now prove detrimental: the lack of
reform when times were good validates questions of whether the Eurozone comprises an
optimal currency area and the lack of political union could ultimately turn out to be the
Achilles heel.
To be sure, we are confident that the question of Eurozone survival is not a question of
‘if’ but of ‘how’. A lot of ink has already been spilled on this subject and we have also
opined on the matter in previous editions of these pages 1. Currently, we have no
intention of dwelling on the deeper political debates. Rather, we attempt to attach
likelihoods to the different options that are on the table and derive implications for the
pricing of Eurozone bonds, CDS and swap spreads.
Risk of insuring sovereign debt has multiplied (selected 5y CDS)
(bp)
300
200
100
0
Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09
Germany US Italy Greece Ireland
Source: Dresdner Kleinwort Research
The EMU options: there is no (easy) way out!
Should a Eurozone member face funding difficulties, various bailout options on different
international levels appear possible. To state our conclusion first: we believe actual
default is no option, EU- or EMU-wide solutions could be difficult to achieve, case-by-
case bilateral support looks most likely and ultimately the ECB could end up taking a
bigger role than it currently likes!
1
See e.g. Ahead of the Curve, 18 December (“What happens if sovereigns can't place their debt?”) or
Ahead of the Curve, 22 January (“From banking to sovereign crisis”).
3
4. Ahead of the curve 5 March 2009
Outright default
Within EMU, even the We see little point in debating why one should not simply let an EMU member default on
smallest country is systemic
existing debt. Within EMU, even the smallest country has to be considered systemic. Default
and should be saved
of one country would bring considerable economic hardship to its citizens and would also
leave investors across the Eurozone feeling the effects (a large part of the Eurozone
countries’ debt is held in other parts of the Eurozone), amplifying the economic plight already
under way. Furthermore, a default of one member would invite speculators to target the next
weakest link. Contagion would be inevitable and the prospective damage to the Eurozone
economies, the euro itself and even political and social stability should provide sufficient
motivation for each member to stop the default of any peer from happening.
Leaving EMU
Prohibitive economic cost of With EMU unlikely to tolerate default and members unable to devalue or inflate their debt
leaving EMU
away, would it not be feasible for countries to leave EMU, possibly creating an “optimal
currency area”? The legal framework of the EU does not provide for this option but
ultimately it would be a political decision. If some countries were to leave by themselves
as a consequence of rising funding problems, we have opined before that, economically,
the consequences would be devastating as countries leaving EMU would be subject to
capital flight and living standards would likely fall back by ages. In the absence of political
revolt we therefore consider this outcome also highly unlikely 2.
IMF bailout
Don’t count on the IMF The international fireman of choice when it comes to sovereign bailouts is the IMF. The
IMF’s pockets, however, are not indefinitely deep. Since being created in 1944, the IMF
has never encountered such a synchronous global growth slowdown where as many
countries were lining up for help like at present. At the end of 2008, the IMF’s one-year
forward commitment capacity stood at SDR 97.6bn (US$150.3bn), down 24% on the
year, and quota increases would have to be agreed upon by an 85% majority among the
Board of Governors (representing roughly 85% of world GDP). Moreover, should an IMF
delegation be visiting a European capital, it would not take long before investors took
flight from other non-core sovereign assets in order to avoid a potential debt
restructuring. And while the IMF should have the best expertise and experience in
helping states in financial trouble, this should not be the first choice for EMU members.
Hence, for a good reason, EU Monetary Affairs Commissioner Almunia hinted in an
interview this week that “there is a solution before visiting the IMF” – even though he
refused to elaborate on the details.
EU financial assistance Hence, in the light of the latest developments, we now believe the IMF will most likely not
possible despite ‘no bail-out
be spearheading a rescue effort if EMU countries face difficulties. The IMF could assume
clause’…
a supervisory/advisory role in any EMU bailout. Funding or insurance of any kind,
however, should come from within the EU: legally, despite the often cited ‘no bail-out
clause’, the European Treaty should not stand in the way of financial assistance. 3 The
key question therefore is what form the support may take and how it can be achieved.
2
If anything, we believe such an option would be explored in times when economic developments deviate
significantly within the Eurozone and could be a long and politically wearing process. To us this remains a
risk scenario only over the 3-5 year horizon.
3
Article 104b of the EU Treaty states that neither the Community nor a member state shall be liable for
commitments of others (so-called no bail-out clause). Yet, Article 103a allows for the Community to grant
financial assistance in the case of “exceptional occurrences” beyond the control of a member state (Article
100 of the Nice Treaty enables the Council to do so with qualified majority).
4
5. Ahead of the curve 5 March 2009
Common Eurozone bond issuance
A common Eurozone bond has increasingly been touted as a funding panacea of late.
We are sceptical, however, whether this project, which has been under discussion ever
since EMU was formed, will finally spring to life in the current crisis. With both German and
French authorities already being critical about common issuance (Germany Financing
Agency’s Daube: “it might take up to 10 years for that to happen”), the issue of common
issuance should be off the table for now (also see last week’s Ahead of the Curve, p. 15).
EIB emergency funding for EMU sovereigns
… but common Eurozone Practically easier to accomplish than a common Eurozone bond could be to utilize the
bonds and EIB funding are
established infrastructure of a European supranational organization, like the European
unlikely to find a consensus
Investment Bank (EIB), to provide emergency funding for ailing sovereigns. In practice,
anytime soon.
however, a significant expansion of the EIB funding programme, if possible at all, would
require significant price concessions. Put differently, it would dilute the funding advantage
of the sounder EMU credits and trigger the same resentments as common issuance (for more
details on the EIB option, see Ted Packmohr and Annegret Hasler’s article on page 16).
Bilateral case-by-case country support
Bilateral case-by-case More likely than agreeing on an EU-wide support mechanism, we believe, would be a
approach most promising
sovereign bailout along similar lines of the bank bailout packages seen so far, i.e. via
bilateral or multilateral guarantees and capital aid. While also politically delicate, sound
EMU credits could provide either guarantees or capital to EMU peers facing a buyers’
strike or even very adverse financing conditions. Effectively, that would mean that the
sounder countries lend their credibility to the more troubled peers. In practice, like with
any bailout, strings would need to be attached and costs will have to be allocated. In the
case of capital support, for instance, one idea could be for Germany to set up a special
fund separate from the common budget, fully passing on funding costs plus potential
fees.
ECB outright purchases
Why is the ECB not buying In times when the Fed and BoE are openly considering purchasing government bonds,
government bonds?
the question why the ECB is not doing the same seems valid. After all, the ESCB is
already holding a domestic assets portfolio worth some €285bn, consisting largely of
EMU government bonds. Legally, outright purchases of ECB eligible assets represent an
explicit monetary policy tool, which has so far never been used. As long as it would be
consistent with the ECB’s monetary policy strategy, such purchases would therefore be
possible. 4 Practically and politically, however, the ECB is reluctant to do so as purchases
targeted at specific issuers could be seen as undermining the ECB’s independence.
ECB repos
ECB could end up funding a Before the ECB would consider outright purchases, we expect to see increased indirect
larger share of EMU debt
financing of EMU debt via ECB repos. This is already common practice under the
through repos
existing framework, and with more banks being state-owned, a channel from the primary
market via commercial banks into the ECB could become more important. In other words,
commercial banks would buy or underwrite the sovereign issues and refinance them at
the ECB in repo operations. Granted, if done on a larger scale, this could also be seen as
gaming the system and would raise eyebrows within the ECB. Yet, if EMU tensions leave
no other pressure valve, the ECB may be forced to tolerate this as it has been doing with
other assets where funding liquidity had evaporated. In theory, the amount of collateral
the ECB can refinance by creating own reserves is unlimited. In practice, financing for
instance the remaining funding requirement of larger issuers (e.g. Italy: €162bn) would
make a noticeable impact on the ECB’s balance sheet. At present, the total volume of
4
The EU Treaty states that without prejudice to its overriding objective price stability, the ESCB “shall
support the general economic policies in the Community” (Article 105). Direct funding of government
deficits or ECB participation in the primary market are prohibited (Article 21 ESCB Statute).
5
6. Ahead of the curve 5 March 2009
open market operations stands at €707bn, and only 10% of the collateral used consists
of central government bonds. In times of full allotment and near zero interest rates,
however, a significant expansion should not be a major obstacle.
Markets to reward countries that are ahead of budget!
(%)
60
50
40
30
20
10
0
DE FR SP AT NL BE IT PT GR FI IE
YTD Avg during the past few years
Source: Dresdner Kleinwort Research
Sovereign bond and CDS spreads: the next
bubble to implode?
In summary, we consider it highly unlikely that any EMU sovereign will not repay its debt
at face value and in EUR. In this case, should it not be a good chance to lock in attractive
yield spreads or to sell credit protection at historically high levels? For buy-and-hold
investors who enjoy the luxury of not caring about mark-to-market risk, our answer is yes.
For everybody else, we advise to think and in particular to look twice!
Bond spreads: beware fundamental event and funding risks!
Markets may well test the As the section above has shown, there is no easy way out of a potential funding crisis,
untested EMU framework as
and markets may well test the untested EMU framework of how to deal with such a
fundamental and funding risk
scenario. There are few countries out there that are not at risk of becoming subject to
don’t go away
such speculation at some point. Away from the most popular candidates, Ireland and
Greece, several other countries could become targets, for instance given their oversized
banking sectors (Benelux), unsustainable corporate sector deficits (Spain, France) or
high exposure to Eastern Europe (Austria).
While following these fundamental themes is therefore of the essence in terms of EMU
sovereign risk allocation, the other key factor in assessing the odds for a buyers’ strike is
Keep overweight in larger funding completion. At the start of this year we introduced a funding barometer in our
well-diversified countries that
weekly auction previews, listing funding completion relative to this year’s expected
are not trailing their funding
schedule issuance and previous year’s path (see the chart above). Only two months into the year,
it is still early stages, but we believe countries that are willing to pay high spreads today
could get rewarded later during the year as the fundamental issues are unlikely to disappear.
We therefore still prefer overweights in big and well diversified countries with decent liquidity
in their outstanding issues across the entire core and peripheral universe (e.g. Germany,
France, Italy – also see our View Portfolio update in Ahead of the Curve, 5 February).
6
7. Ahead of the curve 5 March 2009
CDS spreads: beware one-sided liquidity
CDS spreads to trade Similar to government bond spreads, after easing somewhat during early February, most
detached from fundamentals
CDS spreads over Bunds again reached all-time highs last week, both in absolute terms
for some time
and relative to Germany (also see chart on page 3). Granted, one can probably argue
that specific sovereign CDS spreads are trading detached from fundamentals, especially
in those countries where the CDS spread against Germany is higher than the cash bond
spread (e.g. Austria and Ireland). Still, with few natural sellers of protection likely to
emerge anytime soon, we caution against taking larger outright and relative risks in these
instruments until liquidity improves (also see box below).
Who needs sovereign CDS?
Arguably, financial innovation has given rise to various financial products that should
have never been invented. One instrument with at least questionable economic rationale
is sovereign Credit Default Swaps (CDS), in particular those that insure against the
default of a high-rated AAA country like Germany or the US. Until the fall of Lehman, 5y
German CDS had been trading in single-digit point ranges for most of the time. Last
week, this CDS reached a new all-time high of 92bp, and this can still be considered low
when compared for instance with the Austrian 5y CDS at 272bp. The question therefore
who is willing to buy sovereign CDS from banks that are unlikely to meet their
commitments if a larger country like Germany would be left reeling appears justified.
We believe demand for this product largely stems from three corners: first, real money
investors who have limits on specific issuer names but prefer holding larger amounts of,
say, German Bunds. Such players can be obliged to buy credit protection in order to be
able to increase their exposure. Second, banks that are long illiquid country risk are
natural buyers of CDS to reduce this risk, if only in accounting and not economic terms.
Third, hedge funds that want to speculate on specific country spreads and are no longer
able to do so in the underlying cash instruments after their prime brokers have either
disappeared or have reduced their funding commitments in the current environment.
Swap spreads: beware Euribor spreads at the short end
CDS spreads to trade The systemic risk of EMU we have discussed above has had little impact on German (and
detached from fundamentals
French) credit risk so far. True, German CDS have also surged, but a similar increase has
for some time
been observed in US sovereign CDS. We consider this justified for now. With the risk of
Germany (and France) having to shoulder an EMU bailout rising, real money appetite for
cash duration declining, term premia increasing and overall supply still looming large, we
see little room for longer-dated swap spreads to widen from current levels.
Further down the curve, we are more cautious about swap spread tightening exposure
despite noticeably higher absolute swap spread levels. The downtrend in money market
spreads has already come to a halt and looks at risk of re-widening at least in the near
term (also see page 14). With Euribor spreads one major determinant of shorter-dated
swap spreads (also see page 12), we advocate expressing our strategically bullish view
at the € short end via Schatz longs and receiving EONIA swaps and relative value
exposure by boxing those positions against paying in IRS.
Conclusion
► The financial and economic crisis is ruthlessly exposing flaws in the set-up of EMU,
inviting speculation about default, break-up or at least a buyers’ strike. When weighing
various options, we conclude that default or quick EMU exit is no option and EU- or EMU-
wide solutions could be difficult to achieve. Case-by-case bilateral support looks more
likely and ultimately the ECB could end up taking a bigger role than it currently likes!
7
8. Ahead of the curve 5 March 2009
► Investors should rest assured that all EMU members will repay their debt at face value
and in EUR, and one could make the case that bond and CDS spreads represent the
next bubble to implode. Given that the fundamental and funding situation of most EMU
countries is likely to get worse before improving, however, markets may well test the
untested EMU framework before long. Hence, we believe spreads are at risk of widening
further before tightening again and we maintain our suggestion for overweighting the
larger and more liquid countries.
8
9. Ahead of the curve 5 March 2009
The Week Ahead
Rainer Guntermann Industrial production in January should show that the slump in the European
+49 (0)69 713 12052
economies continued at the start of the year at a practically unrelenting pace.
rainer.guntermann@dkib.com
However, order intake offers a shimmer of hope even though further setbacks
Dr. Ralph Solveen cannot be ruled out in coming months. In the USA, we expect retail sales to show
+49 (0)69 136 22322
that private households are still putting off making purchases.
ralph.solveen@commerzbank.com
Weak start to the year for the German economy
Bernd Weidensteiner
+49 (0)69 136 24527
In the first three months of the new year, the downturn in industrial production was at a
bernd.weidensteiner@commerzbank.com
similar level to the last quarter of 2008 (-6.8% compared to the previous quarter).
According to our calculations, at least car production fell at around the same pace in
Ger: industrial output (Thu)
Forecast -4.5% (-17.0% YoY) January and February. The success of the scrapping incentive, which recently caused
Consensus -3.0% (-15.5%)
new car registrations to soar, was not able to change this fact. It can thus be seen that, to
date, it has been possible to meet the increased demand from inventories and rising
imports. The situation is hardly likely to be any different in other industries in view of the
industry-wide downturn in demand since the fall. As the really cold weather is also
expected to have hit construction activity harder than normal in January, we believe that
production in manufacturing will have fallen again by 4.5%.
Scrapping incentive a success, but soaring car registration fail to boost output
(in '000) (Index, 2000=100)
350
135
325
125
300
115
275
105
250
95
225
200 85
03 04 05 06 07 08 09
New car registration, seas. adj. Car production, seas.adj. (rhs)
Quelle: Thomson Datastream
Ger: new orders (Wed) However, order intake could bring a shimmer of hope. In both of the last two Ifo surveys,
Forecast 2.0% (-25.5% YoY)
the assessment of demand was not quite as dour as it had been at the end of 2008. In
Consensus -1.0% (-26.5%)
the past there was close correlation with the previous year's rate of order intake, and that
is why this is expected to be not quite as negative in January, which would require an
increase in orders compared to the previous months. We believe that there will be a
moderate increase of 2% – compared to the slump in the previous months.
However, this slight increase in orders would not change the fact that production will
continue to fall in the coming months. This means that the downturn in gross domestic
product in the first three months of 2009 will be similar to that in the third quarter, when
the German economy fell by 2.1% compared to the previous quarter.
The industrial sectors in other Euro area countries remain under almost similar stress.
France: industrial output (Tue)
Forecast -1.0% (-12% YoY) Output plans in France for example are also suffering from the fallout in global demand
Consensus -1.0% (-12% YoY)
and are likely to be scaled back in January. The level is expected to be about 12% below
from a year ago but it is only cold comfort that the declines look a bit less severe than in
Germany. The international exposure also leaves the French industrial sector vulnerable
for further setbacks.
9
10. Ahead of the curve 5 March 2009
Production in free fall
(% YoY) (% YoY)
10 10
6 6
2 2
-2 -2
-6 -6
-10 -10
-14 -14
99 00 01 02 03 04 05 06 07 08 09
UK production German production French production
Quelle: Thomson Datastream
In the UK, too, industrial activity is likely to have had a weak start in the year. In theory, a
UK industrial output (Tue)
Forecast -1.1% (-9.9% YoY)
weakening currency should help to improve the international competitiveness, however,
Consensus na
UK firms have hardly used this advantage when setting prices in global markets and
hence exports remain under pressure. We forecast a decline in output of about 1% on
the month with the output level likely to be down about 10% from a year ago.
USA: retail still under pressure
US retail sales (Thu) Private consumption is suffering from the fact that Americans have curtailed their
Forecast -0.5%
purchases of expensive durable goods – and cars in particular. Car dealers' revenues
Consensus -0.5%
have slumped by 23.4% in the twelve months to January. Without cars, the downturn
would quot;onlyquot; have been 6.1%. And car sales are not likely to recover over the short term.
In February just 9.1 million vehicles (annualized monthly sales) were sold. This puts
sales at their lowest level since December 1981. Total retail revenues are expected to
have fallen by 0.5% in February.
US retail sales still under pressure
(%) (%)
12 12
8 8
4 4
0 0
-4 -4
-8 -8
-12 -12
99 00 01 02 03 04 05 06 07 08 09
US retail sales, %y/y Retail sales ex cars, %y/y
Quelle: Thomson Datastream
Apart from the retail sales report, the upcoming monthly report on international trade may
US trade balance (Fri)
Forecast -US$40.5bn attract some market attention. Weak international demand will continue to weigh on exports
Consensus -US$39.9bn
but weak domestic demand implies that import dynamics are suffering almost with same
dynamics. The net result is forecast to be little change in the January trade balance.
10
11. Ahead of the curve 5 March 2009
Calendar
Country Event (GMT) Month Dresdner Kleinwort Median Previous
Date
Week beginning 2nd March
Switzerland CPI (08.15) Feb
FRI 0.0% (0.0% YoY) -0.8% (0.1% YoY)
UK Feb
6th PPI - Input/Output (09.30) 1.1% YoY/3.1% YoY 1.1% YoY/3.1% YoY 2.3% YoY/3.5% YoY
Feb
PPI - Core Output Prices (09.30) 3.7% YoY 4.1% YoY
Q4
Housing Equity Withdrawal (09.30) -£6.5bn -£5.7bn
US Feb
Non-Farm Payrolls/Manufacturing (13.30) -660k/-- -650k/-200k -598k/-207k
Feb
Unemployment Rate (13.30) 8.0% 7.9% 7.6%
Feb
Hourly Earnings (13.30) 0.3% 0.2% 0.3%
Consumer Credit (20.00) Jan -$5.0bn -$6.6bn
Week beginning 9th March (clock change in the US but not yet in Europe)
MON Japan Current Account Adj. (23.50) Jan -¥498.5bn
Germany PPI (07.00) (From Today) Jan
9th 0.3% (3.8% YoY) -0.1% (3.4% YoY) -1.0% (4.3% YoY)
Eurozone Sentix Investor Sentiment/Expectations (09.30) Mar -38.0/-12.0 -36.1/-18.25
Japan Leading/Coincident Index (P) (05.00) Jan
TUE 80.0/92.4
CPI EU-Harmonised (F) (07.00) Feb
10th Germany 0.7% (1.0% YoY) 0.7% (1.0% YoY) 0.7% (1.0% YoY) (P)
Trade Balance/Exports/Imports (07.00) Jan €7.4bn/-4.0% MoM €8.3bn €6.9bn/-3.7% MoM
France Industrial Production (07.45) Jan -1.0% (-12.0% YoY) -1.0% (-12.0% YoY) -1.8% (-11.1% YoY)
Norway CPI/Underlying (09.00) Feb 2.2% YoY/2.8% YoY
UK BRC Sales Monitor - Like-for-Like (00.01) Feb 1.1% YoY
RICS House Price Balance (00.01) Feb -76%
Industrial Production (09.30) Jan -1.1% (-9.9% YoY) -1.7% (-9.4% YoY)
Manufacturing Production (09.30) Jan -1.4% (-11.7% YoY) -2.2% (-10.2% YoY)
Eurozone PPI (10.00) Jan -0.4% (0.3% YoY) -0.1% (0.7% YoY) -1.3% (1.8% YoY)
Wholesale Inventories (14.00) Jan
US -1.0% -1.4%
Machinery Orders (23.50) Jan
WED Japan -1.7% (-26.8% YoY)
11th UK Visible Trade Balance (09.30) Jan -£7.3bn -£7.4bn
Germany Manufacturing Orders (11.00) Jan 2.0% (-25.5% YoY) -1.0% (-26.5% YoY) -6.9% (-27.7% YoY)
US Budget Balance (18.00)
US Feb -$202.8bn -$175.6bn (Feb 08)
Japan GDP (F) (23.50) Q4
THU -3.3% QoQ/-12.7% Ann. -3.4% QoQ/-12.7% Ann. -3.3% QoQ/-12.7% Ann. (P
France
12th CPI EU-Harmonised (07.45) Feb 0.3% (0.8% YoY) 0.2% (0.7% YoY) -0.4% (0.7% YoY)
CPI Ex-Tobacco Index (07.45) Feb 117.51 (0.8% YoY) 117.13 (0.7% YoY)
Spain CPI EU-Harmonised (F) (08.00) Feb 0.0% (0.7% YoY) 0.7% YoY (P)
Italy GDP (F) (09.00) (F) Q4 -1.8% (-2.6% YoY) -1.8% (-2.6% YoY) -1.8% (-2.6% YoY) (P)
Sweden CPI/Underlying (08.30) Feb 1.3% YoY/1.7% YoY
Eurozone ECB Monthly Bulletin (09.00) Mar
Germany Industrial Production (11.00) Jan -4.5% (-17.0% YoY) -3.0% (-15.5% YoY) -4.6% (-12.0% YoY)
Switzerland SNB 3m Target Libor Announcement (13.00) 0.5%
US Initial Jobless Claims (12.30) Mar 7 650k 640k 639k
Feb
Retail Sales Total/Ex-Autos (12.30) -0.5%/-0.4% -0.5%/-0.3% 1.0%/0.9%
Business Inventories (14.00) Jan -1.3% -1.1% -1.3%
Japan Consumer Confidence (05.00) Feb
FRI 27.0
13th Germany Import Prices (07.00) (From Today) Jan -0.3% (-6.1% YoY) -4.0% (-5.1% YoY)
Eurozone Labour Costs (P) (10.00) Q4 4.0% YoY
Jan
Retail Sales (10.00) 0.5% (-1.5% YoY) 0.2% (-1.8% YoY) 0.0% (-1.6% YoY)
US Jan
Trade Balance (12.30) -$40.5bn -$38.2bn -$38.4bn
Import Prices (12.30) Feb -0.8% -1.1%
Consumer Sentiment (P) (13.55) Mar 55.0 56.3 56.3
Canada BoC Senior Loan Officer Survey (14.30) Q1
Week beginning 16th March
-1.6%
MON Japan Tertiary Industry Index (23.50) Jan
70
16th France BoF Business Sentiment (07.30) Feb
0.2% (1.5% YoY) 0.2% (1.5% YoY) (P)
Italy CPI EU-Harmonised (09.00) (F) Feb
1.2% (P)/1.6%
Eurozone HICP (F)/Core (10.00) Feb
106.82 (1.1% YoY)
HICP Ex-Tobacco Index (10.00) Feb
US New York Fed Survey (12.30) Mar -34.6
Net Foreign Securities Purchases (13.00) Jan $34.8bn
Industrial Production/Capacity Utilisation (13.15) Feb -1.8%/72.0%
NAHB Housing Index (17.00) Mar 9
Japan Tertiary Industry Index (23.50) Jan
TUE -1.6%
BoJ Meeting (05.00)
17th 0.1% 0.1% 0.1%
Germany ZEW Expectations/Current Conditions (10.00) Mar -5.8/-86.2
US Feb
PPI Total/Core (12.30) 0.8%/0.4%
Feb
Housing Starts (12.30) 466k
Japan BoJ Monthly Report Mar
WED
Spain Retail Sales (08.00) Jan
18th -6.1% YoY
Italy Industrial Production (09.00) Jan -2.5% (-14.3% YoY)
UK Mar
BoE MPC Minutes (09.30)
Feb
Unemployment Rate/Change (09.30) 3.8%/73.8k
Jan
Headline Average Earnings (09.30) 3.2% 3M/%YoY
Feb
CPI Industrial Trends Survey (11.00) (From Today)
US Feb 0.3%/0.2%
CPI Total/Core (12.30)
FOMC Interest Rate Announcement (18.15) 0.0-0.25% 0.0-0.25% 0.0-0.25%
UK Feb
PSNCR (09.30) -£25.1bn
THU
Feb
19th M4 Money Supply (09.30) 2.5% (17.5% YoY)
Mar
Industrial Trends Survey (11.00)
Eurozone Industrial Production (10.00) Jan -1.8% (-12.1% YoY) -2.6% (-12.0% YoY)
ECB Meeting (No Interest Rate Announcement)
Canada Feb
CPI/Core (12.00)
US Initial Jobless Claims (12.30) Mar 14
Leading Indicators (14.00) Feb 0.4%
Mar
Philadelphia Fed Survey (14.00) -41.3
Japan Vernal Equinox Day
FRI
Germany PPI (07.00) Feb
20th
Italy Unemployment Rate (09.00) Q4 6.0%
Canada Retail Sales/Ex-Autos (12.30) Jan -5.4%/-3.2%
Source: Bloomberg, Dresdner Kleinwort Research
11
12. Ahead of the curve 5 March 2009
Relative Value Strategy
Short-end swap spreads demystified – tactical
Schatz ASW wideners look attractive!
Marcel Bross Zooming in on short end swap spreads: we present the major drivers and a fair value
+49 (0)69 713 15445
model for the asset swap level of the Schatz.
marcel.bross@dkib.com
While we stick with our strategic call for tighter swap spreads, we see increasing risks
for worsening money market conditions over the coming weeks and recommend 2y
ASW wideners on tactical grounds.
For cautious minds, we suggest conditional setups – via buying an ATM call on the
DUM9 and selling ATM swaption receivers against it – where one can benefit from
wider ASWs in a bullish environment and insurance against a risk appetite rally,
causing ASWs to tighten and sending yields higher in the short run.
We spot three major drivers Since the emergence of the financial crisis, swap spreads have entered a new trading
for short end swap spreads
regime with particularly the highly volatile Bund-swap spreads on the short end being in
and estimate a fair value
the spotlight. With sufficient data points now available, we have estimated a fair value
model for the 2y Schatz ASW
model for the 2y Schatz asset swap level (ASW) and identified three factors as the
driving forces behind the movement in German short-end ASWs. First of all, as in our
previous models for the 10y bucket, we have included the consensus expectations for the
German deficit/GDP 5 ratio as a proxy for net supply in the future. Higher deficits usually
translate into higher funding needs, i.e. higher issuance. Second, investors’ risk
perception largely impacts the development of Bund-swap spreads. As investors become
more risk averse, the value of Bunds in their function as “safe haven” assets increases,
causing swap spreads to widen. On the other hand, when risk aversion and/or market
swings decrease, buying riskier pick-up assets, such as swap-related products, becomes
more interesting. Therefore, we have incorporated the implied basis point volatility of
1y2y ATM swaptions as a measure of risk aversion in the 2y area of the fixed income
universe into our model. Finally, money market tensions are playing an important role for
ASW movement, particularly at the short end. We have used the 3m Euribor-Eonia
spread to capture bank credit and liquidity tensions here. When Euribors underperform
the Eonia curve, swaps (IRS) – representing future Euribor fixings – suffer relative to
govies. Furthermore, govies become more valuable as a refinancing tool as the repo-
market should remain more accessible to raise cash as liquidity dries up. Both effects
also go hand in hand with an improved funding/carry situation for ASW wideners. 6
Regression: 2y ASW on exp. deficit/GDP, 1y2y Swaption Vol and 3m Euribor-Eonia Sp.
Constant Exp. Deficit/GDP 1y2y ATM Swaption Vol 3m Euribor-Eonia Spread
Coefficient (t-stat) -21.8 (-6.48) -6.85 (-9.13) -2.54 (-2.93) -0.46 (-14.58)
Source: Dresdner Kleinwort Research
Putting it all together and running a multiple regression using monthly data since 2002
(we use monthly data only since consensus deficit/GDP forecasts are only available on a
monthly basis), we are able to explain some 90% of the Schatz ASW movement, where
all estimated parameters are statistically significant (see the table above). Note that we
included all variables as “levels” – while we are well aware of the econometric
implications associated with this method, the model also delivers satisfying results when
using changes. What do the beta coefficients tell us? Both, the 3m Euribor-Eonia spread
5
We calculated a rolling measure of weighted deficit/GDP forecasts for the current and the following year
using data from consensus forecasts.
6
Note that we refrained from including “curve movement” (one of the traditional ASW drivers) with the
historical ASW tightening impact from steeper curves being offset by the risk-aversion induced bullish-
steepening coupled with ASW widening environment during the past twelve months.
12
13. Ahead of the curve 5 March 2009
and Germany’s fiscal performance are the main drivers for the 2y Schatz ASW. Each
basis point of widening in the Euribor-Eonia spread widens the ASW level by
approximately 0.5bp, while a 1ppt change in the expected deficit/GDP is driving 2y swap
spreads by almost 7bp on average. Applying current values, the asset swap level of the
Schatz Dec10 is rendered closely in line with our model fair value.
That said, where do we go in short-end ASW from here?
While we stick with our
strategic call for tighter swap While we stick with our strategic call for tighter swap spreads largely on the back of
spreads …
significantly increased supply prospects over the next 2-3 years, we see increased
chances for a re-widening, particularly of short end Bund-swap spreads in the near term.
As we have outlined on p. 14, the tightening in money market spreads has already come
to a halt and seems at risk of widening over the coming weeks. As per our analysis
above, even a modest widening of the EONIA-EURIBOR basis (of say 20bp) should push
the 2y ASW wider by around 10bp. Furthermore, investors’ “safe-haven” bidding has
returned to the market, as indicated by the close link of outright and ASW movement
during the past few weeks (see right-hand chart below). Note that not only have swap
spreads lagged a bit in the recent bull leg and should have to catch up (encircled area in
… we see increased risks for the chart), recent financial turmoil and the ongoing severe economic downturn could well
2y ASW to widen over the
entail another wave of risk reduction, where investors rush again into the safest assets in
coming weeks and
recommend positioning the eurogovy space. While such a scenario may suggest tightening pressure on ASWs
accordingly.
from the supply front, and while this may be true for most EGB issuers, the chances for
increased bond issuance this year are fairly small in the case of Germany. The
Finanzagentur’s funding plan in 2009 already foresees a comfortable cushion of €40-
50bn for potential SOFFIN needs (see Ahead of the curve 5 February 2009) and the DFA
recently indicated that further financing needs would likely be covered via additional Bills
issuance rather than increased bond supply. Thus, we recommend positioning for wider
short-end swap spreads on tactical grounds and expect the Schatz ASW to head towards
the upper bound of the old trading range near the -80bp handle before retracing (see left
hand chart below).
Close correlation of outright and 2y ASW movement of late – Schatz ASW set to rebound to wider levels in the short run
(%)
(bp)
(bp)
-60 1.60
-50
-60 1.50
-65
-70
1.40
-80
-70 1.30
-90
-100 1.20
-75
-110
1.10
-120
-80 1.00
-130
01-Feb 08-Feb 15-Feb 22-Feb 01-Mar
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09
2y Schatz P/P ASW 2y Schatz yield (rhs)
2y Schatz P/P ASW
Source: Dresdner Kleinwort Research
For cautious minds we For investors, who see increased chances for a rebound in risk appetite, we recommend
suggest conditional bullish
positioning for wider swap spreads via conditional trades. Thus, one stands to benefit
swap spread wideners via
buying an ATM call option on from wider swap spreads in a market of increasing risk aversion and lower yields, and is
the DUM9 and selling ATM
not exposed to potential “safe-haven” unwinding rallies causing swap spreads to tighten
receivers against it.
and sending yields higher in the short run. This can be achieved via buying a call option
on a bond or a bond future and selling ATM receiver swaptions against it. A mock trade
set-up using May expiry calls on the June Schatz future and the corresponding receiver
swaptions can be found in the table below. In the case of higher yields (and swap rates)
both options expire worthless, whereas in a bull market the trade makes money if the
implied yield of the Schatz future falls by more than the maturity-matched swap rate.
Clearly, the main risk of the trade is a swap spread tightening scenario in a bullish
environment or a substantial change of the recent directional co-movement of swap rates
13
14. Ahead of the curve 5 March 2009
and government bond yields, i.e. falling swap rates and rising government bond yields,
so that only the swaption would be in the money at expiry. However, both risk scenarios
seem very unlikely to us and we think current entrance levels offer an attractive risk-
reward profile. The trade can be set up at low costs, translating into a break-even spread
of the implied Schatz future yield and the maturity matched swap rate of 67bp. We
recommend holding both options until expiry on 23 April and aim for 10bp to be made.
Mock trade setup: 2y bullish conditional swap spread widener
Trade Setup Long Call Schatz Future Short Receiver Swaption Overall Position
Expiry (Eurex May series) 23-Apr-2009 23-Apr-2009
Underlying Schatz DUM9 maturity matched Swap
Notionals (€m, PVBP neutral) 10.0 (100 contracts) 11.27
ATMF (impl. yield) 108.41 (1.36) 1.99 Spread in bp -63.0
Strike (impl. yield) 108.41 (1.36) 1.99 Spread in bp -63.0
Price 0.37 0.26
Intake/Give-up (€'000) -36.5 29.8 Net Intake (€'000) -6.7
Intake/Give-up Equivalent in bp -18.0 16.5 Net Intake (bp) -1.5
Carry (bp) -2.5
Breakeven Spread (bp) -67.0
Source: Dresdner Kleinwort Research
Euribor risk on the rise!
Christoph Rieger While Euribor fixings keep printing historical lows on a daily basis, it feels like a déjà-
+49 (0)69 713 19029
vu to see Euribor-EONIA spreads widen again.
christoph.rieger@dkib.com
Looking at the driving forces of spreads, we see the risk that spreads will widen
Benjamin Schroeder
+49 (0)69 713 15443 further in coming weeks.
benjamin.schroeder@dkib.com
While acknowledging drawbacks when modelling money market spreads, our formal
approach underscores our suspicion that in particular longer-dated Euribor spreads
are too low.
Following the modest improvement in money markets after the turn of the year, spreads
found a floor last month and are trending upwards again – although until now only very
moderately. We believe a number of factors are at play and think the risk for a further re-
widening in particular of longer-dated spreads (e.g. 12m) has increased.
Déjà-vu in money market In a similar fashion to last year, Euribor spreads continued their descent (which started in
spreads
December) after the turn of the year as liquidity lines were re-opened and hopes were
running high that risk aversion would recede. It now feels like déjà-vu when spreads
bottomed out in February (albeit at higher levels this time around) and re-widened from
there, as lines became full or clogged again and risk-aversion staged a comeback.
Government support helps but On the more positive side, the government support in various forms should allow
warning signs dominate
structurally lower spreads as the capital and liquidity position in particular of the weaker
names improves and these banks remain absent with bids in the unsecured interbank
market. On the negative side, however, we believe the surge in risk aversion and the
noticeably higher money market spreads in the US and the UK have left Euribor spreads
at levels below fair value and therefore harbour the risk of a re-widening in spreads.
14
15. Ahead of the curve 5 March 2009
Upside risks for 12m Euribor-EONIA from mounting credit risks and UK and US spreads
[bp]
350
350
300
300
250
250
200
200
150 150
100 100
50 50
0 0
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Jan-08 May-08 Aug-08 Nov-08 Mar-09
1y cds EUR GBP USD
Source: Bloomberg, Dresdner Kleinwort Research
We have analysed the driving forces of money market spreads before and acknowledge
the changing nature of the underlying relationships as the crisis evolves. While this is
making it difficult to model the spreads, formalizing the analysis can still be useful in
determining where we stand.
Formalizing our approach… Broadly speaking, Libor-OIS spreads are subject to two main driving forces: a credit
influence (reluctance to lend out of fear of default) and a liquidity component (reluctance
to lend for term out of concern of a liquidity shortage). We have run a multivariable
regression analysis of the 12m Euribor-EONIA spread using different proxies for credit
and liquidity risk as exogenous factors. One component of credit risk was directly
captured by using the average 1Y CDS of financial institutions as an exogenous variable.
A Dax-volatility index was used to capture risk overspills from other markets (i.e.
equities). The standard deviation of contribution rates reported by the EUR-Libor panel
banks was included as a proxy for liquidity risk, capturing segmentation in the unsecured
interbank market as well as overall uncertainty of where actual Libor rates should be. To
capture the effect of the turn of the year as already described above we have also
included a dummy variable (=0 prior to 2009, =1 from 1- Jan-2009 on).
Regression estimate suggests 12m Euribor-EONIA spread is too low
300
250
200
150
100
50
0
-50
-100
Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09
1y euribor-eonia Est residual
Source: Dresdner Kleinwort Research
15
