Global Correlations

Global Rates Focus
Rates Strategy | Global

14 August 2009
Rate hikes: not so soon

Riccardo Barbieri +44 20 7996 5897
Economist/Strategist
MLPF&S (UK)
Global rates overview riccardo_barbieri@ml.com
The market is pricing in significant rate hikes by the leading central banks in 2010. Global Rates Strategy Team
This is partly a consequence of QE programs that are too large and rigid to be MLPF&S (UK)
rapidly unwound without hiking rates. However, the market is also probably under- Michael Cloherty +1 646 855 8846
estimating how long it will take for the economy and the banking system to heal. Rates Strategist
MLPF&S
US strategy michael_cloherty@ml.com
As Fed winds down its Treasury buyback program we expect it to concentrate its Shogo Fujita +81 3 6225 6684
purchases in on-the-run and olds in its target 2yr to 10yr sector. US rates Fixed Income Strategist
derivatives: With credit markets continuing to improve and less long duration Merrill Lynch (Japan)
swap demand from pension funds, we see less pressure keeping back-end shogo_fujita@ml.com
spreads disinverted. US Futures: Sep/Dec calendar spreads should continue to Bin Gao +81 3 6225 6247
be driven largely by level of rates and shape of curve. Decisions whether to be Fixed Income Strategist
long or short should not be made solely based on richness/cheapness. US TIPS: Merrill Lynch (Japan)
Treasury will gradually increase issuance in FY2010 and possibly replace 20-yr bin_gao@ml.com
with 30-yr TIPS auctions (which we believe will occur). Front end of TIPS curve is Joseph B. Shatz +1 646 855 7281
still cheap, but take some profits on longs given downward risks to CPI from Government/FF&O Strategist
CARS program. US agencies: We believe Congress will need to start actively MLPF&S
joseph_shatz@ml.com
discussing the future of GSEs this fall. We do not expect them to complete this
process before year end, but a stream of headlines may create some volatility in Alan Stewart +44 20 7996 7236
agency spreads. Fixed Income Strategist
MLPF&S (UK)
European rates & derivatives strategy alan_stewart@ml.com
Rates strategy: We keep a neutral to moderately constructive bias on the long- Antonio Villarroya +44 20 7995 8952
end of the euro curve, keeping an eye on USTs and global equities, while Fixed Income Strategist
continuing to look for relative value opportunities, especially those benefiting from antonio_villarroya@ml.com
a low-rates-for-long scenario. Euro front-end: We think the recent sell-off in ER See Team Page for Full List of Contributors
Reds was too extreme even acknowledging its directionality. Receive Z10 vs Z9
and Z1 (or 2s vs 1s and 3s), outright or PCA-weighted. Euro bonds: peripheral
tightening seen as overdone. UK into Euro via 10y Payers: In a sell-off we see
GBP 10y rates underperforming euro rates. We weight the trade using Walk vol
for a better entry level. Global FX & Debt Investor Survey: Investors reduce
their duration exposure. UK Rates: We like money market flatteners and long
10y10y gilt rates as we believe that free float restrictions in the QE program will
favour the 20y
Pac-Rim derivatives
JGBs: JGB2s10s flattener with 10y above 1.4% attractive for mega-banks.
10s20s will likely stay steep but worth scaling in if spread goes above 75bp. Yen
volatility: Current market favours higher swap rates. We think there are better
alternatives than long tenor high strike payers. Consider selling high strike payers
to finance belly short positions to capture values in volatility or curve flattening in a
selloff. AUD rates: Despite recent selloff, we still like receiving 2y fwd 1y. Even if
the RBA hikes, not many believe they will go beyond 5.5%. Thus, 2y fwd1y above
6% is a comfortable position to enjoy the rolldown. Mark-to-market risk is high
though.
Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Refer to important disclosures on page 44 to 46. Analyst Certification on Page 43. 10862818
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1 4 Au gus t 20 09
Global rates - summary of our views

Global Rates Strategy Team
Table 1: Summary of Our Views on G-4 Rates markets: Direction, curve, vol, swap spreads, IL break-evens, etc
US Direction Rationale
Treasuries are right in the middle of their 3.25%-4% range. Although they may remain in this range for quite some time, we believe that in the long run
10yr Yields higher these yields will break range to the upside.
2s/10s Curve steeper The front-end of the curve is pricing in a Fed hike much too early; 2s should continue to rally to reflect a Fed on hold.
10yr Spreads neutral to wider We continue to expect spreads to remain directional particularly with the 30y current coupon around 4.60%, but are biased towards wider spreads.
2s/10s Spread curve neutral to steeper 2y spreads seem to have little impetus to break range and we expect the spread curve to follow the direction of 10y spreads.
Gamma will likely continue to follow skew. With gamma of short tails at recent highs, a seasonal rally in rates should have them outpace longer tails on
Gamma lower a decline.
Vega lower Following the recent rally on the back of rising rates and hedging demand a slight pull back seems to us probable.
10-year Agency
spreads to swaps neutral Spreads continue to remain volatile.
These BE's have widened a lot over the last month and could give back some of the widening in the near term, but we remain positive on longer maturity TIPS BE's
10yr TIPS breakevens Wider for longer horizon investors.
Euro
Front end Stable - Lower (Roll The ECB is done (at least for the time being). Therefore a sizeable rally is unlikely. Yet we think the increasing rates priced in by the forwards are unlikely to be
down trades) fulfilled
10-year swap rate stable - Lower Economic data is coming better than expected but uncertainty about the extent of the recovery should keep rates range bound
2s/10s swap curve Stable /Flatter With short-term rates unlikely to fall much from current levels, the long end will likely remain the main curve driver, flattening the curve in rallies and steepning in
sell-offs
10s/30s swap curve Stable /Flatter A moderately flatter 2-10 slope and volatile equity markets should keep the long-end well bid
10-year ASW Stable / Tighter Supply fears should keep swap spreads relatively tight in most of the curve, although in some areas the movement has already been substantial.
Swap spread curve Stable- Disinverting We think front-end BOR-OIS are unlikely to tighten much from current levels.
Gamma Slightly lower Low rates for long should continue to put downward pressure on the Upper Left Corner despite the high delivered vol. Although rich, avoid shorting
very long-dated gamma. Most Vols look slightly rich at current levels.
Vega Stable The trend is for vols to trend slightly lower.
UK
Front end Slightly lower With rates already ay 0.5%, scope for rally is limited, though short sterling curve remains too steep
10-year swap rate Lower 10-yr gilts should still rally, aided by qme, but deteriorating credit quality can lead to 10-yr swaps giving best return
2s/10s swap curve Flatter Temporary steepening as supply changes absorbed, but more QME and RSIs looking stretched on all steepener trades already. Medium-term flattening the trade
now
10s/30s swap curve Steeper Temporary flattening as supply changes absorbed, though QME buying limits 10s sell-off. As last week, we suggest those in 10s move longer to 20 years outright or
versus 30s
10-year ASW Stable/Narrower 10-yr Gilts underperformed swaps, but with a backdrop of Moodys threatening downgrades, could move further.
Swap spread curve Steeper Wider spreads at 10s due to rebound on buybacks & LDI
10y IL Break-even Stable - Lower After a strong rise and consensus already looking for higher break-evens, we think the bad news is priced in
Japan Direction Rationale
Front end Higher The front-end rally has reached a point. Turn of fiscal and calendar year.
JGB 10-year Yield Marginally higher July increase in supply should be taken down well by the market, but the risk cannot be ignored.
JGB 2y10y spread Steeper We think 2y will still do well due to its low volatility, Increased supply creating uncertainty in 10y and futures sector. 10y20y also likely to get flatter
ASW Mod- flatter 7yr ASW cheap relative to 5y ASW. Strong 20y JGB auction bodes well for its out performance over swap with USD/JPY stabilizing.
2s/10s swap curve Marginally steeper Risk of widening in funding cost may keep the front-end from rallying with belly to 10yr.
10s/30s swap curve Neutral Strong yen has flattened the super-long end of the curve, but the momentum is weakening.
Gamma Stable/lower Short tail gamma vol stable on expected BoJ inaction. USD/JPY in range should help to stabilize the back-end, lower the gamma vol on long-tails.
Vega Lower Rising skew creating opportunity to sell high strike payers, adding pressure for the skew to move back down.
Linker real yield Higher Profit taking and bearish view on JGBs.
Australia Direction Rationale

Front end Lower Market nearly priced out RBA cuts while we think cuts are still in the cards
ACGB 10y yield Lower Weak economic number to prevail over short term yield rise in sympathy of the UST
ACGB 3y10y Steeper Curve has flattened quite a lot, partly due to squeeze on front-end positions. Front-end pricing in too many hikes due to correct.
Swap spread Wider Sub-20bp 3y EFP too low to justify credit risk, and is risky if mortgage borrowers turn fix rate from floating rate.
* Please note that those marked in bold are changes from last weeks GRF summary views (30-07-09)
Source: Banc of America Securities - Merrill Lynch
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Riccardo Barbieri +44 20 7996 5897 Global strategy overview

Rate hikes: not so soon
The money market is pricing in In recent months, as signs of improvement in economic conditions slowly
significant rate hikes by the leading emerged, the money markets started to price in significant rate hikes by the
central banks in 2010. This is partly a leading central banks. At some stage in early June, Fed Funds futures contracts
consequence of QE programs that are too discounted a rate hike by the US Federal Reserve as early as Q4 of this year.
large and rigid to be rapidly unwound Even as we write, the market is pricing in approximately 160bp of rate hikes by
without hiking rates. However, the the Fed and the ECB and 230bp by the Bank of England.
market is also probably under-estimating
how long it will take for the economy and At face value, market pricing seems at odds with the current stance of monetary
the banking system to heal. policy around the world and particularly in the advanced economies. Indeed, the
Fed and other leading central banks are still engaging in quantitative easing (QE),
i.e. buying government bonds and asset-backed securities outright – i.e. ‘printing
Table 2: Central banks: What is priced in?
money.’ Thus, we think it would be very surprising if they raised rates while they
Current Dec-09 Jun-10 Dec-10
Fed 0-0.25% 0.26% 1.00% 1.93%
were still buying bonds outright, or if they rapidly reversed course after easing
ECB 1.00% 0.98% 1.41% 1.97% policy to an unprecedented extent – though the precedent of the Bank of Japan
BoE 0.50% 0.43% 1.16% 2.25% does suggest that securities purchases may well continue while the central bank
As of 13 August, 2009. mops up some of the excess liquidity in a repeat of ‘operation twist.’
Source: Banc of America Securities-Merrill Lynch Rates Strategy
Based on OIS curves.
Why, then is the market pricing in rate hikes? We can see two possible
explanations: the first is that particularly during market sell-offs, the bond market,
which is under pressure due to also to large supply, ultimately pulls the short end
higher. In other words, the front end sells off ‘in sympathy’ with the long end,
though we feel very few investors actually believe that the Fed or the ECB will
actually tighten policy in the next six to twelve months.
Table 3: Fed balance sheet: Assets The second reason has to do with QE. The Fed and the BoE in particular are
(US$ billion) Aug-09 Apr-09 buying an unprecedented amount of securities and, partly as a result of that, on
Gold 11.0 11.0 the liability side of their balance sheet, excess reserves of the banking system
SDRs 2.2 2.2 have grown sharply. The Fed and the BoE have suggested that as and when
Coin 1.9 1.9
credit extension picks up and they decide to mop up some of the excess liquidity,
Treasury bills 18.4 18.4 they may do so by raising the rate they pay on bank reserves and/or sell some of
Treasury nominal notes and bonds 636.9 485.1 the securities in their portfolios. Raising the rate on banks’ excess reserves would
Treasury inflation linked notes & in all likelihood entail a rise in interbank rates such as the effective Fed funds.
bonds 44.6 41.0
Inflation adjustment 5.4 4.6 The reasoning is thus as follows: central banks are ‘printing’ a lot of money. If at
Agency securities 108.1 68.2
some stage they concluded that they printed too much, and as a result unwound
Mortgage-backed securities 542.9 366.2
some of the ‘unconventional measures,’ they may also have to hike rates in the
Repurchase agreements 0.0 0.0 process. This point requires some further elaboration, as one would in principle
Term auction credit 233.6 403.6 expect central banks to first reverse the unconventional policy measures and then
Other loans 105.7 101.5 hike rates. This is in fact the line that both the Fed and the ECB took a few
months ago as they announced QE measures.
Net holdings of CP Funding facility 61.2 181.8
Net holdings of Maiden Lane, I, II,
III 62.4 72.3 However, as the debate on ‘exit strategies’ intensified and the markets became
more nervous about inflation risks on the back of improving economic data,
Central banks liquidity swaps 76.3 249.5 central banks refined their message, and the Fed in the Monetary Report to
Congress on July 21 mentioned explicitly the option of mopping up excess
Other 81.1 61.0
liquidity via a mix of Treasury Bill issuance, reverse repos, and hiking the rate on
Total 1991.7 2068.1 banks’ reserves.
Source: Federal Reserve
The message of the leading central banks concerning unconventional policies
and QE can thus be summarised as follows: we are still in the process of boosting
banks’ reserves by buying Treasury securities, MBS and covered bonds (in the
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case of the ECB). Given that we expect economic conditions to remain weak and
we anticipate that we’ll have to support the banking system for a prolonged period
of time, our game plan is to complete our QE programs and then stay on hold for
Table 4: Fed balance sheet: Liabilities an extended period of time. If, as we expect, financial conditions improve slowly,
(US$ billion) Aug-09 Apr-09 then our balance sheet will naturally shrink as banks seek reduced support via
Notes 872.2 863.1 our various liquidity provision facilities and as some of the bonds we bought
Reserve repurchase agreements 66.8 67.3 outright mature. (The Fed’s portfolio will decline by just under $100bn in 2010 due
Deposits to redemptions). If, on the other hand, the economy improves more rapidly than
Depository institutions 724.7 812.9
expected, then we’ll mop up the liquidity by hiking rates.
US Treasury, general account 61.5 62.8
US Treasury, supplementary 199.9 199.9
financing account Based on this revised framework for QE and for exit strategies, the reason why
Other 16.2 15.2 the markets are pricing in rate hikes already in 2010 must thus be that they are
Capital 50.4 46.9 more optimistic about the economic outlook than the central banks and/or that the
Total 1991.7 2068.1 current QE programs are too rigid.
On the first point, it is evident from the latest ECB forecasts and from the BoE
August Inflation Report (and the decision to extend the QE program) that central
banks do not share the market’s enthusiasm about economic prospects – or that
they simply cannot afford to take any chances with the economy, as we have
repeatedly argued.
Table 5: Fed's SOMA holdings by maturity ($bn)
2009 2010 2011 2012 2013 2014 The second point requires some additional explanation. We have long argued
T-bills 8.4 - - - - - that the Fed’s securities purchase programs, which if fully implemented would
Notes and bonds 38.0 66.9 55.4 97.9 51.0 44.7
amount to $1.75trillion, would take up most of the asset side of the Fed’s balance
Inflation-indexed - 5.5 4.0 5.8 1.3 1.1
securities* sheet – especially if conditions in the money market improve and the liquidity
Agencies 0.8 23.1 24.1 11.7 13.6 11.9 provision facilities decline in size, as has been the case in the past two months.
Total 47.1 95.6 83.5 115.4 65.9 57.6 (The Fed’s balance sheet has declined by about 10% since May.)
SOMA: System Open Market Account
As of 13 Aug, 2009. *Par value. On its part, the ECB’s approach is based on committing to unlimited long-term
funding at a fixed rate of 1%. Indeed, the ECB provided €442billion of financing
on the one-year maturity in June, and has announced two additional auctions in
September and December. While the ECB said that it may charge a margin over
the policy rate, we do not expect the ECB to do so in September, and even
Table 6: BoE balance sheet (£bn) December may not be the right time to implicitly signal a prospective rise in policy
Aug-09 Jan-09 rates. What this means is that Euro area banks would be able to fund at a 1%
Short-term open market operation 30.1 -
rate for the best part of 2010 for unlimited amounts.
Long term sterling reverse repo 61.0 189.9
Advances to HM Government 0.4 19.9
Bonds other securities acquired via If the economy surprised to the upside in the coming quarters, the ECB may have
market transactions 13.0 11.8 to mop some of the liquidity provided to banks through long-term operations by
Other assets 142.2 36.2 hiking the depo rate and conducting reverse repo operations. In all likelihood, this
Total assets 246.6 257.8 would entail a rise in interbank rates compared to current levels.
Notes in circulation 46.8 45.0
Recapping what we have been arguing thus far, the main reason why the money
Reserve balances 163.9 53.4
Short-term open market operation - 101.3 markets are pricing in significant rate hikes over the next twelve to eighteen
Foreign currency public securities months is that with the economic data improving, the market is beginning to think
issued 3.6 5.6 that too much liquidity is being injected into the system and that central banks will
Cash ratio deposits 2.5 2.4 have to reverse course quite soon.
Other liabilities 29.9 50.1
Total liabilities 246.6 257.8 But why would central banks need to reverse course? What should we be
Source: BoE
watching in order to predict the turning point in monetary policy? Here it seems to
us that central banks need to refine their policy framework and their
communication to the market. The common approach is to stick to inflation
targeting. But, if one looks at the inflation projections of the Fed, ECB and BoE,
however, one does not detect a risk of protracted deflation that is so severe to
warrant the extreme forms of monetary easing that were put in place over the
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past ten months. Clearly, the banking crisis and the attendant surge in
government borrowing requirements were the key factors. Consequently, in order
Table 7: ECB refinancing by maturity to predict future central banks policy moves, we have to take a view not only on
(€bn) 1W 1M 3M 6M 12M Total the business cycle and inflation, but also on the outlook for the banking sector.
12-Aug-09 74 31 74 107 442 727
Source: ECB, Banc of America Securities-Merrill Lynch Research We have been in the optimistic camp for some time, having taken the view that
the advanced economies would bottom out in the second half of the year and that
banks’ profitability would be supported by strong trading revenues, which would
cushion the impact of sharply rising loan loss provisions. However, we believe
Chart 1: BoE CPI inflation projections that we are nowhere near the point where central banks can safely conclude that
normality has been restored to the banking system. While liquidity has surged,
credit extension keeps contracting. If lending to the real economy did not recover,
central banks could decide to cut the rate they pay on banks’ excess reserves.
And even if they didn’t, we believe that the evidence pointing to a pickup in credit
extension would have to be quite compelling to induce central banks to tighten
monetary policy.
Moving to economic fundamentals, the latest data releases brought encouraging

news with respect to the business cycle, with Germany and France posting
positive growth in Q2, one quarter ahead of our expectations. The pace of
deterioration in the US labour market slowed considerably in July, and the ISM
Based on market interest rate expectations and £175bn asset purchase.
manufacturing production index was above the 50 threshold for the second month
Source: BoE in a row. However, as BoE Governor Mervyn King argued, we should not lose
sight of levels: we are still at extremely depressed activity levels, and recoveries
from balance-sheet recessions are normally slow. In fact, the BoE decided to
increase the QE program and to keep it running for three more months (i.e. the
end of October or early November, about the same time when the Fed will
complete its own Treasury securities purchase program).
Table 8: ECB staff macroeconomic projections Inflation risks appear moderate. We believe central banks must maintain their
for the Euro area credibility and will thus put growing emphasis on exit strategies and keeping
(%) 2009 2010 inflation under control. But the only potential inflation risks on a two-year view
GDP growth -5.1 to -4.1 -1.0 to 0.4 come from food and energy prices, and even OPEC is now voicing concern on
HICP inflation 0.1 to 0.5 0.6 to 1.4
underlying weakness in demand for oil and gas. The key goal of central banks
Source: ECB
remains to prevent a deepening of the recession or a relapse following an initial
bounce-back.
The bottom line is that we remain positive on the front end of the market. Indeed,
even on an optimistic view of the business cycle, the rate hikes currently priced
into the front end of European and US money market curves look excessive. Our
team’s current forecast is that the Fed will be on hold till Q3 2011, i.e. for the next
Table 9: Fed's economic projections (central twenty four months, while the ECB and the BoE would commence a tightening
tendency)
process in mid-2010, though hiking rates by less than what is currently priced into
(%) 2009 2010 2011 the curve.
GDP growth -1.5 to -1.0 2.1 to 2.3 3.8 to 4.6
Unemployment rate 9.8 to 10.1 9.5 to 9.8 8.4 to 8.8
PCE inflation 1.0 to 1.4 1.2 to 1.8 1.1 to 2.0 Over the coming weeks, we will be further analysing the monetary policy outlook,
Core PCE inflation 1.3 to 1.6 1.0 to 1.5 0.9 to 1.7 and regional views may change somewhat as a result of that. From a global
Source: Federal Reserve's Monetary Report to the Congress, July 2009 perspective, we believe it is unlikely that the leading central banks will be hiking
rates for the next twelve months, and we have a hard time seeing the ECB
tightening policy before the Fed, though we would not rule out the introduction of
a small margin over the refi rate at the December one-year auction. A surprise by
the BoE is always possible, but we see the risks to our BoE Base Rate forecast
as being stacked on the downside.
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Antonio Villarroya +44 20 7995 8952 Global FX & Debt Investor Survey
Alan Stewart +44 20 7996 7236
Investors reduce their duration exposure
Duration survey
Duration exposure was cut globally last month. Investors are now
underweight duration exposure in USTs, JGBs and UK gilts
Chart 2: US, Euro and Japan duration exposure UST exposure was cut 6 points to an underweight 47 mainly due to
80
US and European based investors, both of who cut their exposure by 8
70
points
60
Euro govt exposure was cut 5 points to 56. Europe remains the only
50
40
developed region where exposure is significantly above neutral
30
20
Currency survey
US Japan Euro (Dm Block)
10
US$ positions were increased 2 points to a still underweight 46 (50 is
0
neutral). This was mainly due to European and UK based investors.
Jan-00 May-01 Sep-02 Feb-04 Jun-05 Nov-06 Mar-08 Aug-09 Dec-10 Japanese based investors actually cut their US$ exposure by 17 points to
a heavily underweight 36. Euro exposure was cut 4 points to 45 just
Source: Banc of America Securities – Merrill Lynch
below the 2-year average of 47
Other points of interest

Investors now believe bonds are overvalued and that bond yields will
increase over the next year. They are positioned accordingly.
Chart 3: Consensus neutral Fed Funds rate A net 5% now believe global bond markets are overvalued (last month a
net 6% thought they were undervalued) and a net 32% expect to see
30%
August higher global 10-year rates in a year’s time
25%
July
20%
A net 73% expect corporate/ high yield bonds to outperform governments
15%
10%
over the next year (was 39% in July, 57% in June)
5%
0%
Table 10: Market Moves from Last Survey and Latest Survey Results
% .5 % .0 % .5 % . 0 % . 5 % . 0 % . 5 % . 0 % . 5 % . 0 % CURRENCY POSITIONS
0 .0 0 1 1 2 2 3 3 4 4 5
Net Exposure Index $* ¥ €
£† C$ A$ Scandi EM
Source: Banc of America Securities – Merrill Lynch Net Exposure Index (12-Aug-09) 46 48 45
51 47 54 58 60
Net Exposure Index (08-Jul-09) 44 47 49
54 52 55 55 55
* % move versus $ -
-4.0% 2.7%
-0.5% 7.8% 7.7% - -
DURATION POSITIONS
Net Exposure Index U.S. Euroland Japan U.K. Canada Australia Scandi EM
Net Exposure Index (12-Aug-09) 47 56 44 46 51 49 51 55
Net Exposure Index (08-Jul-09) 53 61 45 46 55 54 53 55
Change in 10yr yields (bps) 39 18 11 17 26 26 - -
† % move versus euro for sterling. A reading of 50 means Neutral. See the Note on page 4 for regional investor breakdowns.
Sources for the following charts and tables: ML Global Investor Survey.
Scandi: The Scandi question asks investors about overall Scandinavian positions. EM: Emerging markets
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Michael Cloherty +1 646 855 8846 US market strategy

Treasury purchase wind down
With the Fed extending the Treasury purchase program until the end of October,
they now have 11 weeks to buy $47bn of securities. As they gradually taper off
their purchases, one question will be whether they end the purchases out of their
2yr to 10yr target sector earlier (to avoid extremely small out-of-target operations)
or whether they scale back all purchases on the same percentage basis. Our
preliminary guess would be that the out-of-target purchases cease in the second
half of September, with the last few weeks of the program all being in the 2yr to
10yr bucket.
Tapering the purchases makes it more likely that the Fed will continue to focus on
on-the-runs and olds. The big risk of a jarring end to the program was that the
market had become accustomed to concentrated purchases in on-the-runs and
olds, and secondary market liquidity in recently auctioned issues had become
somewhat reliant on Fed demand. There were two ways to wean the market from
Fed purchases: slowly shift purchases into the off-the-runs to allow for a gentler
transition in the on-the-runs/olds, or gradually wind down the sizes of each
purchase. Since the Fed chose the gradually smaller sizes option, on-the-runs
and olds should continue to be the primary beneficiaries of Fed demand, and
have represented 70% of purchases in recent buybacks.
In addition, with the Fed’s announcement to taper off its Treasury purchase
program, one logical conclusion is that they will likely do the same for their other
two programs, Agency debt and MBS. The $300bn of Treasury purchases have
been a relatively small percentage of total issuance, while the MBS purchases
have been taking down the bulk of gross production—Treasuries have been 20%
gross issuance over the past six months, while the MBS purchases are likely to
be more than 60% of gross production. So the shock to ending the MBS
purchase program is far more problematic.
At the very least, the MBS program is likely to be extended to the February 1 end
date for the short-duration asset programs (the Currency Swaps, etc). And more
likely, the purchases are likely to gradually run down throughout Q1. The
expected deceleration in the pace of mortgage production should make it easier
to lighten up on Q4 purchases in order to allow for some in Q1.
Chart 4: International reserve assets excluding While the Fed is winding down their Treasury purchases, we note that foreign
gold inflows are likely to remain strong. After falling throughout the crisis, foreign
reserve assets excluding gold have been soaring. Net, that change in the mix is
7,200,000
positive for longer duration assets—there is less inflation fear, and a similar
7,000,000
duration takedown. Accordingly, we think some of this week’s aggressive rally
6,800,000
will be reversed, but that the larger range will continue to hold.
Millions
6,600,000
6,400,000
6,200,000
6,000,000
Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09
Source: Bloomberg
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Jonathan Rick +1 646 855 8845 US rates derivatives

Has it really been 2 years?
Chart 5: 1YÆ1Y and 1YÆ10Y Implied Vol With the 30y current coupon back above 4.60% (our mortgage strategists’ view
180 that as the point of maximum negative convexity for the mortgage universe) we
170
160
saw the expected rally in atm volatility as we moved along skew towards higher
150 rates and slightly outpaced it as hedging demand rose. However, unlike the spike
140
130
we saw in early June, the rally in vol has come from far greater two-way flow as
120 improvement in markets has increased risk taking. Moreover, with glimmers of
110
light from the end of the tunnel, the market has began to become concerned with
100
90 an exit strategy which has bid up the upper left corner (ULC) to recent highs while
80
3/19/2009 4/2/2009 4/16/2009 4/30/2009 5/14/2009 5/28/2009 6/11/2009 6/25/2009 7/9/2009 7/23/2009 8/6/2009
gamma of longer tails remain within their recent range. We continue to be of the
1Y-> 1Y 1Y -> 10Y
opinion that the Fed will need to first reduce its balance sheet before it can hike
Source: Banc of America Securities – Merrill Lynch and that once it starts hiking it will be aggressive, which pushes out our
expectations for the first hike by the FOMC. Given our bias, we like conditional
bear steepeners from both a rate and vol perspective.
Chart 6: 3m LIBOR/OIS is at its lowest levels of In July 2007, 3m LIBOR/OIS basis began to widen from hovering around 8bps for
the Credit Crunch a long period of time. On August 9th of that year the spread gapped from 13bps
to about 40bps on its way to a peak value of 364bps in October of 2008. Now a
400
350 little over two years after the Credit Crunch began we are back into the mid 20s
300
250
and slowly grinding lower. We do not claim that we are through the looking glass,
200 but we have began to seen significant signs that credit concerns are beginning to
150
100
ease as the CDX 5y IG on-the-run index is now approaching 100bps. It appears
50
that credit markets have normalized although at new levels that seem to better
0
8/1/2007 11/1/2007 2/1/2008 5/1/2008 8/1/2008
3mLIBOR/OIS
11/1/2008 2/1/2009 5/1/2009 8/1/2009
reflect the inherent risk that remains in the market.
Source: Bloomberg
With balance sheet concerns abating on improved credit, one would expect the
back-end pressure that has pushed 30y swap spreads into negative territory to
ease. With the long bond back above 4.50% and within its pre-2008 range, the
attractiveness of the yield pick up of an essentially risk-free asset as opposed to a
“risky” swap should correct the dislocation. The major reason why 30yr swap
spreads were inverted was that investors didn’t want to spend their cash on a
Treasury, since they saw other extremely attractive investment opportunities.
Now that the IG has collapsed and stocks are 40+% off the lows, the “there are
better opportunities” reason to receive 30s rather than buying a 30yr bond has
disappeared.
We can see the market beginning to gravitate in this direction as the correlation
between credit and long dated spreads improved noticeably starting in the end of
April as early reports of the results of the Supervisory Capital Assessment
Program (SCAP) indicated that most banks would raise enough capital to avoid
the federal government having an equity stake in the firms. Since April 27th,
correlation between the IG index and 30y spreads has an R^2 of 58%, while from
the start of 2009 to the end of April the R^2 of the relationship is close to 0% (if
you don’t roll the index and only consider series 11, the value improves to around
10%).
8
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1 4 Au gus t 20 09
Chart 7: 30y spreads and CDX NA 5y IG index

0 100
-5 110
-10 120
-15 130
-20 140
-25 150
-30 160
-35 170
-40 180
-45 190
4/27/2009 5/11/2009 5/25/2009 6/8/2009 6/22/2009 7/6/2009 7/20/2009 8/3/2009
30y spreads CDX NA 5y IG (RHS Inv erted)
Source: Bloomberg and Banc of America Securities – Merrill Lynch
Cross Reference Another consideration for back-end spreads is the natural demand from pension
Pensions & Endowments monthly, 4 August 2009 funds. As market conditions improve, our Pensions & Endowments Research
Analyst, John Haugh, expects their will be a divergence of flows from the pension
community. Severely underfunded plans will need to continue to spend their cash
on risk assets, since buying long cash bonds would simply lock in their
underfunded status—they will continue to take their duration in swaps and hope
for a massive risk asset rally to eliminate the underfunding. However, plans that
are not as severely underfunded are likely to take some chips off the table,
lightening on risk assets and taking their duration in cash bonds. This means
pension flows should be less of a hindrance to back-end spread disinversion.
Moreover as rates drift higher, the arbitrage condition given the current
environment should increase demand for back-end spreads. We like spread
locks and forward steepeners, particularly in conditional space.
With the belly of the curve at relative cheaps, we would recommend trades such
as 6m Æ 5s30s bear steepeners, curve neutral with respect to the underlying,
with strikes at atmf+25 (3.76% on 5y tail) and atmf+15 (4.67% on 30y tail) as the
trade is costless and expires in the money if 5y rates are above 3.76% as long as
the spread is above 91bps. The trade rolls well as 3m Æ 5s30s has a spread of
113bps and spot spread is 134bps. With the Fed on hold and inflation remaining
subdued into 2010, as we move forward through time the belly of the curve
should continue to roll down a steep curve. Meanwhile, with the aforementioned
consideration and concerns of the auction process in the back-end, especially as
the Fed ends its buyback program, should place growing upward pressure on
back-end rates. From a volatility perspective, 6m Æ 5s30s vol spread is at its
tights of the year and some pull back seems likely given the aforementioned
growing risk in back-end and increased paying pressure, while the Fed on hold
should help short to mid-term yields move lower bringing vol along the skew. The
major risk of this trade seems to be an inflationary scare which would drive mid-
term rates higher but would have a muted effect in the back end as markets
anticipate that the Fed will react to quell long-term concerns.
9
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1 4 Au gus t 20 09
Joseph Shatz +1 646 855 7281 US rates futures

Stanley Sun +1 646 855 9420
Steepening/flattening drives
calendar spreads
We prefer to be long the September/December 2009 30-yr Treasury bond
(USU9/USZ9) and 10-yr Treasury note (TYU9/TYZ9) futures calendar spreads.
Despite its richness, we also prefer to be long the 5-yr (FVU9/FVZ9) Treasury
note futures calendar spread due to our higher rates and steeper curve views.
We prefer to be short the 2-yr (TUU9/TUZ9) Treasury note futures calendar
spread.
The September/December 2009 Treasury bond and note calendar spreads have
been and should continue to be driven largely by a combination of the level of
rates and shape of the curve. The forward yield spread between the respective
cheapest-to-deliver (CTD) Treasuries of the near (i.e. Sep) and deferred (i.e. Dec)
contracts is a key driver of the calendar spreads. There is a different CTD into
every September contract than into the respective December contract for all of
the Treasury bond and note futures contracts (2’s, 5’s, 10’s and 30’s). Since a
longer maturity security is CTD into the Dec contract than each respective Sep
contract, the calendar spread should generally tend to widen when the Treasury
yield curve steepens and narrow when it flattens.
The Sep/Dec calendar spreads should all (to varying degrees) exhibit some
market directionality, generally tending to widen in selloffs and narrow in rallies.
One reason for this is that the basis point value (BPV) of the December contract
is higher than that of the September contract for each respective calendar spread,
using a constant repo assumption (i.e. repo remains unchanged even as yields
rise/fall). This assumption could be well justified under most scenarios given that
the Fed is likely to be on hold for the rest of the year.
In addition, calendar spreads should also tend to widen in selloffs and narrow in
rallies due to the likelihood that the curve will steepen in a selloff and flatten in a
rally in the current environment. With the Fed likely on hold for an extended
period, the front end of the curve should be less volatile, and the longer end of the
yield curve should continue to lead. A steepening should cause the calendar
spreads to widen (all else equal) and a flattening should cause them to narrow.
The USU9/USZ9 and TYU9/TYZ9 calendar spreads are both slightly cheap, in
our view, primarily due to the slight richness of the December contracts. In
contrast, the FVU9/FVZ9 and TUU9/TUZ9 calendar spreads are slightly rich,
primarily due to the cheapness of the December contracts. The market appears
to be undervaluing the embedded switch option in the USZ9 and TYZ9 contracts,
while it is overvaluing it in the FVZ9 and TUZ9 contracts.
Although some of the calendar spreads are trading rich or cheap to theoretical fair
value, we do not believe that decisions whether to be long or short these calendar
spreads should be made solely based on this richness/cheapness. Given
balance sheet constraints in the current environment, futures contracts can
deviate quite substantially from theoretical fair value and their
richness/cheapness can be quite volatile. Investors’ rate and curve views are
very important for calendar spread roll decisions.
10
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1 4 Au gus t 20 09
Buy USU9/USZ9; Slightly Cheap and Should

Chart 8: US Rich/(Cheap) vs. Cycle Widen Slightly in Bear Steepener
12 40
Given that the calendar spread is only slightly cheap and that the USZ9 contract
10 USU9 35
USH9 (RHS) 30
is unlikely to converge to fair value before expiry of the USU9 contract (see
8
Rich/(Cheap) in 32nds
25 margin Charts), we would not buy this calendar spread based purely on its
6 USZ9
4
20 cheapness. But we would still slightly prefer to be long the calendar due to our
15
2
view that rates are headed higher and the curve steeper.
10
USU9/USZ9 is Cheap to Fair Value; Embedded Switch Option in USZ9 is

0
5
(2)
Being Undervalued by Market
USM9 (RHS) 0
(4) (5)
(75) (50) (25) 0 25 50 75 100 The USU9/USZ9 calendar spread is slightly cheap to fair value, in our view,
Days to Lead Contract
(assumes roll on First Intention Day)
primarily due to the slight richness of the December contract. The market
Source: Bank of America – Merrill Lynch appears to be undervaluing the embedded switch option in USZ9. The net basis
of the 7.625% 2/15/25 (the USZ9 CTD), representing the market’s valuation of the
Chart 9: US Roll Rich/(Cheap) vs. Cycle embedded “switch” options of the futures contract, is only trading at about 3/32
0 10 currently. Yet, according to our model, the embedded switch option in the Dec
(1) Buy USU9 / Sell USZ9
5 contract is worth more than this.
(2)
0
Rich/(Cheap) in 32nds
Buy USM9 / Sell USU9

(3)
A long net basis position versus USZ9 is similar to owning a deep out-of-the-
(4) (5)
money (OTM) put option on bonds in the 15 to 30-yr sector. If interest rates in
(5) (10)
(6)
this sector rise substantially, the CTD should switch to a longer duration security
(15)
(7) Buy USH9 / Sell USM9 (RHS)
(assuming all else equal). For example, using a constant repo assumption, a
(8)
Buy USZ8 / Sell USH9 (RHS)
(20)
parallel increase in yields of all Treasuries in the deliverable basket of
(9)
(46) (40) (34) (28) (24) (18) (12) (6) 0 4 11
(25) approximately 90 bps would cause a switch in the CTD for USZ9 from the current
Days to First Intent CTD, the 7.625% 2/15/25, into the 6.625% 2/15/27, a much longer duration
Source: Bank of America – Merrill Lynch security.
Forward Yield Spread between Different CTD’s Has Been More Important
Chart 10: USU9/USZ9 vs. 30-Yr Yields
Driver than Level of Yields for USU9/USZ9 Calendar
43 4.7
The Sep/Dec T-Bond calendar spread (USU9/USZ9) should be very market
4.6
Calendar Spread (32nds)
42
directional from a theoretical perspective based on the respective basis point
4.5
41 value (BPV) of the Sep and Dec contracts. Yet, the calendar spread has not
Yields (%)
4.4
40 behaved entirely in this fashion (see margin Chart). The constant repo BPV of
4.3
39 USZ9 is considerably higher than that of USU9 according to our model. But this
4.2
38 is primarily due to the way our futures model calculates the BPV of Treasury bond
4.1
37
USU9/USZ9 Price Spread and note futures contracts. The BPV of the contract is essentially a probability-
30-Yr Yield (rhs)
4.0
weighted average of the “forward BPV divided by conversion factor” of each
36 3.9
6/22/09 7/1/09 7/10/09 7/19/09 7/28/09 8/6/09 security in the basket that has a chance of being CTD. Since our model is
Source: Bank of America – Merrill Lynch
currently indicating that there is a much more significant chance of a considerably
longer maturity security becoming CTD into USZ9 than into USU9, the probability
Chart 11: USU9/USZ9 vs. Feb’25 – Nov’24 weighted BPV that our model calculates is substantially higher for USZ9 than
Forward Yield Spread USU9. If the futures contract BPV was instead calculated solely based on the
CTD (i.e. assume 100% chance that the current CTD will be the CTD at expiry),
43 11.0
then the BPV of USZ9 would barely be higher than that of USU9, even under a
CTD Fwd Yld Spread (bps)
42 10.5 constant repo assumption (and under a parallel repo assumption it would actually
41
10.0 be lower). The market appears to be trading USU9/USZ9 more to this simplistic
40 100% CTD assumption.
9.5
39
38
9.0 The primary driver of the widening in USU9/USZ9 has largely been the change in
37 USU9/USZ9 Price Spread 8.5 the forward yield spread between the respective Sep and Dec contract CTD’s.
US CTD Fwd Yld Spread (rhs) The 7.625% 2/15/25 (USZ9 CTD) yield has risen relative to the yield of the 7.5%
36 8.0
6/22/09 7/1/09 7/10/09 7/19/09 7/28/09 8/6/09 11/15/24 (USU9 CTD), causing the Dec contract to cheapen relative to the Sep
contract and thus the calendar spread to widen (see margin Chart).
11
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1 4 Au gus t 20 09
Buy TYU9/TYZ9; Slightly Cheap and Should

Widen in Bear Steepening
Chart 12: TYU9/TYZ9 vs. 10-Yr Yields Given the slight cheapness of TYU9/TYZ9 in combination with our view that that
50 4.2 longer maturity yields will continue to rise and that the curve will continue to
TYU9/TYZ9 Price Spread
49 4.1 steepen, we expect the calendar spread to continue to widen.
10-Yr Yield (rhs)

4
48
3.9
TYU9/TYZ9 is Cheap to Fair Value; Embedded Switch Option in TYZ9 is
Yields (%)
47 3.8
46 3.7 Very Valuable
45 3.6 The Sep/Dec 10-yr T-Note calendar spread (TYU9/TYZ9) is slightly cheap, in our
3.5 view, primarily due to the slight richness of TYZ9. The embedded switch option in
44
3.4
43 3.3
the December contract does have substantial value. The 4.875% 8/15/16 is
42 3.2 currently CTD into TYZ9, but there are many other securities in the basket that
6/22/09 7/1/09 7/10/09 7/19/09 7/28/09 8/6/09 could become CTD due to either a general rise in the level of yields, a steepening
Source: Bank of America – Merrill Lynch of the yield curve, or just a richening/cheapening of the CTD versus other issues.
Even with the CTD net basis trading at about 7/32’s (close of 8/12/09), the market
is still undervaluing the embedded switch option, in our opinion.
TYU9/TYZ9 Widens in Steepening Selloffs; Narrows in Flattening Rallies

Chart 13: TYU9/TYZ9 vs. Aug’16 – May’16 TYU9/TYZ9 should generally tend to widen in selloffs and narrow in rallies (see
Forward Yield Spread margin Chart). This market directionality is in part due to the higher BPV of TYZ9
50 22 relative to TYU9 under a constant repo assumption. TYU9/TYZ9 has been and
should continue to be driven by the forward yield spread between the near
49
21
48 contract and deferred contract cheapest-to-deliver (CTD), widening (narrowing)
20
47 when the forward yield of the 5.125% 5/15/16 (TYU9 CTD) decreases (increases)
46 19 relative to that of the 4.875% 8/15/16 (TYZ9 CTD) (see margin Chart). Thus,
45
18
TYU9/TYZ9 should tend to widen when the yield curve steepens and narrow
44 when it flattens. These forces of the level of rates and the shape of the curve
TYU9/TYZ9 Price Spread 17
43
TY CTD Fwd Yld Spread (RHS)
should tend to work in unison; since the Fed is likely to be on hold for at least the
42 16 next few months, an increase in yields will likely be accompanied by a steepening
6/22/09 7/1/09 7/10/09 7/19/09 7/28/09 8/6/09
of the 2/10-yr curve and a decrease in yields by a flattening. In a bear steepening
of the yield curve led by an increase in longer maturity yields, the value of the
embedded switch option in TYZ9 would increase rapidly and at a faster pace than
that of TYU9, and there would likely be a switch in the TYZ9 CTD; this would
likely cause the calendar spread to widen.
Buy FVU9/FVZ9; Slightly Rich, But Rate and

Curve View is More Important
Chart 14: FVU9/FVZ9 vs. 5-Yr Yields Despite the richness of FVU9/FVZ9, we believe that a decision whether to be
47 2.9 long or short FVU9/FVZ9 should be made primarily based on an investor’s rate
46 and curve view. We are biased for a higher yield and steeper curve environment
2.8
45
2.7
over the next month. Given this view, we still prefer to be long FVU9/FVZ9,
44
despite the slight richness of the calendar spread. But investors who disagree
Yields (%)
43 2.6
42 with our rate/curve view may find FVU9/FVZ9 an attractive short given its
41 2.5
richness.
40 2.4
39 FVU9/FVZ9 Price Spread
38 5-Yr Yield (rhs) 2.3 FVU9/FVZ9 is Slightly Rich to Fair Value
37 2.2 The Sep/Dec 5-yr T-Note calendar spread (FVU9/FVZ9) is trading slightly rich to
7/15/09 7/22/09 7/29/09 8/5/09 8/12/09 fair value, in our view, due to the cheapness of FVZ9. The market is overvaluing
Source: Bank of America – Merrill Lynch the embedded switch option in the deferred Dec contract. The chance of a switch
in the CTD for either contract is extremely unlikely, and the embedded switch
option has minimal value, in our view. Yields on securities in the 5-yr sector are
just so low that the shortest duration security is extremely likely to remain CTD
12
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1 4 Au gus t 20 09
even in a large selloff or steepening. Thus, the current net basis of almost 3/32’s
for the FVZ9 CTD is too high, and the FVU9/FVZ9 calendar spread is slightly rich.
FVU9/FVZ9 Widens in Steepening Selloffs; Narrows in Flattening Rallies

Chart 15: FVU9/FVZ9 vs. Feb’14 – Nov’13 FVU9/FVZ9 should generally tend to widen in selloffs and narrow in rallies (see
Forward Yield Spread margin Chart). This market directionality is due to the higher basis point value
47 30 (BPV) of the deferred (i.e. Dec) contract relative to the near (i.e. Sep) contract
46 under a “constant repo” assumption. Even more importantly, FVU9/FVZ9 has

29
45
28
been and should continue to be driven by the forward yield spread between the
44
43 near contract and deferred contract cheapest-to-deliver (CTD), widening
27
42 (narrowing) when the forward yield of the 2% 11/30/13 (FVU9 CTD) decreases
41 26
(increases) relative to that of the 1.875% 2/28/14 (FVZ9 CTD) (see margin Chart).
40 25
39
Thus, FVU9/FVZ9 should tend to widen when the yield curve steepens and
FVU9/FVZ9 Price Spread 24
38 FV CTD Fwd Yld Spread (rhs)
narrow when it flattens. These forces of the level of rates and the shape of the
37 23 curve should tend to work in unison; since the Fed is likely to be on hold for at
7/15/09 7/22/09 7/29/09 8/5/09 8/12/09
least the next few months, an increase in yields will likely be accompanied by a
steepening of the 2/5-yr curve and a decrease in yields by a flattening.
Sell TUU9/TUZ9; Rich and Front End Yield Rise

is Overdone
Chart 16: TUU9/TUZ9 vs. 2-Yr Yields We prefer to be short this calendar spread. TUU9/TUZ9 appears to be rich to its
24 1.4 theoretical fair value. In addition, although we believe that yields further out the
23 curve are likely to rise further, we believe that the recent rise in yields in the front
1.3
22 end of the curve is slightly overdone given that the Fed is unlikely to be raising
1.2
rates for quite some time. A rally in 2-yr yields could cause the calendar spread
Yields (%)
21
20 1.1 to narrow. Investor positioning (i.e. extremely high long speculator position) also
19
1.0
could contribute to driving the calendar spread narrower.
18
17
TUU9/TUZ9 Price Spread 0.9 TUU9/TUZ9 is Rich to Fair Value
2-Yr Yield (rhs)
16 0.8 Similar to FVU9/FVZ9, the 2-yr (TUU9/TUZ9) Treasury note futures calendar
7/20/09 7/25/09 7/30/09 8/4/09 8/9/09 spread appears to be slightly rich to its theoretical fair value due to the cheapness
Source: Bank of America – Merrill Lynch of TUZ9, but it is really difficult to determine since the Dec contract is still
extremely illiquid at this point in the cycle. The market is overvaluing the
embedded switch option in the deferred Dec contract. The chance of a switch in
the CTD for either contract is extremely unlikely, and the embedded switch option
Chart 17: TUU9/TUZ9 vs. Sep’11 – Jun’11 has minimal to no value, in our view. Yields on securities in the 2-yr sector are at
Forward Yield Spread such incredibly low levels that the shortest duration security is extremely likely to
24 37 remain CTD in almost any scenario. Thus, the current net basis of about 4/32’s
35
23 for the TUZ9 CTD is way too high, and the TUU9/TUZ9 calendar spread is rich.
33
22
31 Theoretically, the calendar spread should just trade at approximately the spread
21 29 between the forward price/conversion factor of the TUU9 CTD minus the forward
20 27 price/conversion factor of the TUZ9 CTD.
19 25
23
18 TUU9/TUZ9 Price Spread 21
TUU9/TUZ9 Widens in Steepening Selloffs; Narrows in Flattening Rallies
17 TU CTD Fwd Yld Spread (rhs)
19 TUU9/TUZ9 should be very market directional, widening in selloffs and narrowing
16 17 in rallies, due to the much higher basis point value (BPV) of the Sep contract
7/20/09 7/25/09 7/30/09 8/4/09 8/9/09
relative to the June contract under a constant repo assumption (see margin
Chart). TUU9/TUZ9 also has been and should continue to be highly correlated
with the forward yield spread between the near contract and deferred contract
cheapest-to-deliver (CTD), widening (narrowing) when the forward yield of the
5.125% 6/30/11 (TUU9 CTD) decreases (increases) relative to that of the 4.5%
9/30/11 (TUZ9 CTD) (Chart 12). Thus, similar to the 5-yr calendar spread, a
13
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1 4 Au gus t 20 09
steepening of the yield curve should cause TUU9/TUZ9 to widen, while a

flattening curve should cause it to narrow. Once again, since the Fed is likely to
be on hold for at least the next few months, an increase in yields will likely be
accompanied by a steepening of the curve and a decrease in yields by a
flattening.
Net Long Speculator Position Could Put Downward Pressure on

TUU9/TUZ9
Chart 18: CFTC Non-Commercial Net Long Although it is still very early in the cycle, the 2-year Sep/Dec roll at only 1.07%
Position on 2-Yr Treasury Note Futures (as % of rolled so far is behind schedule from the previous cycle (3.89%) and even slightly
open interest) below the average over the last four cycles (1.67%). Non-commercial (i.e.
30% speculator) long positions have steadily been building up in the 2-yr contracts into
20% the heaviest speculator long position (as a % of open interest) in the last few
years (see margin Chart). There could be downward pressure on the
10%
TUU9/TUZ9 calendar spread as these speculators roll their long positions into
0% TUZ9 (i.e. sell TUU9 and buy TUZ9).
-10%
-20%
-30%
1/6/05 9/6/05 5/6/06 1/6/07 9/6/07 5/6/08 1/6/09
14
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1 4 Au gus t 20 09
Joseph Shatz +1 646 855 7281 US inflation linked securities (TIPS)

Stanley Sun +1 646 855 9420
TIPS Issuance to Increase and 30-yr TIPS Likely to
Replace 20-Yr TIPS
As anticipated, the Treasury announced at the August quarterly refunding that
they will be expanding the TIPS program both by gradually increasing the amount
of issuance in FY2010 and possibly by replacing the 20-yr TIPS auctions with 30-
yr TIPS auctions. According to Treasury, potential changes to the TIPS program
(such as replacing 20-yr TIPS with 30-yr TIPS) will be announced at the
November 2009 refunding.
Increasing TIPS Issuance and Replacing 20-yr TIPS with 30-

yr TIPS
Figure 1: TIPS 3.375% 4/15/32 yields vs. TIPS The 3.375% 4/15/32 TIPS cheapened substantially relative to the 2.5% 1/15/29
2.5% 1/15/29 yields TIPS leading up to the refunding announcement (and cheapened slightly further
2.40 after) as the market correctly anticipated that the Treasury is considering
2.35 replacing 20-yr TIPS with 30-yr TIPS (Figure 1). From a supply/demand
2.30 perspective, increasing the overall supply of TIPS should put some initial upward
2.25 pressure on real yields, as was just the case in the 30-yr sector as the market
2.20 anticipated the re-introduction of 30-yr TIPS. But by Treasury re-affirming its
2.15 commitment to the TIPS program and increasing the amount of issuance, TIPS
2.10 liquidity should generally increase; this is a positive for the overall TIPS market.
TIPS 2.5 1/29
2.05 TIPS 3.375 4/32
2.00 Both increasing the amount of TIPS issuance and bringing back 30-yr TIPS
7/1/09 7/9/09 7/17/09 7/25/09 8/2/09 8/10/09
makes sense in our view (see J. Shatz, “Aug 2009 refunding preview; TIPS
program could be expanded”, Global Rates Focus, 7/30/09). Increasing the
annual amount of TIPS issuance can help fund the continued substantial deficits.
TIPS auction sizes have remained basically unchanged since 2007, while
nominal Treasury issuance has increased dramatically. Since August 2008, TIPS
have been declining as a percentage of the total marketable Treasury debt
outstanding. Increasing TIPS issuance could help lower the borrowing cost to
Treasury of issuing nominal Treasuries both by lowering the supply of nominal
Treasuries and by providing credibility to a low inflation policy. By issuing TIPS,
Treasury is able to issue less nominal Treasuries than would be necessary
otherwise. This helps lower the average cost of nominal issuance, especially in
the current environment of high deficits with large funding needs. TIPS issuance
appeals to a somewhat different investor base than nominal Treasuries. The
issuance of TIPS by Treasury also helps provide credibility to a Fed policy of
keeping inflation low, thereby lowering their cost of borrowing in the nominal
Treasury market. The market would likely assume that if the Treasury is willing to
increase issuance of an inflation-linked liability, the government must be relatively
confident that they can maintain low inflation. This helps lower the inflation
expectations and inflationary risk premium components embedded in nominal
Treasuries, thus lowering Treasury’s cost of borrowing.
We believe that Treasury will decide to replace the 20-yr TIPS with 30-yr TIPS.
30-yr TIPS were last auctioned in 2001. Both 30-yr nominal Treasuries and 30-yr
TIPS were then eliminated from the auction schedule. When the Treasury
decided to bring back a longer maturity TIPS issue in 2004, 30-yr nominal bond
issuance had not yet been resumed. As we discussed in our preview of the
Treasury refunding, bringing back 30-yr TIPS makes sense now that there is a
30-yr nominal bond to compare/trade on a breakeven basis against it. Also, if 20-
yr TIPS were to continue to be issued, starting with the 1/15/32 maturity 20-yr
15
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1 4 Au gus t 20 09
TIPS that would be issued in January 2012, there would no longer be a similar
maturity nominal Treasury to match the new 20-yr TIPS against; this would be the
case for a few years since Treasury did not issue 30-yr nominal bonds from 2002
through 2005. In addition, switching to 30-yr TIPS also makes sense because
there should be more demand for 30-yr TIPS from accounts such as pension
funds and insurance companies than there is for 20-yr TIPS.
Front End of TIPS Curve Still Cheap But Very Risky

The front end of the TIPS curve is still cheap in our view, although it is not as
cheap as it was when we first recommended long 4.25% 1/15/10 and 0.875%
4/15/10 TIPS trades in the Global Rates Focus on 7/30/09. As an example, using
our latest economists’ total CPI NSA (CPURNSA) projections out to the
November CPI print and a repo rate of approx. 30 bp, a leveraged purchase of
the 4.25% 1/15/10 TIPS could earn a profit of approx. $0.95 per $100 notional
(inflation adjusted notional is much higher, about $214.57 for 8/13/09 settle) at
expiry based on all the cash flows in this scenario. For the investor to lose money
on this trade, total CPI NSA would have to be considerably lower on the whole
than our economist projections. Our economists are currently projecting an
October print of 216.454 and a November print of 216.284 (which is a little higher
than the initial projections from two weeks ago). Similarly, the 0.875% 4/15/10
TIPS are still attractive, but not quite as attractive as two weeks ago.
Although these trades have performed very well since initiated two weeks ago,
they are increasingly risky. One major risk to this trade is that the “cash-for-
clunkers” (CARS) rebate program could put downward pressure on some CPI
prints in the near term (for a discussion, see D. Matus, G. Bigg, N. Dutta, L.
Helwing, “CARS: Disinflation risk?”, 8/10/09 and the US Economics section by
Lori Helwing in this publication). Another risk is if a substantial energy price
decline were to occur, it could drag down total CPI well beyond economist
projections. Given the risks, it may be prudent to take some profits here.
Extremely Positive TIPS Carry Coming to an End Soon

TIPS carry is extremely positive, and much higher than on similar maturity
nominal Treasuries, for the rest of August on the back of the extremely strong
June total CPI print. TIPS carry may be barely positive in September, but it should
not be higher than the carry on similar maturity nominals during that month. The
carry on TIPS is likely to be relatively low during September because we expect a
relatively weak July total CPI NSA print. Core CPI should be relatively weak, and
total CPI is likely to be even slightly weaker. Gasoline pump prices were down on
average during July versus during June. For the rest of the CPI prints in the 2009
calendar year (August through December CPI prints), seasonal factors will work
against TIPS carry (Oct ’09 through Feb ’10 carry, due to the lagged nature of
TIPS inflation accretion).
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Table 11: Forward breakeven calculator for TIPS vs nominals from 08/14/09 out to 09/01/09
Fwd - spot Fwd - spot Spot Forward B/E
Cpn/mat Yield Fwd yld Yld chg (bp) Cpn/mat Yield Fwd yld Yld chg (bp) B/E B/E protection
4.25% 1/15/10 0.039% 1.369% 132.98 2.125% 1/31/10 0.195% 0.200% 0.49 0.156% -1.169% 132.49
0.875% 4/15/10 0.180% 0.986% 80.66 4% 4/15/10 0.282% 0.292% 1.04 0.102% -0.694% 79.61
3.5% 1/15/11 0.414% 0.794% 37.94 4.25% 1/15/11 0.798% 0.821% 2.36 0.383% 0.027% 35.59
2.375% 4/15/11 0.592% 0.920% 32.78 4.875% 4/30/11 1.003% 1.029% 2.61 0.411% 0.109% 30.17
3.375% 1/15/12 0.897% 1.131% 23.36 4.875% 2/15/12 1.413% 1.439% 2.64 0.515% 0.308% 20.71
2% 4/15/12 0.979% 1.191% 21.17 4.5% 4/30/12 1.552% 1.579% 2.73 0.573% 0.389% 18.44
3% 7/15/12 1.041% 1.237% 19.63 4.375% 8/15/12 1.690% 1.718% 2.79 0.650% 0.481% 16.85
0.625% 4/15/13 0.987% 1.138% 15.10 3.125% 4/30/13 2.070% 2.097% 2.77 1.083% 0.960% 12.33
1.875% 7/15/13 1.408% 1.558% 14.99 4.25% 8/15/13 2.181% 2.208% 2.71 0.773% 0.650% 12.28
2% 1/15/14 1.543% 1.678% 13.53 4% 2/15/14 2.416% 2.443% 2.70 0.873% 0.765% 10.83
1.25% 4/15/14 1.273% 1.397% 12.37 1.875% 4/30/14 2.569% 2.596% 2.67 1.296% 1.199% 9.70
2% 7/15/14 1.618% 1.741% 12.29 4.25% 8/15/14 2.624% 2.651% 2.69 1.005% 0.909% 9.60
1.625% 1/15/15 1.777% 1.889% 11.27 4% 2/15/15 2.830% 2.857% 2.66 1.053% 0.967% 8.60
1.875% 7/15/15 1.735% 1.839% 10.38 4.25% 8/15/15 2.988% 3.014% 2.62 1.252% 1.175% 7.76
2% 1/15/16 1.815% 1.912% 9.71 4.5% 2/15/16 3.138% 3.164% 2.59 1.324% 1.252% 7.12
2.5% 7/15/16 1.818% 1.910% 9.17 4.875% 8/15/16 3.268% 3.294% 2.62 1.450% 1.385% 6.55
2.375% 1/15/17 1.813% 1.898% 8.56 4.625% 2/15/17 3.399% 3.423% 2.50 1.586% 1.525% 6.07
2.625% 7/15/17 1.791% 1.872% 8.11 4.75% 8/15/17 3.492% 3.516% 2.44 1.701% 1.644% 5.67
1.625% 1/15/18 1.790% 1.864% 7.41 3.5% 2/15/18 3.592% 3.615% 2.31 1.802% 1.751% 5.10
1.375% 7/15/18 1.788% 1.858% 6.95 4% 8/15/18 3.661% 3.684% 2.28 1.873% 1.826% 4.68
2.125% 1/15/19 1.793% 1.861% 6.87 2.75% 2/15/19 3.689% 3.710% 2.10 1.896% 1.849% 4.77
1.875% 7/15/19 1.796% 1.861% 6.49 3.125% 5/15/19 3.694% 3.715% 2.16 1.898% 1.854% 4.33
2.375% 1/15/25 2.300% 2.347% 4.69 7.625% 2/15/25 4.330% 4.350% 2.01 2.031% 2.004% 2.68
2% 1/15/26 2.285% 2.328% 4.35 6% 2/15/26 4.398% 4.417% 1.87 2.114% 2.089% 2.48
2.375% 1/15/27 2.285% 2.327% 4.24 6.625% 2/15/27 4.410% 4.429% 1.84 2.126% 2.102% 2.39
1.75% 1/15/28 2.285% 2.323% 3.88 6.125% 11/15/27 4.426% 4.444% 1.79 2.142% 2.121% 2.09
3.625% 4/15/28 2.354% 2.398% 4.36 6.125% 11/15/27 4.426% 4.444% 1.79 2.072% 2.046% 2.57
2.5% 1/15/29 2.274% 2.314% 3.91 5.25% 2/15/29 4.461% 4.478% 1.67 2.187% 2.164% 2.24
3.875% 4/15/29 2.355% 2.397% 4.24 5.25% 2/15/29 4.461% 4.478% 1.67 2.107% 2.081% 2.57
3.375% 4/15/32 2.254% 2.291% 3.68 5.375% 2/15/31 4.480% 4.496% 1.59 2.226% 2.205% 2.09
Source: Banc Of America Securities - Merrill Lynch
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Michael Cloherty +1 646 855 8846 US agencies

Marcus Collier +1 646 855 8849
GSE Outlook
Since Fannie Mae and Freddie Mac’s unlimited credit line with the Treasury
expires on December 31st, Congress will need to start actively discussing the
future of the GSEs this fall. We don’t expect them to complete this process
before year end, suggesting there will be a temporary extension of the credit line,
but a stream of headlines may create some volatility in agency spreads.
We review some of the options, borrowing very heavily from our mortgage and
credit strategists. For more detail, see the August 7th piece “GSEs and the Future
of the Housing Finance System”
http://research1.ml.com/C?q=FDsqIpKpOz1oLbO12wntxA%3d%3d&s=clohmi
It remains very early in the process, so the outcome remains extremely uncertain.
There could be a struggle between the government’s public policy desires and the
rights of Fannie and Freddie’s equity holders, which could drag out the process.
Also, we suspect that the political winds will shift over time as the FHA realizes
substantial losses. The bulk of the Fannie Mae and Freddie Mac’s losses have
been due to the credit guarantee program rather than the portfolio. Over the last
six quarters, Freddie has taken $29.5bn of credit loss provisions that are
attributable to the guarantee book (versus total before tax net income of -$54.8bn
in those quarters) while Fannie has $60.4bn of credit loss provisions that are
attributable to the guarantee book (versus before tax net income of -83.1bn).
This may change the tone of the debate from specifically questioning the GSEs to
questioning whether the benefits of using public policy to support housing are
worth the cost, and may shift the focus away from the GSEs’ retained portfolios.
The large losses in the guaranteed book reduced the GSEs ability to act as the
backstop bid in the MBS market. If the government is going to keep the portfolios
in place (likely, in our view), it makes more sense to separate the guarantee
business from the portfolios.
Nonetheless, there are likely to be four goals to the new structure:
1) reduce risk to the government
2) maintain a standardized and liquid MBS market
3) continue to stabilize the mortgage market in times of stress
4) increase home ownership through affordable housing programs
The current structure proved extremely effective on the third goal, as the agency
market was the only functioning mortgage market through the crisis, but was
weak on the first goal. If the decision was made today, we think the government
would strongly come out in support of strengthening the guarantee business
through explicit government support (the Ginnie Mae model). However, as noted,
the politics may shift as FHA losses grow.
Reducing risk to the government—skin in the game. One of

the common criticisms of the current structure has been that underwriters have
minimal residual exposure to loans that they originated, which reduces the
incentives to maintain strong underwriting standards. We suspect there will be an
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1 4 Au gus t 20 09
attempt to ensure that underwriters keep some skin in the game over a longer
horizon, keeping standards high and reducing the systemic (and governmental)
risk.
Covered bonds. The extreme version of this is the covered bond market, where
banks would keep loans on their balance sheet, but would segregate a collateral
pool that would pay covered bondholders if that bank defaulted. This would mean
no MBS production, and no government risk to MBS.
Unfortunately, the covered bond provides far less separation for the government
than it first appears. Total bank assets are $11.8T. Agency MBS outstanding is
about $5 ¼T. Shifting a large percentage of the loans in agency MBS onto bank
balance sheets would cause massive growth in bank assets, greatly exaggerating
the “too big to fail” issue. The government would reduce its exposure to the MBS
market, but increase its exposure to the banking system.
Partial guarantees. Another solution would be for the government to only

provide a partial backstop to the mortgage loans, with the originator picking up
the residual exposure. The government exposure would need to be large enough
to give the originating banks significant capital relief, or else their capacity to
originate and sell loans would be greatly reduced.
If there was less than a 100% government guarantee on MBS, suddenly investors
would care deeply about which originator was backstopping the loans—pools
backed by different originators could have significantly different prices. And goal
#2, a standardized and liquid MBS market, would suffer. Instead, we could see
the originators being partially on the hook at the loan level, with the government
explicitly providing a full backstop at the bond level.
Skin in the game and hedging flows in rates. Currently, there are two types
of mortgage hedgers in the rates market—portfolios and servicers. If originators
are forced to maintain credit exposure to the loans backing MBS, they have a
liability that disappears when the loan refinances. If rates rise sharply, the value
of their credit exposure rises since their outstanding loans are likely to be around
for longer. This is the inverse of servicers’ exposure to rates. Accordingly, if
originators are forced to maintain some of the credit risk, we should see more
total hedging flows in the rates market from the mortgage community. However,
the price impact on the rate market should be less pronounced because the flows
from two types of hedgers should be partially offsetting (servicers versus
originators).
Portfolio business. The portfolio was unable to act as a shock absorber in

this crisis as large capital losses limited its ability to grow. Instead, the Treasury
and the Fed were forced to provide the backstop bid.
We doubt that the Fed will want to be the backstop bid in the future due to the
long-lasting impact on the Fed balance sheet. Instead, the Fed is likely to
strongly support another entity to be the liquidity provider. This could be the
Treasury, although that would make Treasury financing needs even more cyclical.
Or it could be the GSEs, which seems the more likely outcome.
That said, even if they are chosen to be the backstop bid, the GSE portfolios are
likely to be dramatically smaller. Under the current conservatorship agreement,
the GSE’s portfolios start shrinking by 10% each year in 2011 until they hit
$250bn (roughly in 2020). Unless the GSEs are financed by the Treasury, the
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1 4 Au gus t 20 09
portfolio sizes need to remain large enough so that they remain regular issuers in
the marketplace—for the GSEs to be an effective backstop, they would need to
be able to expand their issuance quickly, which means they need to remain on
investors’ approved lists (infrequent issuers tend to drop off of approved lists).
Nonetheless, shrinking outstandings is likely to reduce liquidity in agency debt, so
they should trade cheap to Treasuries even if their credit quality is comparable.
Good bank/bad bank. In the good bank/bad bank framework, nonperforming

assets are shifted into one entity, with the “good” assets in another entity. For
debtholders, the major risk from good bank/bad bank would be having debt that
was shifted into the bad bank. That debt should have no credit issues, as the
government will be providing a capital backstop. However, the bad bank is
unlikely to issue much new debt, while the good bank will continue issuing. As
the debt ages, the bad bank debt is likely to become less and less liquid, while
the good bank debt maintains some liquidity.
Hedging the retained portfolio. Assuming that the GSEs are fully
backstopped by the government, it is unclear whether the regulators will continue
to demand that the GSEs hedge their interest rate exposure, or whether they will
take the same approach as the Fed and simply use a buy-and-hold approach.
While preserving market stability argues for a more active trading approach which
needs some form of P&L measurement, we assume that GSE hedging flows are
likely to diminish.
However, for the rates market, the question becomes – as we get closer and
closer to the final act – which investor picks up the slack amid which ultimate
outcome as government purchases decline and the dynamics of the mortgage
market shift. Already, there has been a significant shift into hands that are less
active hedgers—the Fed, the Tsy, etc. Holdings by active domestic investors are
likely to fall below $1T by year end, and more than 2/3rds of those holdings are in
index investors’ hands. It seems likely that those active investors are the ones
who pick up the slack from the Fed and the GSEs in 2010, so we think the
hedging flows are unlikely to fade in the medium term horizon.
Table 12: Agency MBS Outstanding

Dec'08 Dec'09
Size of the Agency MBS Market $4.80 T $5.3 T
Federal Reserve + Treasury $0.06 T $1.50 T

Domestic Banks + Savings Inst. $1.02 T $1.10 T
GSEs (Fannie + Freddie) $0.82 T $1.02 T
Overseas Investors $0.75 T $0.70 T
Agency MBS Held by Others $2.15 T $0.98 T
Note: 1) We assume that the Fed will buy $1.25 T Agency MBS in 2009.
2) These projections include seasoned pool issuance by Fannie Mae
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Antonio Villarroya +44 20 7995 8952 European rates strategy

Risk appetite and CBs in the driving seat
Since our last publication, economic data have been noticeably better than
expected which, together with some positive surprises on corporate earnings, has
caused a sizeable increase in risk appetite (see our version in the margin chart).
Chart 19: Risk aversion is finally leaving behind This further improvement in risk perception can be observed in both the credit
the Sep-08 (LEH) levels behind. Currently ‘just’ and equity markets. In the former, helped by the further decline in the degree of
around 9/11 or LTCM levels bank lending tightening, the cost of credit protection against corporate defaults
GSEs / LEH
120
Thai Baht Deflation
scare
/ Stock mkt
collapse
has declined significantly in recent weeks with the 5y € CrossOver Itraxx trading
9/11
below 600bp and the USD CrossOver CDX tightening by 100bp last month.
LTCM /
100 Russia
Subprime
80
Y2K
Investors are becoming more optimistic on equities
LEH
On the equity side, despite the recent pullback, the change in perception can be
Excess
60
Liquidity summarised by the recent bullish notes from our European equity strategy
40
colleagues, who are currently forecasting a 30%+ rally in Euro stocks until the
end of next year, while US colleagues’ expectations about earnings growth in
20
Jan-97 May-98 Sep-99 Feb-01 Jun-02 Nov-03 Mar-05 Aug-06 Dec-07 Apr-09 coming quarters prompt their bullish stance in this market.
Cross-asset correlation remains very high
This increasing optimism is very relevant for rates markets, as the
improvement in the global macro and financial outlook means investors are more
willing to add risk to their portfolios, putting to work cash that had been parked in
safe haven assets. Accordingly, the cross-correlation between most financial
markets remains very high, with equities recently taking over credit as the market
leader – at least, as long as the rates sell-off is not significant enough to
endanger the incipient economic recovery.
This relationship is clear in the table below from our Cross-correlation Tool,
showing how the correlation between rates (EUR and USD 2s and 10s), equities
(SP500 and VIX), credit (HG and EM spreads, Itraxx and CDX) has remained
fairly high since last March (UK and US QE announcements). Interestingly, the
assets that have been less correlated to the rest are the front-ends of the EUR
and USD curves, as official rates are expected to remain relatively stable for quite
some time. It therefore seems that, as long as risk appetite continues to
improve, global rates, especially the 5-10y sector, can remain under
pressure.
Table 13: Cross correlation between assets since March 2009
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Adjusting our rates forecasts to faster growth / earlier hike

Concentrating now on the euro area, the recently released better-than-expected
economic figures have caused our economists to revise higher their growth
projections for the region for the next few quarters, fine-tuning their ECB call.
They now expect the first ECB hike in June 2010, with subsequent 50bp hikes
per quarter in the following few months. We have therefore adjusted our German
bond yield forecasts, although mainly in the front-end.
In this regard, and bearing in mind the above-mentioned correlation and lead-lag
relationship between equity markets and rates, we assessed to what extent our
yield projections are consistent with the equity rally our strategists are forecasting.
Acknowledging the relationship – and elasticity – between both assets is far from
linear and/or stable; as seen in the chart below, the 300 level in the SXXP our
strategists target by end-2010 seems consistent with 10y Bunds yielding
around 3.90-4.00% by the end of next year. This is not, by the way, very far
from where the forwards are currently. See in the back pages our complete set of
yield forecasts.
Chart 20: German 10y Bunds and forwards
Chart 21: 10y Bund yields regressed vs Euro Stocks and forecasts –assuming a linear
compared to Euro ‘core nominal’ GDP and
appreciation of European equities towards our strategists’ Dec-10 forecast for SXXP
MER-BAS forecasts
5
10
YOY GDP + Core CPI 2006-09
10y Bund + Fwds y = 0.0047x + 2.4737
8 Fo r w ar d s
4.5 R2 = 0.5972
L as t m o n th
6
L as t
4
10yBund
2
3.5
0
0
1
2
4
5
6
7
8
9
1
2
4
5
6
7
9
0
y = 0.0042x + 2.4695
-9
-9
-9
-9
-9
-9
-9
-9
-9
-9
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-1
-1
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
ar
M
M
M
M
M
M
M
M
M
M
M
M
M
M
M
-2 3 R2 = 0.3453
-4
2.5
Source: Banc of America Securities - Merrill Lynch 150 200 250 300 350 400
Eu r o Sto xx600
One final point worth highlighting would be the relationship between ‘Nominal’
GDP (real GDP + core CPI annual growth) and 10y Bunds and its forwards –see
margin-, which still seem a bit high even relative to the economic recovery our
economists are pricing in. In addition, we think sub-potential growth will keep
inflation subdued for some time and, although it is obvious that the systemic risk
has been reduced, some concerns and vulnerabilities remain, including further
writedowns and losses by euro banks (still far from the €283bn ECB estimate),
their exposure to Eastern European countries or their dependency on the public
support.
We keep a neutral (to slightly constructive) bias on the long-end of the Euro
curve, keeping a close eye on USTs and global equities for direction, while
we continue looking for relative value opportunities, with some of them
benefiting from a low-rates-for-long scenario.
In recent days two of the trades in our portfolio have expired:

1) Euro 1y-5y Conditional bull flattener. €532k loss
2) US into Euro via 3mPayers (27-April-09). Net profit $5.3mln (our long 10y
Payer expired 40bp ITM while the Euro one was 20bp below the swap rate).
Looking for new entry points.
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Antonio Villarroya +44 20 7995 8952 EUR front-end & ECB operations
ECB long-term funding rises above 60%
In last Tuesday’s 1-week MRO, the ECB awarded €73.4bn (vs €80.8bn expiring)
with a similar reduction in net liquidity in the 1mth LTRO, where €30.7bn was
awarded. The following day, the amount allocated in the three-month LTRO
declined sharply to €13bn from €34bn expiring while banks basically rolled over
Chart 22: Relative weight of the different ECB the €11bn maturing in the 6mth LTRO. The net amount of the money lent by
facilities: Latest vs one year ago and Jan-08 the ECB in these operations therefore declined by €34bn this week.
100%
90%
MROs and 1mth LTROs, from 100% to 20% of the ECB funding
80%
70%
12m
Accordingly, the share of short-term funding from Euro banks vs the ECB
64% 61%
6m
60% continues to decline, while the 6mth and the June 1y LTRO currently add up to
3m
50% more than 60% of all the funding provided by the ECB. This breakdown is
1m
40%
1w
especially relevant when compared to the situation one year ago or to the
30%
beginning of 2008. As seen in the margin chart, the weekly MRO is now just
20%
10%
slightly more than 10% of the funding provided by the ECB, similar to the relative
0% weight of the 3mth, while in the past they were the only sources of funding.
Jan08 13Aug08 12Aug09

The average duration of the ECB liquidity remains near its highs
Another interesting way of looking at this shift is to track the average duration of
the ECB lending to the euro system as, although the 1y LTRO took place 50 days
ago, the net decline in the shorter-term operations (bids < amount expiring) has
Chart 23: Average duration –in days- of the ECB
monetary operation with the Eurosystem banks kept basically stable this duration (around 215 days), is close to its all-time high
250
and more than four times longer than it was before June 08 (see margin chart).
218.1
200 204.6 EONIA could drift slightly higher, yet clearly below refi
As to short-term rates, the usual one-day liquidity drain operation on the last day
150
of the MP (at a 70bp weighted average), together with some possible pre-funding
of the banks’ account holdings with the ECB and the above-mentioned decline in
100
the total amount of liquidity, helped to move EONIA rates higher on Wednesday
54.3
50 (47bp), but they came back one day later to the previous 33bp level.
0 We think that some tightening vs the refi rate is possible in coming

Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09
weeks, but EONIA rates will remain closer to the deposit rate than to the
Source: Banc of America Securities - Merrill Lynch refi as net liquidity remains excessive (the benchmark allocation for this
week’s MRO was -€32bn).
Interestingly, the amounts placed in the deposit facility declined to €124bn on

Chart 24: Euro 3mth BOR-OIS spreads, spot and Wednesday, but the main reason is the above-mentioned pre-funding as banks
forwards + changes have started the MP, placing €267bn in their accounts with the ECB while the
80
EUR
average need is around €215bn.
70 113
60 Sep 1y LTRO: at 1% or with a spread?
50 45 The next relevant source of information for the euro very front-end will be a
40
38 38
decision as to whether the next 1y LTRO (30 Sep) will be at the refi rate (1%, as
30 28 28 28
25 25 in June) or by adding a spread, which could ‘scare’ the market if seen as a
20 tightening of monetary policy, even a very mild one. This, with the new set of Staff
10 Today 13-Jul-09 31-Dec-08 Macro projections, will be the focus of the next ECB meeting on 3 September, but
0 until then, we do not expect massive changes in the very front end of the Euro
Spot Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11
curve or Libor-OIS spreads, which are currently trading around 38bp in ERU9 and
Source: Banc of America Securities - Merrill Lynch Z9 and ~28bp for 2010 ER contracts (see margin chart).
Strategy wise, we remain long the March 2010 ECB meeting (1mth fwd
EONIA) at 1%. Reload if it gets again close to this level.
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Antonio Villarroya +44 20 7995 8952 EUR money market strategies

Receive Dec10 Euribor vs Dec09 & Dec11
This is a summary of the Trade Idea Flash note published on 5 August. We have
updated the levels and charts.
Chart 25: Euribor Dec9-Dec10-Dec11 Fly (2nd-6th-
10th contracts) regressed vs the belly yield
Over the past couple of weeks, helped by the better-than-expected economic
(Dec10) and the wings’ slope (Dec11-Dec9)
data, most Euribor contracts have sold off with ERZ0 yields currently around
2/6/10-Fly v.s . Be lly 2.40% after trading below 2% five weeks ago. Yet with the ECB expected to
100.0
80.0
remain on hold for quite some time, very front-end contracts have barely suffered
Fly (2*ERZ10 -(ERZ09
60.0 – or even rallied - helped by the low levels of OIS rates after the ECB 1y LTRO
+ ERZ11))
40.0 with BOR-OIS spreads tightening further, especially in the shorter expiries.
20.0
0.0 With the Green sector relatively range-bound in recent weeks, the Red pack has
-20.0 performed even worse than it should against its wings according to its usual
-40.0 Be lly (ERZ10) directionality, becoming attractive vs their wings, not only to express a bull
1.92 2.12 2.32 2.52
flattening view, but also hedging this exposure. The margin charts shows how the
2/6/10 - Fly v.s. Slope belly of the Dec9-Dec10-Dec11 trades cheap vs the levels of rates (Dec10) or the
80.0 slope of the money market curve (Dec9-Dec11).
60.0
(ERZ09 + ERZ11))
Fly (2*ERZ10 -
40.0 That said it is also fair to acknowledge that there seems to be a new relationship
20.0
being built between the fly and the level of rates or the slope, with a steeper beta,
0.0
ie, larger reaction in the Reds vs the wings for the same change in rates/slope.
-20.0
Yet even if this new directionality proves to be the prevailing one, this residual
-40.0 Slope (ERZ11 - ERZ09)
163.00 183.00 203.00 223.00 does not seem to be extremely directional -see left chart below- and the belly of
the fly still appears cheap vs the slope of the curve and, very important, this fly
rolls very positively (52bp in the gross fly to Sep9-Sep10-Sep11).
Investors not willing to take a directional view could consider using regression or
Chart 26: EUR PCA-weighted 1-3-5 fly + mean
PCA weights to minimize this exposure. Using the last three months for the
reversion and forwards
regression, the weights would be 22% and 97% for Z9 and Z1. The residual in
this weighted fly is still above 10bp (see bottom margin chart).
‘Shorter-winged’ flies such as H10-Z10-U11, M10-Z10-M11 or those with Sep10

or Mar11 as the belly also show large residuals vs the recent movement in rates.
A similar trade can also be expressed via swaps, as two-year rates seem
too cheap vs 1s and 3s, spot or three months forward, not just in 50:50 terms
but also using PCA weights (approx weights = 28%-77%). See margin chart.
Source: Banc of America Securities - Merrill Lynch In the € front-end we also keep ERZ9 OTM Call ladders and ERH0 and ERM0
Call spreads, outright or vs Puts. Also 3m2y Rcvr Ladders and CS vs Puts.
Chart 27: Residual of the Z9-Z0-Z1 fly (50:50) regressed vs Z0 rates Chart 28: PCA-weighted Dec9-Dec10-Dec11 fly vs Dec10 rates
and Dec10 yield. It has become directional only recently
2/6/10- M R Fly v.s . Be lly
40.0 2/6/10 - Fly v .s. Belly 2.65
- 142.04
30.0 2.55
Residuals
20.0 2.45 - 147.04
10.0 2.35
- 152.04
0.0 2.25
-10.0 2.15 - 157.04
-20.0 2.05
- 162.04
-30.0 1.95
Res iduals v.s . Belly
-40.0 Belly ERZ10 1.85 - 167.04
-50.0 1.75 1.92 2.02 2.12 2.22 2.32 2.42 2.52
3m
07- 27- 16-Jun- 06-Jul- 26-Jul- 15- 04-Sep- B e l l y ( E R Z1 0 )
May-09 May -09 09 09 09 A ug-09 09

24
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1 4 Au gus t 20 09
Antonio Villarroya +44 20 7995 8952 Europe cross-country strategies

UK into Euro, through 6m10y Payers
Given our expectations about a faster recovery in the UK economy vs the euro
area, helped by the evolution of both currencies in past quarters and the
expectation that the BoE will start to hike before the ECB, we think that despite
the BoE gilt purchases over the next three months, GBP 10y rates could
underperform euro rates in the next six months, especially in a bear market.
Accordingly, it could be interesting to structure a UK-into-Euro trade through 6m

payers. The roll-down of the trade is negligible and the volatility aspect could help
the trade.
Currently 6m10y implied volatility is very similar in both areas, trading around 95-
97bpa in both forwards. In fact GBP 6m10y vol is currently trading slightly below
the equivalent Eur vol (2bpa). Yet the GBP fwd is delivering significant more
volatility than the euro forward, with the ratio of both 3mth Walks vols at 1.11x.
Accordingly, if we weight the trade according to delivered (Exponential walk)

volatility rather than implied, we could strike the trade a few bp (4bp approx, 8bp
earlier this week, using mid prices) better than the spot and the forward spread.
As seen in the chart below, based on the recent history of both markets, in a sell-
off, GBP rates should underperform EUR rates and only in a sell-off with the
spread tightening below 52-53bp would the trade lose money at expiry. In fact,
the chart shows how if forward rates remain stable the trade could end up slightly
ITM.
Chart 29: Payout profile of a GBP-EUR trade via 6mPayers, including recent history and
zero-cost curve
80 6m10y Payers Profit

70
60
GBP-EUR Spread
50
no P&L
40 History
30 Latest
20 Loss ATM
10 Zero cost
0
3.25 3.75 4.25 4.75
GBP 10y
Buy £100mln 13-Feb-11 maturity, GBP 10y Payer, k=4.4485% ( = ATMf),

Sell €128.6mln 13-Feb-11 maturity, EUR 10y Payer, k = 3.884% (3.806% =
ATMf), fx rate = 1.161. Zero cost (mids).
Using implied vol or a 1:1 ratio to weight the trade, the EUR strike wld be ~3.85%
25
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1 4 Au gus t 20 09
Sphia Salim +44 20 7996 2227 Euro area bonds

Peripherals – gone too far?
Table 14: Current spreads to Germany and Four consecutive weeks of tightening have brought peripheral spreads to levels
changes versus 25 Sep 2008 levels not seen since the transfer of risk from banks to governments last year (see
5y vs DE chg 10y vs DE chg margin Table). While CDS spreads reached a trough on 3 August, peripherals
France 11 (12) 18 (5) continued to perform well until early this week – with a 3bp widening versus
Finland 12 (8)
Netherlands 12 (6) 24 1
Germany in the 5y sector yesterday. The negative net supply provided, in our
Austria 26 2 37 8 view, the support to high-yielding bonds despite the loss of momentum in the
Ireland 92 59 153 112 CDS market. All countries and sectors were affected, as seen in the Table below.
Belgium 24 (19) 40 (3)
Spain 18 (20) 43 (3) We believe, however, that the reversal observed on Wednesday could be
Portugal 47 5 55 9 more than a one-off and extend further, especially by the end of August.
Italy 43 (9) 62 6
The past tightening indeed appears overdone based on the relationship between
Greece 71 0 107 37
peripherals and equities, volatility and credit, but also considering the still-fragile
fundamentals.
Table 15: Current benchmarks spreads to Germany minus 3m average – 10 to 20bp away
With the exception of the 10y sector, all

countries trade rich to Germany based on
a 3m relationship – most of them with a
z-score lower than -2 (yellow shading in
the right table)

Heatmap shading is according to z-score ie residual /(standard deviation over 3m)
Too far … in light of other asset performances

Over the past two years, peripheral spreads have displayed a strong correlation
to several asset classes including equities, volatility and credit (see bottom left
chart). The higher dependence of peripheral spreads on risk aversion levels has
generated the current strong correlation with equities (over 90% with Eurostoxx)
while the relationship with credit indices has been amplified by the transfer of risk
from the banking system to governments (higher correlation and higher beta, see
next page’s margin chart).
Chart 30: 2y correlation - Peripheral spreads highly correlated not only Chart 31: Residuals - the regressions imply in general tighter
to credit indices but also to equities and volatility (2y period) peripherals (green) mainly in light of equity levels and volatility
Source: Banc of America Securities – Merrill Lynch Source: Banc of America Securities – Merrill Lynch – the residuals for peripherals are in %
The return of risk appetite translated into higher equity prices, lower volatility and
tighter credit spreads; however these performances in most cases do not
currently justify such low peripheral yields (see upper right chart) and even
optimistic scenarios do not imply much more tightening.
26
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1 4 Au gus t 20 09
Upside based on credit markets but limited by asset allocation changes

Chart 32: 1st PCA component of euro area 5y Currently, peripheral spreads are cheap/fairly priced versus credit indices (see
ASWs versus 5y Itraxx Main
margin chart showing bond ASWs trading in line with the relationship vs Itraxx
y = 2.4298x - 181.46
400 From Jun07 to Oct08
since 15 Sep
since 20 Jan
R2 = 0.8702 established in mid-January). Yet in a scenario of a continuous increase in risk
300 last
appetite, we would see a move in asset allocations to higher yielding and
ASW : 1st PCA component
y = 3.1561x - 530.67
200
R2 = 0.585
therefore riskier assets; favouring A-rated corporate bonds or even HY bonds
100
0
(see chart below). We could therefore observe additional tightening of European
-100
0 50
y = 0.062x - 138.5
100 150 200 250
credit indices with little impact on peripherals.
R2 = 0.0081
-200
Chart 33: Risk-return: higher risk appetite could favour A-rated corporate bonds or HY
-300 itrax main
bonds
Source: Banc of America Securities – Merrill Lynch R eturn-Volatility R elationship (Jan-09 - Aug-09)
80%
HY (3.3)
70%
60%
Average Weekly Return (annualised)

Chart 34: 10y BTP-DBR vs a measure of 50%
volatility in the swap market 40%
30%
20% A (4.1)
IT 7-10yr (7.1) IT 10yr+ (12.4)

10% AAA (4.2)
Bills IT 1-3yr (1.8)
0%
0% 5% 10% 15% 20% 25% 30%
-10%
-20%
An n u alise d Vo latility o f re tu rn s
Overdone according to volatility

The regressions between peripheral spreads and rates volatility as well as FX
volatility imply that 10y peripheral spreads (with the exception of Ireland) should
Source: Banc of America Securities – Merrill Lynch (*) SMOVEU3M index , be trading 5bp to 15bp wider in the 10y sector (see residual matrix on the
previous page). Taking as an example the 10y Italian spread vs Germany, it
appears that the recent increase in rates volatility has not translated (yet) into
Chart 35: 10y GGB-DBR versus ‘minus’ wider peripheral spreads - see middle margin chart, red highlight. In addition,
Eurostoxx. Limited tightening even in an equity historically the reaction in the peripheral market appears to have lagged that in
rally the volatility market (blue lines) on several occasions. Such a lag transposed
today would imply a 10bp widening of BTP-DE in coming weeks.
Overdone according to equities even in a bullish equity scenario
Further peripheral tightening appears limited even in a scenario of a strong equity
rally. Based on the long-term relationship between peripheral spreads and the
Eurostoxx, we find that since February the beta between equities and peripherals
has more than doubled, the equity rally driving spreads tighter at a faster pace.
Yet, following the longer term non linear relationship (blue trend line in bottom
margin chart), elasticity for peripherals spreads should be much lower in case of
any further rally in the equity market. The tightening limit should therefore stand
not far from current levels, as seen in the expected trend (red dotted).
27
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1 4 Au gus t 20 09
Too far … considering the fundamentals

The outperformance of peripherals and the new higher beta observed versus
other asset classes cannot be explained by fundamentals. The factors that drove
a massive widening from Oct 08 to Feb 09, ie, the increase in debt/GDP levels,
the financing of banks’ recapitalisation and the rating downgrades, were not
Table 16: Budget deficit / GDP. BAS-ML eliminated and could even trigger new worries in the near future. Governments
estimates for 2009 and 2010 are expected to start discussing 2010 budgets in the coming weeks and,
2008 2009 (f) 2010(f) according to our economists, not only are deficits unlikely to shrink in 2010, but
Germany -0.1 -5.0 -7.0 they could even widen, for instance in the case of Italy (see margin table). With
France -3.4 -8.0 -7.5
Spain -3.8 -10.2 -8.8
net supply coming back positive in September, any news on increased 2010
Italy -2.7 -5.5 -6 borrowing should raise both volatility and spread levels in the peripheral world.
Source: Banc of America Securities – Merrill Lynch. 2009 and 2010 numbers
are BAS-ML economists’ forecasts as of 6 Aug 09. Too far … and can be exploited
To profit from the potential widening of peripherals, we like to focus on countries
which are: 1) displaying a negative residual according to the regressions above,
2) lagging behind in their 2009 borrowing programmes, and 3) expected to see a
Chart 36: 5y ES-FR in CDS (orange) and par widening of their budget deficits in 2010.
rates (blue). The rate differential close to 2008
lows while CDS implies rising risk in Spain. Two weeks ago as we called for a peripheral widening by mid- to end-August, at
100
the end of a negative net supply period, we discussed selling Spanish bonds
80
ES 5 CDS vs FR ES 5 par rate vs FR
versus French or Finnish ones, in light of their respective borrowing programmes
60 and their advancement. We continue to like this trade, in particular in the 5y
40
sector (see margin chart). We proposed buying the Irish CDS-bond basis which
was correlated to risk aversion levels and close to its all-time low, the trade
20
performed well (5y basis increasing 30bp since then) and we like to close the
0 trade at current levels. We also found that Belgium in the CDS market was
8
9
8
9
7
8
7
8
8
9
7
trading too rich on principal component analysis versus other European govies.
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
un
un
eb
eb
ct
ct
ec
ec
pr
pr
ug
ug
ug
-O
-O
-20
-A
-A
-J
-J
-F
-F
-D
-D
-A
-A
-A
01
01
01
01
01
01
01
01
01
01
01
01
01
This still remains the case and we like buying 5y protection on Belgium
(potentially versus Germany).
28
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1 4 Au gus t 20 09
Alan Stewart +44 20 7996 7236 UK rates strategy

Inflation Report shows inflation still below target
Chart 37: CPI inflation projection based on
The Bank of England published the August edition of its quarterly Inflation Report
market interest rate expectations and £175bn
asset purchases on Wednesday. The report was slightly on the dovish side and continued to show
inflation below the 2% target in two years time, assuming market implied interest
rates (see upper margin chart). It did, however, show expected inflation on target
in the scenario of a constant 0.5% base rate. Both scenarios took into account the
impact of the £175bn gilt purchases - £50bn of which was unexpectedly
announced last week.
The short sterling money market curve looks too steep

As well as providing some explanation for the extension of the program, the
report suggests that if the other assumptions behind the analysis remain
unchanged (eg, oil prices, etc), then either the money market curve should flatten
or the bank may extend gilt purchases further. We think the market will move to
moderate the implied rate increases next year and look for the money market
Source: Bank of England curve to flatten. The Dec9Dec0 curve is currently 209bp (see margin chart)
The new purchases have been equally split by sector

The new gilt purchases have been evenly split between the three new buckets
Chart 38: L Z9Z0 money market curve is now and the current weekly rate is £4.2bn or £1.4bn in each sector. More than
over 200bp £126.4bn of the £129.2bn total gilts purchased so far have been in the 5-25 year
2.5 bucket. This has significantly reduced the free float to trade in the sector, which is
now only £71bn from a total outstanding amount of £159bn (see chart on
2
following page). In addition, the bank has made it clear that it will not purchase
1.5
bonds with a free float below 30% and on this basis Sep14, Mar20, Jun21 and
1 Mar22 have already been excluded.
0.5
The 10-25 sector has lower free float
0
16-Feb 7-A pr 27-May 16-Jul 4-Sep Taking the 30% free float restriction into account, the size of potentially
purchasable bonds in the 10-25 year sector is only £23bn, which compares with
£112bn and £64bn in the 3-10 year and 25 year+ buckets, respectively (see chart
on following page). So if the Bank of England continues the £50bn purchase split
evenly between the three buckets (ie £16.7bn apiece), they will be buying 14%,
Chart 39: Forward gilt rates and QE 70% and 26% of the available (taking into account the 30% limit) bonds in the 3-
announcements – the 10y10y rate has rallied 10, 10-25 and 25+ buckets, respectively. We believe this will favour the 10-25
76bp since the £50bn QE extension year sector and in particular the long maturities in this bucket, as most of the
7.0%
short bonds have already been excluded because of their low free float.
6.5%
6.0%
5.5%
If continued should result in further 10y10y strength
5.0% In terms of rates we look for the 20y sector to outperform, particularly against 10y.
4.5%
This is what has happened since last week’s announcement of the £50bn
4.0% GB 10y 10y
3.5% GB 20y 10y
extension as the 10y10y forward gilt rate has rallied 76bp (see bottom margin
3.0% QE announcements chart). This compares with a 174bp rally in the days following the initial £125bn
2.5%
2.0%
announcement of the program in March. If the bank continues to purchase equal
1-Jan 20-Feb 11-Apr 31-May 20-Jul 8-Sep amounts from each sector, we expect this rate to rally further.

And relative value opportunities
In relative value terms we believe the low free float in the 10-25 year bucket
should favour UKT 4.25 Jun32 and UKT 4.75 Dec30, which are the longest
maturity bonds in the sector, against UKT 4.50 Sep34, which is the shortest bond
in the 25+ sector. The Dec30 has actually cheapened in recent days and is
currently 1.9bp cheap on the BAS-ML splined curve while the Sep34 is 1.8bp
cheap.
29
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1 4 Au gus t 20 09
Table 17: Gilts eligible for purchase in the extended program

DMO
BoE Holding BoE Holding % Free float to Free float to trade Available to buy leaving 30%
Bond Size (bn) Holding
Cash 13-Aug-09 Nominal 13-Aug-09 trade (bn) (bn)
(end Mar-09)
UKT 4.50 Mar-13 23.9 3.7 0.6 0.6 82% 19.7 12.5
UKT 8.00 Sep-13 8.4 2.6 - - 69% 5.8 3.3
UKT 2.25 Mar-14 23.3 0.0 0.4 0.4 98% 22.9 15.9
UKT 5.00 Sep-14* 23.2 4.7 13.7 12.1 28% 6.4 -0.5
UKT 4.75 Sep-15 25.0 5.0 13.0 11.6 34% 8.4 0.9
UKT 8.00 Dec-15 10.0 2.8 5.2 3.9 33% 3.3 0.3
UKT 4.00 Sep-16 25.8 4.3 6.4 5.9 60% 15.6 7.8
UKT 8.75 Aug-17 10.5 3.1 3.5 2.5 47% 4.9 1.7
UKT 5.00 Mar-18 22.4 4.4 13.2 11.5 29% 6.5 -0.2
UKT 4.50 Mar-19 26.3 1.2 6.7 6.2 72% 18.9 11.0
UKT 3.75 Sep-19 7.8 0.0 1.4 1.4 82% 6.4 4.0
UKT 4.75 Mar-20* 16.6 3.4 9.4 8.5 29% 4.8 -0.2
UKT 8.00 Jun-21* 22.7 6.3 16.4 11.3 22% 5.1 -1.7
UKT 4.00 Mar-22* 9.8 0.0 6.9 6.8 30% 2.9 0.0
UKT 5.00 Mar-25 22.1 5.7 4.9 4.4 55% 12.1 5.4
UKT 4.25 Dec-27 21.4 3.9 6.6 6.5 51% 11.0 4.5
UKT 6.00 Dec-28 15.9 4.5 4.3 3.5 50% 8.0 3.2
UKT 4.75 Dec-30 18.8 3.4 5.0 4.7 57% 10.7 5.0
UKT 4.25 Jun-32 23.6 6.0 7.5 7.5 43% 10.1 3.0
UKT 4.50 Sep-34 7.0 0.0 0.0 0.0 99% 7.0 4.9
UKT 4.25 Mar-36 20.2 5.2 0.0 0.0 74% 15.0 8.9
UKT 4.75 Dec-38 22.8 5.3 0.2 0.2 76% 17.3 10.5
UKT 4.25 Sep-39 7.0 0.0 0.4 0.4 94% 6.6 4.5
UKT 4.50 Dec-42 19.1 4.1 - - 78% 15.0 9.3
UKT 4.25 Dec-46 17.8 4.0 0.1 0.1 77% 13.7 8.3
UKT 4.25 Dec-49 14.0 1.5 0.2 0.2 88% 12.3 8.1
UKT 4.25 Dec-55 20.1 4.2 0.4 0.4 77% 15.6 9.6
Source: Banc of America Securities - Merrill Lynch * not currently being purchased due to low free float
30
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1 4 Au gus t 20 09
Bin Gao +81 3 6225 6686 Pac Rim Rates

Chart 40: JGB2s10s and 10s20s
Back to flattening bias for JGBs
120
10y becomes attractive again to the banks
110
Since early July, we have been looking for the JGB2s10s curve to bear steepen
then followed by bull-flattening (Global Rate Focus, 9 July 2009). The main
100 argument behind the outlook resides on that the mega-banks in Japan, with
JGB2s10s money at hand, was unwilling to dive into the 10y sector due to the unattractive
JGB10s20s
90 yield at that time. With the 10y finally reaching 1.45% a few days ago, we believe
it is high enough to induce the banks switching out of the front-end position and
80 extending their duration. As argued by Shogo Fujita later on in today’s piece,
Japan’s bank is still the 800lb guerrilla who will guide the direction of the JGBs.
70
On the other hand, our call on JGB10s20s to flatten from 70bp has not worked.
60
The key thing we missed was that the pension and insurance companies have
6/29/09 7/9/09 7/19/09 7/29/09 8/8/09 done most of their purchase for this half fiscal year. Thus, although we foresee
JGB2s10s to move down to 100-110bp range, the 10s20s will stay relatively
Source: Bloomberg, BAS-ML
steep, missing the catalyst to flatten it. On the other hand, we do not see it to
steepen much either and favours scaling into bigger position if the spread gets
Chart 41: JPY and AUD front end above 75bp. We think the catalyst will come toward the end of September and
October when the new half fiscal year starts. The pressure for 10s20s flattening
1.0 6 will be especially strong if 2s10s would have dropped below 110bp by then.
5.8
0.8 5.6 The stable JPY front end vs. the volatile AUD one
5.4 Japan and Australia, two economies both highly integrated into Asia now, seem
0.6 5.2 to follow very different paths in this Asia led recovery. The difference is obvious to
5 the naked eyes in the short term interest rates. In less than a month’s time, the
0.4 4.8 AUD 1y fwd 1y saw a swing of 120bp, while the JPY 1y fwd 1y got stuck in a
4.6
band of 10bp. What is being priced in here?
0.2 4.4
JPY 1y fw d 1y (lhs)
In Japan, the market still believes that there will be no rate hike anytime soon.
AUD 2y fw d 1y (rhs) 4.2 The Bank of Japan this week does say that the economy is stabilizing, but still
0.0 4 sees deflation ahead. Thus, the stable front end rate is rather a reflection of
6/19/09 7/9/09 7/29/09 Japan’s reality and little tightening priced in works out to be a rationale reaction to
this economic reality. That said, there is a event risk for the rate to rise suddenly if
Source: Bloomberg, BAS-ML the global recovery proves to be exceptionally strong. The best way to benefit
from this scenario is through the 1y1y payer (JPY volatility section for details)
Chart 42: AUD 1y fwd 1y and 2y fwd 1y
Australia, on the other hand, is a totally different story. Economic numbers
7.0
AUD 2y fw d 1y released recently have been positive. Rightly, the market rightly prices in RBA
AUD 1y fw d 1y hikes. However, there is still question about the speed and the level. Currently the
6.5
debate centers on when the RBA will start tightening, later this year, 1Q10, 2Q10,
6.0 etc. The fact is: no one is sure. What investor generally seems to agree is that if
the RBA tightens, even if it moves relatively quickly, the terminal rate will be
5.5 somewhere around 5 to 5.5%. That’s where the problem is with the 2y fwd 1y. 3m
BBSW trades 20 basis point above 3m OIS rate. If the RBA does hike rate all the
5.0
way to 5.5% and stops there, the 1y swap rate should have a princely value of
5.7% if the OIS/BBSW spread sticks. That calls into the question of how the 2y
4.5
fwd 1y rate can consistently stay above 6%.
4.0
Our recommendation of receiving 2y fwd 1y has seen very large P/L swings (Pac
6/19/09 7/9/09 7/29/09 Rim Alpha, 22 June 2009). Fortunately, we picked the right sector and are still in
the money. Given the economic improvement, we do not look for it to go down to
5.25%, but we are comfortable watching it nicely rolldown the curve.
31
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1 4 Au gus t 20 09
Shogo Fujita +81 3 6225 6684 Japan bond strategy

JGBs: The Anatomy of Japanese Bank
JGB Investment Activity
We continue this week expanding into supply and demand dynamics of the JGB
market. As we established a couple of weeks back, the JGB market is dominated
by domestic investors, namely financials and at the moment the banks are in
control of short-mid term rates. We look into the factors that need to be
considered when we talk about domestic bank JGB investment activity.
It’s not just about Net Interest Margins…There’s a lot more

on the Plate
OK, when banks buy fixed income products they usually buy them because it
earns them incremental interest over what they’d typically earn when they lend
out to companies, right. Otherwise it won’t make economic sense…
WRONG. What people need to understand is, it’s a totally different ball game in
Japan. Not only does buying JGBs earn no Net Income Margin (NIM), the fact is
it earns them negative NIM. So why do banks in Japan do what they do. Buy
JGBs when they know it loses them money? Here’s a brief list of what a typical
Japanese bank would take into consideration when they invest in JGBs:-
Chart 43: Asset Yield Levels and Financing Costs for The Return Factor: Carry, Financing Costs(internal and actual)
Japanese Banks
2.5 Lending and Deposit Activity: Lending standards, Bad loans, Deposit Size
2
Accounting and Tax Issues: Classification, Hedge Accounting and Potential
1.5 changes to Accounting Rules
30bp
1
Risk Management and Regulatory Issues: Basel II, Value-at-Risk
0.5 Yields on Loans
Yields on Securities We will take a quick look at each of these factors and show that the investment
Financing Costs including General and Administrative Expenses
0 decision making process is far more complex than making simple ‘economic
Fiscal 2000
Fiscal 2001
Fiscal 2002
Fiscal 2003
Fiscal 2004
Fiscal 2005
Fiscal 2006
Fiscal 2007
Fiscal 2008
sense’. What it boils down to is banks need to sufficiently satisfy all the above
points, simultaneously. And sometimes that means booking a loss on your
Source: Japanese Bankers Association portfolio, when there are no viable alternatives available. We look into each
factor to elaborate that point.
Chart 44: Net Interest Margins of Japanese Banks The Return Factor – Booking Negative Interest Margins
0.8
NIM on Loans NIM on Securities Net Interest Margin
make Sense in Japan
0.6
Here’s where the Japanese banking industry stands in terms of revenue, costs
and margins. As you can see from the charts, buying JGBs at yield of less than
0.4
1.42% does not make economic sense. After all if financing costs(including
0.2 general and administrative expenses) are running at 1.42%, buying any kind of
0 asset at below that rate only books in losses. In reality though, the securities
Fiscal 2000
Fiscal 2001
Fiscal 2002
Fiscal 2003
Fiscal 2004
Fiscal 2005
Fiscal 2006
Fiscal 2007
Fiscal 2008
-0.2
portfolio of the Japanese banking sector is currently yielding 1.12% and running a
30bp negative carry to financing costs. So you ask yourself this. Why are they
-0.4
accumulating so much in their securities portfolio when NIM is negative, shouldn’t
-0.6 they just increase their loan portfolio which is yielding 1.98% and has a positive
Source: Japanese Bankers Association
NIM? Point taken, but the truth of the matter is there is very little viable loan
demand out there, as we will discuss in more detail later.
So banks are sitting on a load of cash that they cannot lend out for one reason or
another, and they also do not want increase their securities portfolio as it will
32
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1 4 Au gus t 20 09
simply lock in losses. But ask yourself this – “is there an alternative”. Banks can
either sit on their cash which yields next to nothing in the current zero interest rate
environment or they can attempt to yield ‘something’ by increasing their securities
portfolio. In fact, banks have opted for the latter. For them booking negative
interest margins, makes sense, as doing nothing will lose them more money. So
for Japanese banks, the loan portfolio is effectively subsidizing the securities
portfolio, and as long as the bank is making money in their entire portfolio of
investments, negative NIM is logical.
So we get an awkward situation where the negative NIM on bank securities

portfolio is widely accepted. In fact, it has been negative for some time now, as
we can discover from the charts. Therefore, to ensure that the portfolio
management section has incentive to carry out their day-to-day operation, the
internal (or managerial) financing cost is lowered. From dialogue with customers,
this internal financing cost varies from O/N GC repo rates – 3M Tibor rates(bulk of
the banks are at the lower rates range). Therefore it is only natural that short–
medium term rates head lower to converge with these rates. In fact for banks that
have internal financing costs at the lower end of the spectrum, the portfolio
management section theoretically earns carry, internally off course.
Chart 45: Bank Loan and Deposit Growth This explains why coupon levels on JGBs are a very important investment factor
8.0
Total Bank Loan (yoy growth%)
at auction timing and one reason why simple yields as opposed to the customary
6.0
Total Deposit (yoy growth%)
yield-to-maturity are used more frequently.
4.0
Lending and Deposit Activity– Lending Standards, Bad Loans
2.0
and Deposit Size, There’s Just too much money that needs
- to be put to Work…
04/01/1999
04/01/2000
04/01/2001
04/01/2002
04/01/2003
04/01/2004
04/01/2005
04/01/2006
04/01/2007
04/01/2008
04/01/2009
-2.0 In a simple nutshell, there’s just too much money that needs to be put to work.
-4.0 As of June 2009, bank lending activity has stalled, declining from a peak of 422
trillion Yen this March to 416 trillion. Deposits on the other hand have increased
-6.0
from 564 trillion to 568 trillion. So the deposit-lending ‘gap’ has increase by apx.
-8.0
10 trillion Yen in the course of just three months. So what is happening?
Source: Bank of Japan, BAS-ML
Note: Figures do not include Yucho Bank and other special government bank entities
Most of the increase in loans occurred in the aftermath of the Lehman crises,
when liquidity just evaporated. Japanese corporate rushed in to reinforce their
Chart 46: Total Size of Bank Loan and Deposits working capital positions which was depleting at a pace never seen before.
6,000,000 Commitment lines were pulled from various bank sources as the capital market
Total Bank Loans Total Deposits
literary closed down. Since then, industrial production has stabilized (albeit at a
5,500,000
lower level) and markets have resumed operation. The extraordinary demand for
5,000,000
capital and liquidity has subsided and money is being returned to banks. At the
current pace, we expect bank loan growth(yoy) to turn negative during 2009.
4,500,000
So borrowings are being returned, and people are saving more. But surely at
4,000,000
such low interest rates, there’s bound to be more potential borrowers out there,
3,500,000 after all that’s what modern economics has taught us. This is simply not the case,
1999/04
1999/12
2000/08
2001/04
2001/12
2002/08
2003/04
2003/12
2004/08
2005/04
2005/12
2006/08
2007/04
2007/12
2008/08
2009/04
not in Japan anyway. The perception is only true, if asset values are stable, the
post-bubble years in Japan has taught us this crucial lesson. When broad asset
Source: Bank of Japan, BAS-ML
values are in decline and net wealth is being lost, people/corporates tend to save
Note: Figures do not include Yucho Bank and other special government bank entities, more and banks tend to lend less(due to a decline in confidence of asset security
units in 100 million Yen values). The more acute the decline in asset values, the more vivid the
phenomenon. Let’s look at this in more detail.
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1 4 Au gus t 20 09
Chart 47: Total No. of Corporate Bankruptcies(liabilities >10million Chart 48: Non-performing Loans(NPL) and Total losses from NPL
Yen) 25
Total Losses(disposal of non-performing loans)
2000 Bankrupt/De facto Bankrupt Loans
Doubtful Loans
Special Attention Loans
1800 20
1600
15
1400
1200 10
1000
5
800
600 0
1999/3
1999/9
2000/3
2000/9
2001/3
2001/9
2002/3
2002/9
2003/3
2003/9
2004/3
2004/9
2005/3
2005/9
2006/3
2006/9
2007/3
2007/9
2008/3
2008/9
2009/3
Jan-99
Jul-99
Jan-00
Jul-00
Jan-01
Jul-01
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Source: FSA(Japan), BAS-ML, Unit: trillion Yen
The global decline in asset values need not be discussed. Equity and real estate
values have all declined over the last year and the recession has led to an
increase in corporate bankruptcies and bank losses from non-performing
loans(NPL). This has led to a huge shift in credit mentality and sentiment.
Chart 49: Demand for Loans in each Sector Chart 50: Firm/Household demand for Loans Chart 51: Bank Lending(credit) Standards
50 60
Firms Local Governments Households
Large Firms 50
Medium-Sized Firms Large Firms
40 50 Small Firms
Household/Mortgage Medium-Sized Firms
30 40
Household/Consumer Loans 40 Small Firms
Households
20 30
30
10 20
20
0 10
2000/06
2000/12
2001/06
2001/12
2002/06
2002/12
2003/06
2003/12
2004/06
2004/12
2005/06
2005/12
2006/06
2006/12
2007/06
2007/12
2008/06
2008/12
2009/06
-10 0 10
2000/06
2000/12
2001/06
2001/12
2002/06
2002/12
2003/06
2003/12
2004/06
2004/12
2005/06
2005/12
2006/06
2006/12
2007/06
2007/12
2008/06
2008/12
2009/06
-20 -10
0
-30
200 0/0 6
200 0/1 2
200 1/0 6
200 1/1 2
200 2/0 6
200 2/1 2
200 3/0 6
200 3/1 2
200 4/0 6
200 4/1 2
200 5/0 6
200 5/1 2
200 6/0 6
200 6/1 2
200 7/0 6
200 7/1 2
200 8/0 6
200 8/1 2
200 9/0 6
-20
-40 -30 -10
Source: Bank of Japan, BAS-ML Source: Bank of Japan, BAS-ML Source: Bank of Japan, BAS-ML
As mentioned before, the current increase in bank credit is due to commitment

lines being pulled in the wake of the credit crises. As conditions have stabilized
and the economy is resetting to the new world, credit demand from both
corporates and household has declined. Indeed the only sector currently in need
of credit is local governments and municipals (due to tax shortages). Meanwhile,
banks have also tightened lending (or credit) standards. So we are experiencing a
phase where demand for credit is low and banks are unwilling to lend. Therefore
we do not expect lending to increase in the near future, but to decline even further.
The implication is simple. Banks are holding more cash that they need to invest,
but are unwilling to take credit risk of which there’s no demand for anyway.
Where to park the cash – JGBs.
Accounting and Tax Issues – Classifications, Hedge

accounting and Potential changes to Accounting Rules
Accounting and tax issues play a key role in bank securities investment. Nearly
all of the JGBs held in bank portfolios are accounted for under the Available for
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1 4 Au gus t 20 09
Sales(AFS) classification. Due to the problem mentioned in the previous section,

the typical bank securities portfolio is currently incurring negative NIM. Therefore
having an available-for-sales book that has various JGB issuances with decent
unrealized gains become all the more important. Whenever the bank decides in
the last minute that they need to book profits, the easiest way is to sell JGBs that
are trading at a premium. Therefore it is important to own multiple issues at
various average costs so that profit booking operations can be dealt with
smoothly. This leads to anomalies between each individual bond valuation, i.e.
the curve becomes more segmented, which is what we have consistently
experienced in the short-medium term sector of the JGB curve.
The treatment of hedge accounting also plays a vital factor when considering
Japanese bank investment activities. It is important here to understand that
hedge accounting in Japan is treated rather differently to other countries. The US,
for example, requires the ‘hedge’ component to be a near ‘perfect hedge’ to the
underlying i.e. requires the hedge to be ‘highly effective’, which makes hedge
accounting difficult to implement. We only need to go back a few years to see
what happened to FNMA, FHLMC and GE to understand the complexities in
applying hedge accounting within the US. Japan, however is a little more lax in
their treatment of hedge accounting.
There are mainly two types of hedge accounting, deferral hedge accounting (or
cashflow hedge) and fair value hedge accounting. Requirements for application
are (1) Implementation of internal risk management policies together with
adequate internal control (2) Retrospective monitoring - the hedge effectiveness
must be monitored during and also after hedge application. The basic framework
and rules are similar in most countries, but interpretation and implementation
varies tremendously with accounting convention and practice. Cutting long
stories short, Japan is a little more ‘accommodative’ in hedge accounting
application.
In effect, Japanese banks run huge deferred hedge reserves, which are also
acknowledged on a tax basis. This makes investment operations a lot easier as
hedge PL is deferred and realised throughout the lifespan of the hedge. In short,
without the hedge accounting factor, investing in JGBs will be a challenge. Banks
will not be able to control the PL in their securities portfolio, making it harder to
own bonds under a mart-to-market environment.
Setting accounting advantages aside, the direct impact of hedge accounting can
be felt in the asset swap market and the valuation of the JGB futures. This is only
natural as derivatives such as swaps and futures will be the typical hedge tool
used for such operation. There will be two typical scenarios where Japanese
banks will implement hedge operations in sizable amounts. (1)Absolute rate
levels – when market rates head higher which nullifies the portfolios unrealized
gains, there will be huge incentives to pay swaps/sell futures to neutralize the
effect. They will control the PL and wind down their hedged position (JGBs and
swaps/futures) while gradually accumulating JGBs at higher yield levels. (2)Yield
curve shape – when market conditions are such that the curve starts to invert, i.e.
the longer rates are lower than short term rates, the banks typically pay fix and
receive floating rates in order to alleviate further negative carry. The whiplash
nature of the Japanese asset swap and futures market can be explained partly by
the huge hedging activity of Japanese banks. So understanding the accounting
difference, especially the hedge accounting component is crucial to forecasting
spreads and rates, a factor which is frequently overlooked when outside investors
look into Japan.
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Table 18: IASB Schedule for Financial Instrument There are currently sweeping revisions underway to financial instrument
Accounting Revisions accounting. The International Accounting Standards Board (IASB) is coordinating
Project phase Exposure draft Finalisation a global effort to amend and unify financial instrument accounting (IAS39) which
In time for 2009 year- will alleviate some of the accounting pressures that the industry experienced
end financial
1. Classification during the subprime crises. This will no doubt have huge ramifications for
July 2009 statements - but no
and Measurement investment activity, which will be felt all over the world. The changes will not only
mandatory aplication
before 2012 be in the method by which securities are classified, but also on how impairment
2. Impairment October 2009 In 2010 and hedges will be applied. The impact will not be small in Japan. As hedge
3. Hedge accounting plays are far greater role in controlling revenue than in other countries,
December 2009 In 2010
Accounting
as we have discussed. Thus changes to accounting rules needs to be closely
Source: IASB
monitored as it may lead to a huge shift in JGB market dynamics. The transition
to the new accounting method may be far more painful let alone more
cumbersome than people currently think, especially in Japan.
Risk Management and Regulatory Issues – Basel II, Value-at-

Risk, is Everyone on the Same Boat?
As we discussed in the previous section pertaining to negative interest margins in
bank securities portfolios, one must wonder why Japanese banks won’t just invest
in say 10yr JGBs which is currently yielding 1.42%. This will turn their securities
portfolio into a revenue driving machine. Unfortunately, as much as banks would
like to do exactly that, they will not be permissible from a regulatory and risk
management perspective. Taking on excessive risk will lead to the financial
institution being labelled an ‘outlier’ under the new Basel II framework and from
an internal risk management point of view also, it will be equally as difficult.
Under the value-at-risk (VaR) framework which most institutions use in one form
or another, market volatilities are measured over a given period, say one year.
The current market volatilities that most VaR frameworks use, will include the
heightened volatility period of the Lehman shock. This makes it harder to take on
risk. Even the simplest risk of extending duration is difficult.
The flip side will also be true. As risk management volatilities start to decline over
time, the risk taking capabilities at banks will start to rise, leading way to further
duration extension and credit expansion. Thus the risk management and the
regulatory framework play an important role in investment activities of banks.
Understanding the framework is important as not all countries are on equal
footing. Basel II is a prime example of this, Japan and Europe have implemented
Basel II early, the US has only done so last year.
On a different note, the current global move by officials to consolidate the

regulatory framework and to expand the authority of state and central bank
oversight on financial institutions may, if done improperly, lead to further reduction
in the risk taking capabilities of the financial industry. This may be
counterproductive when risk taking capacities as a whole, are in considerable
decline. Developments in this front will also need to be watched closely from a
regulatory arbitrage point of view, as jurisdictions which opt out of imposing
stringent regulation may result in not everyone being on the same boat.
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1 4 Au gus t 20 09
Conclusion – Japanese Banks to continue buying with no

Other Alternative, with Scope of extending Duration
In short, Japanese banks are left with no viable alternative, but to increase
accumulation of their securities portfolio. Deposits are increasing, lending is
declining and cash needs to be put to work. The accounting factor is still an
unknown, with potential for big changes further down the road, but too early to
speculate as of yet. Regulatory risks are also a factor which could drastically
change investment activity, but that too will need more clarification.
Going forward, Japanese banks are estimated to accumulate 600-700 billion yen
of cash every month (the average monthly trend over the last 5 years), which all
in due course will be allocated to JGB investment. Coupled with the decline in
lending activity and the money returning to the vault from borrowers, the deposits-
to-lending ‘gap’ will have increased by the end of fiscal 2009 by apx.20-30 trillion
yen. The central zone for bank investment will be the 2-5 year curve zone, thus
yields in that zone will stay low for the foreseeable future. However, as risk
management volatilities begin to decline, there will be more scope to extend
duration. Banks will no doubt use the opportunity to extend out the curve, as this
will help mitigate some of the negative interest margin.
All in all, bank purchases of JGBs should continue going forward. We do not
forecast any changes financial policy and the BOJ will be on hold for the rest of
the year. Thus, short-mid term JGB rates will remain comfortably in the lower end
of the range throughout the remainder of the year. We believe 2yr JGBs will stay
in the 0.20-0.35% range, 5yrs to stay in the 0.60-0.80% range. And as volatilities
start to decline, the risk taking capacity of banks will be freed up, leading to an
increased investment on the longer 10yr part of the curve, we foresee 10yr JGB
rates to be trading at 1.20-1.40% at year end.
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Bin Gao +81 3 6225 6686 Yen volatilities

Chart 52: JPY implied volatility surface (ATM)
Cheaper way to higher rate
Implied normal volatility (08/10/2009) Strong interest in higher rates
2Y 3Y 5Y 7Y 10Y 15Y 20Y Now the Federal Reserve sees “the economy is levelling out”, though “likely to
3M 23.70 28.40 35.98 45.21 53.29 56.58 61.33
6M 26.13 31.57 39.04 45.22 53.23 56.32 60.78
remain weak for a time”. Amid the improved economic sentiment, interests are
1Y 30.89 36.16 42.68 47.47 53.80 56.67 60.43 high among investors seeking to short the rate market. Naturally, Japan’s low rate
2Y 38.09 42.71 47.94 52.43 56.60 58.78 60.60 level starts attracting market attentions again after a quiet period of time. Among
3Y 44.68 47.97 51.93 54.87 57.92 59.40 60.73
4Y 50.05 51.92 54.24 56.84 59.27 60.48 61.48 different alternatives, the high strike payer swaption on long tails proves to be the
5Y 53.52 54.28 55.84 58.17 60.03 60.54 61.53 most popular. In this piece, we argue for a few better alternatives.
7Y 57.49 57.30 57.07 58.29 60.15 60.14 61.03
10Y 58.87 58.37 57.61 58.77 59.49 59.70 60.21
Bird’s eye view of the ATM volatility surface
Source: BAS-ML
Not surprisingly, with the Bank of Japan staying put, the short expiry/short tail
volatility remains the cheapest in absolute terms. The landscape of expensive
Chart 53: JPY 5y20y volatility curve volatility changed slightly from a few months ago. The long tenor swaptions are all
similarly priced now, regardless of the expiry. Arguably, the volatility for these
90 2.0
1w Change (rhs, bp) long tails will stay high as long as there is elevated concern on the value of
85 8/11/09 1.8
8/4/09
currency, which has been the primary driver for the long end swap rates.
80 1.6
7/9/09 Recently, the long tenor became even more volatile with the increased interests
75 5/14/09 1.4 in the high strike payers. On top of the high volatility, the high strike payer has
70 1.2 also steepened the volatility curve. In our view, the combination of the high skew
65 1.0 and the rising volatility makes the high strike payers much less attractive and also
60 0.8 makes it an attractive candidate to be sold in financing other legs.
55 0.6
50 0.4 Benchmark 1y1y, still stuck in the low level
45 0.2
After dropping precipitously during a long stretch of time, the 1y1y volatility is now
stuck in a range with the straddle premium around 20bp. In absolute levels, it is
40 0.0
only slightly above the 2005 low. Relative to the rate level, the volatility is not too
1.0% 2.0% 3.0% 4.0% far from its cheapest point. For investors who are concerned about higher interest
rate, the ATM payer at around 11bp offers a cheap hedge for inflation induced
Source: BAS-ML
higher rates. If inflation does rise due to global inflation and cheap JPY, the BoJ
will hike. Mirroring this possibility, even the 1y1y skew has steepened relative to
three months ago, though it is nowhere as extreme as those of the longer tenor
ones. Yet, the volatility for current ATM forward 0.67% strike managed to come
down a bit, providing a sweet spot for setting up the ATMF payer at cost of 10bp.
Chart 54: JPY 1y1y implied volatility and 1y fwd 1y rate Chart 55: JPY 1y1y implied volatility/1y fwd 1y rate
Source: BAS-ML Source: BAS-ML
Long tail payer spread

We have suggested using the 1x2 payer structures to capture the value of steep
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1 4 Au gus t 20 09
volatility skew. In particular, we recommended a 5y10y 2.2% vs. 3.3% 1x2 payer
trade (Pac Rim Alpha, 26 June 2009). The trade is about three basis point in the
money right now, and proved to be stable despite the skew’s roller coaster ride
over the last one and half months. Now, the value seems to have shifted to the
2y10y skew, which sits only a shade below the peak it reached on 26 June. This
skew provides a good opportunity for those investors who want short the rate
using a 1x1 payer spread. For a 2% vs. 3% 1x1 spread, the investor is expected
to pay 23bp of forward dv01, with a maximum upside of 77bp. With the ATMF
around 1.9%, this trade has a good chance to end up in the money when it
expires.
Making the expensive volatility/skew of long tenor pay

Be it 1x2 or 1x1 payer spread, the game is to make the high skew pay! Part of
the reason that the action has been focused on the longer tenor is that for equity
investors, the relevant discount rate is the long term rate. However, as a fixed
investor and especially from the relative value perspective, it makes more sense
to use the expensive skew/volatility in financing a belly position.
Chart 56: JPY 5y10y – 5y2y normal volatility Chart 57: JPY 5y10y and 5y2y skew
21
5y 2y Skew (ATM+100bp v ol - ATM v ol)
19
5y 10y Skew (ATM+100bp v ol - ATM v ol)
17
15
13
11
7
1/5/09 2/5/09 3/5/09 4/5/09 5/5/09 6/5/09 7/5/09 8/5/09
Source: BAS-ML Source: BAS-ML
Currently, investors need to pay 10bp forward dv01 to establish the 5y10y 3% vs.
5% 1x1 payer spread. For the same amount of money, one can replace the 5y10y
3% strike with a 5y2y 2.2% payer. The question now becomes which one is more
likely to be in the money. Today’s market seems to believe that the long term rate
can rise without the corresponding short rate move. Maybe true in the spot
market! However, the terminal date for the 5y2y is the 7y point, a sector famous
for its volatility because that’s where the only JGB futures trade. Historically, the
5y2y volatility has been higher than that of the 5y10y. Recently however, the tide
has changed with the 5y10y volatility trading above that of the 5y2y. It can stay
this way as long as there is no big rate moves. But it is unlikely to stay this way
for reasons we will state below. The skew of 5y2y, about the same level as that of
5y10y, also works for the trade. Since 2.2% is only 40bp above the ATMF of
5y2y, while 3% is 60bp above the ATMF of 5y10y, investors are paying less for
the 5y2y skew.
The key advantage to this trade, a combination of payer spread and conditional
bear flattener, rests on this: if the stars finally line up to move the rate higher, the
futures sector will move due to the CTA trading. At the same time, the
pension/insurance support will mute the back-end move. The combination of
these two forces will make the 5y2y 2.2% payer vastly outperforms 5y10y 3%
payer in a large sell-off, exactly the scenario the rate hedge is suppose to help.
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Ling Wu +81 3 6225 6315

Pac Rim Rates Futures
Sell-off provides opportunities
The sell-off in JGB provided an opportunity to buy call spread and excess
expectation on RBA rate hikes provided an opportunity to re-enter bank-bill
flattener.
Chart 58: JGB Sep09 futures Chart 59: Payout of JBU9 Sep 1x2 call spread and strangle
140
1.0 1x2 138/139 call spread
135.5/139.5 strangle
139
JBU9
0.5
138
137 0.0
135.0 136.0 137.0 138.0 139.0 140.0 141.0
136
-0.5
135
Dec Jan Feb Mar Apr May Jun Jul Aug -1.0
Source: Bloomberg, Banc of America Securities - Merrill Lynch Source: Bloomberg, Banc of America Securities - Merrill Lynch
JGB futures call spread

The Sep futures were sold off aggressively below 138 after the August option
expiration. The Sep09 137/138/139 call ladder initiated on 18 June will expire on
31 August. The ladder reached 49sen on 3 August before falling to 38sen. We
entered the Sep09 1x2 138/139 call spread. Both the ladder and spread are
protected on the downside and positioned for a rebound of futures price toward
the 138. We also like to sell the Sep09 135.5/139.5 Strangle as the FOMC
decided to extend UST purchases to October, which eases the risk of volatile
global long-term yield movement in the short term.
Chart 60: Euroyen Sep09 futures and Sep09 1x2 Euroyen futures put spread
99.5/99.375 put spread
Euroyen futures weakened further as the improved outlook for the economy has
99.56 5 increased the odds that the central banks and governments will wind down the
99.54 stimulus. G20 finance ministers may set a timetable for stimulus withdrawal at its
4
99.52 summit in Pittsburg on 24-25 September. The Euroyen Sep09 futures declined to
3 99.465 before the BoJ policy meeting. The BoJ meeting, however, stated that the
99.5
2 bank is still "paying attention for the time being to the downside risks to economic
99.48
activity and prices", so the futures rebounded back to 99.475 after the meeting.
99.46 1
The risk of a potential funding cost increase in 2H still exists. We have argued
99.44 0 that the seasonality may favor higher TIBOR funding. The Euroyen Sep09 1x2
99.42 put spread with strike prices at 99.5 and 99.375 continues to edge up slowly.
-1
99.4 YEU9
99.38 1x 2 put sprd (L, in sen) -2 ASX 90-day bank-bill futures flattener
99.36 -3 The consumer confidence gained 3.7% in August, rising 27.8% since May, which
Feb Mar Apr May Jun Jul Aug
indicates the consumer spending will hold up for now. Our economists still think a
rate hike is not likely until early next year, while risk of a late 2009 move is
Source: Banc of America Securities - Merrill Lynch, Reuters, Bloomberg. increasing. The OIS has priced in over 225bp hikes by the end of 2010 and
100bp hike by 1Q10. The bank-bill futures have fallen more than 20bp in two
weeks for all the tenors until Dec10. The Jun/Sep/Dec10 fly has gained over 10bp
at 15bp. The Sep09/Mar 10 spread flattener, however, was stopped out at 80bp
(initiated at 63bp), before momentum carry the spread to as steep as 104bp on
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1 4 Au gus t 20 09
11 August. We still think the spread is too steep, which has priced in a scenario of
very aggressive RBA rate hikes or an extreme tightening of inter-bank lending in
the next six months. Historically, if we exclude the period in 1994, when the RBA
hiked rates aggressively (three consecutive hikes of total 175bp), the maximum
Chart 61: ASX bank-bill Sep09/Dec10 spread increase of 3M bank bill in a period of six months since 1990 was only 110bp.
and 9M OIS implied rate hikes (bp) Moreover, part of the recent bear-steepening in bank-bill was also driven by the
risk that Federal government may withdraw the guarantee on large deposits and
150
Sep09/Mar10 bank-bill spread wholesale funding. The Australian Treasurer, Wayne Swan, said this week, that
100 9M OIS implied rate hikes the government would not discuss a reduction in its economic stimulus program
until late 2009 and added that the upcoming G20 financial ministers would set a
50 timetable for stimulus withdrawal, so the package is likely to remain in place until
early 2010, according to Australian Financial Review. The statement should ease
0 the jittery over a sudden reversal of the stimulus. We would like to re-enter the
flattener at 100bp with target at 60bp and stop at 120bp.
-50
ACGB futures rebound
-100
The 3yr futures were sold off further in tandem with increased rate hike risk,
dipping to as low as 94.95 or an implied rate above 5%. With spread between 3yr
-150
yield and central bank target at its widest level in 14 years, the 3yr yield has fully
Apr May Jun Jul Aug priced out the possibility that the central bank’s neutral rate level could be below
5%, even if we assume the rate hiking cycle would last for three years.
Despite the sell-off led by the front-end, the 10yr has been more resilient. The
3y10y flattened to 48bp on 10 August and the 10yr yield failed to challenge the
5.85% level reached on 19 June for the second time. The 10yr futures have
managed to rebound after testing the 28 July level near 94.32. A reduction in rate
hike expectation driven by a rethinking of global growth outlook may help 10yr
futures to test their recent peak at 94.82 if prices break above 94.5.
Chart 62: 3M bank-bill rate changes in a period of six months Chart 63: ACGB Sep09 futures and 3y10y spread
400 97
Sep 10y r futures
300
96.5 Sep 3y r futures
200
100 96
0
95.5
-100
-200 95
-300
94.5
-400
-500 94
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 Apr Apr Apr May May Jun Jun Jul Jul Aug
Source: Bloomberg, Banc of America Securities - Merrill Lynch. Source: Bloomberg, Banc of America Securities - Merrill Lynch
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1 4 Au gus t 20 09
Max Leung (44) 20 7996 6580 Forecasts

Update to Euro govt yield forecasts 4Q09 Table 19: Quarter-end government bond benchmark forecasts
10y Bund cut to 3.60% from 3.80% Latest 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10
US 3 mth* 0.44 0.55 0.50 0.45 0.45 0.45 0.55
2 yr 1.12 1.00 1.00 1.05 1.10 1.30 1.50
5 yr 2.59 2.50 2.60 2.65 2.65 2.70 2.75
10 yr 3.63 3.85 4.10 4.10 4.15 4.15 4.20
30 yr 4.47 4.55 4.75 4.80 4.80 4.80 4.85
Euroland 3 mth* 0.84 0.90 1.00 1.25 1.80 2.28 2.75
2 yr 1.39 1.45 1.50 1.75 2.20 2.65 3.10
Table 20: Official rate forecasts 5 yr 2.57 2.65 2.70 2.90 3.10 3.43 3.75
10 yr 3.44 3.50 3.60 3.65 3.75 3.88 4.00
Latest Sep-09 Dec-09 30 yr 4.10 4.15 4.25 4.25 4.35 4.45 4.50
FED 0.15 0.00-0.25 0.00-0.25 Japan 2 yr 0.28 0.40 0.45 0.55 0.60 0.80 0.85
BoJ 0.10 0.10 0.10 5 yr 0.73 0.65 0.90 1.00 1.00 1.25 1.50
ECB 1.00 1.00 1.00 10 yr 1.42 1.35 1.60 1.55 1.60 1.75 1.95
UK MPC 0.50 0.50 0.50 30 yr 2.32 2.15 2.35 2.25 2.40 2.30 2.55
China 5.31 5.31 5.31 U.K. 3 mth* 0.78 1.30 1.30 1.40 1.70 2.30 2.80
BoC 0.25 0.25 0.25 2 yr 1.00 1.10 1.35 1.75 2.10 2.60 3.00
RBA 3.00 2.75 2.50 5 yr 2.97 2.45 2.80 3.05 3.30 3.65 3.95
RIKSBANK 0.25 0.25 0.25 10 yr 3.80 3.60 3.80 4.00 4.10 4.30 4.50
NORGESBANK 1.25 1.25 1.25 30 yr 4.29 4.65 4.70 4.75 4.80 4.80 4.80
SNB 0.25 0.25 0.25 Australia 2 yr 4.52 3.50 3.80 4.00 4.10 4.10 4.20
Czech Rep 1.50 1.25 1.25 5 yr 5.47 4.60 5.40 5.40 5.10 5.50 5.80
Hungary 8.50 8.50 7.50 10 yr 5.70 4.80 5.60 5.50 5.20 5.60 5.90
Poland 3.50 3.25 3.00 Canada 2 yr 1.32 0.80 0.90 1.10 1.25 1.25 1.25
Source: BAS-ML Economics, Central Banks 5 yr 2.61 1.75 1.75 1.90 1.95 2.00 2.00
10 yr 3.51 2.75 2.60 2.60 2.55 2.50 2.50
Sweden 10 yr 3.54 3.60 3.80 3.90 4.10 4.20 4.30
Norway 10 yr 4.21 4.25 4.45 4.50 4.60 4.70 4.75
Source: BAS-ML Global Rates Strategy, Bloomberg. *3-month rates are LIBOR. Latest as of 1730 GMT.
Table 21: FX Forecasts Table 22: Macro

Latest Sep-09 Dec-09 2008 2009E 2010E
EUR-USD 1.43 1.45 1.50 2007A ML Cons ML Cons ML Cons
USD-JPY 95.34 100.00 105.00
Real GDP % YoY
EUR-JPY 136.03 145 158
US 2.2 1.1 1.1 -2.6 -2.5 2.3 2.0
EUR-GBP 0.86 0.86 0.85
Euroland 2.6 0.7 0.8 -4.2 -4.3 1.8 0.6
GBP-USD 1.66 1.69 1.76
Germany 2.6 1.0 1.1 -5.6 -6.0 2.0 0.4
EUR-NOK 8.63 8.40 8.20
France 2.1 0.7 0.8 -2.6 -2.8 1.7 0.7
EUR-SEK 10.23 10.00 9.75
Italy 1.4 -1.0 -1.0 -4.7 -5.0 1.5 0.4
EUR-CHF 1.53 1.54 1.58
Spain 3.7 1.1 1.2 -3.3 -3.7 1.3 -0.8
Source: BAS-ML FX strategy, Bloomberg
Japan 2.4 -0.6 0.0 -5.6 -5.9 3.5 0.9
UK 3.0 0.7 0.8 -4.4 -4.1 1.1 0.8
Sweden 2.6 -0.5 -0.5 -4.7 -4.5 1.3 0.5
Norway 6.1 2.4 2.0 -1.7 -1.2 1.6 1.5
Inflation % YoY
US 2.9 3.8 3.9 -0.3 -0.6 1.6 1.7
Euroland 2.1 3.3 3.3 0.4 0.6 1.0 1.1
Germany 2.3 2.6 2.6 0.3 0.5 0.9 0.6
France 1.6 3.2 2.9 -0.1 0.2 1.0 1.2
Italy 2.0 1.2 3.3 0.5 0.9 1.1 1.4
Spain 2.8 4.1 4.1 -0.3 -0.2 1.4 1.4
Japan 0.0 1.5 1.4 -1.3 -1.1 -0.5 -0.6
UK (CPI) 2.3 3.6 3.6 1.9 1.8 1.8 1.5
Sweden 2.2 3.5 3.5 -0.1 -0.5 1.3 1.1
Norway 0.8 3.8 3.8 2.5 1.9 1.9 1.8
Source:: BAS-ML Economics
42
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1 4 Au gus t 20 09
Analyst Certification
I, Riccardo Barbieri, hereby certify that the views expressed in this research
report accurately reflect my personal views about the subject securities and
issuers. I also certify that no part of my compensation was, is, or will be, directly
or indirectly, related to the specific recommendations or view expressed in this
research report.
43
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1 4 Au gus t 20 09
Important Disclosures
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BAS-ML fixed income analysts regularly interact with sales and trading desk personnel in connection with their research, including to ascertain pricing and
liquidity in the fixed income markets.
44
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1 4 Au gus t 20 09
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Team page
Riccardo Barbieri +44 20 7996 5897
Economist/Strategist
MLPF&S (UK)
riccardo_barbieri@ml.com
Michael Cloherty +1 646 855 8846
Rates Strategist
MLPF&S
michael_cloherty@ml.com
Marcus Collier +1 646 855 8849
Rates Strategist
MLPF&S
marcus_e_collier@ml.com
Shogo Fujita +81 3 6225 6684
Fixed Income Strategist
Merrill Lynch (Japan)
shogo_fujita@ml.com
Bin Gao +81 3 6225 6247
bin_gao@ml.com
Max Leung +44 20 7996 6580
MLPF&S (UK)
max_leung@ml.com
Jonathan Rick +1 646 855 8845
Rates Strategist
MLPF&S
jonathan_rick@ml.com
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sphia_salim@ml.com
Joseph B. Shatz +1 646 855 7281
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Antonio Villarroya +44 20 7995 8952
antonio_villarroya@ml.com
Ling Wu +81 3 6225 6315
ling_wu@ml.com
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Global Rates Focus

Rates Strategy | Global

Rate hikes: not so soon

Global rates - summary of our views

Australia Direction Rationale

Riccardo Barbieri +44 20 7996 5897 Global strategy overview

Moving to economic fundamentals, the latest data releases brought encouraging

Other points of interest

Michael Cloherty +1 646 855 8846 US market strategy

Jonathan Rick +1 646 855 8845 US rates derivatives

Chart 7: 30y spreads and CDX NA 5y IG index

30y spreads CDX NA 5y IG (RHS Inv erted)

Source: Bloomberg and Banc of America Securities – Merrill Lynch

Joseph Shatz +1 646 855 7281 US rates futures

Buy USU9/USZ9; Slightly Cheap and Should

USU9/USZ9 is Cheap to Fair Value; Embedded Switch Option in USZ9 is

Buy USM9 / Sell USU9

Buy TYU9/TYZ9; Slightly Cheap and Should

10-Yr Yield (rhs)

TYU9/TYZ9 Widens in Steepening Selloffs; Narrows in Flattening Rallies

Buy FVU9/FVZ9; Slightly Rich, But Rate and

FVU9/FVZ9 Widens in Steepening Selloffs; Narrows in Flattening Rallies

CTD Fwd Yld Spread (bps)

Sell TUU9/TUZ9; Rich and Front End Yield Rise

steepening of the yield curve should cause TUU9/TUZ9 to widen, while a

Net Long Speculator Position Could Put Downward Pressure on

Source: Bank of America – Merrill Lynch

Joseph Shatz +1 646 855 7281 US inflation linked securities (TIPS)

Increasing TIPS Issuance and Replacing 20-yr TIPS with 30-

Front End of TIPS Curve Still Cheap But Very Risky

Extremely Positive TIPS Carry Coming to an End Soon

Michael Cloherty +1 646 855 8846 US agencies

Nonetheless, there are likely to be four goals to the new structure:

1) reduce risk to the government

2) maintain a standardized and liquid MBS market

3) continue to stabilize the mortgage market in times of stress

4) increase home ownership through affordable housing programs

Reducing risk to the government—skin in the game. One of

Partial guarantees. Another solution would be for the government to only

Portfolio business. The portfolio was unable to act as a shock absorber in

Good bank/bad bank. In the good bank/bad bank framework, nonperforming

Table 12: Agency MBS Outstanding

Federal Reserve + Treasury $0.06 T $1.50 T

Antonio Villarroya +44 20 7995 8952 European rates strategy

Table 13: Cross correlation between assets since March 2009

Source: Banc of America Securities - Merrill Lynch

Adjusting our rates forecasts to faster growth / earlier hike

Source: Banc of America Securities - Merrill Lynch

In recent days two of the trades in our portfolio have expired:

Source: Banc of America Securities - Merrill Lynch

0  We think that some tightening vs the refi rate is possible in coming

Interestingly, the amounts placed in the deposit facility declined to €124bn on

Antonio Villarroya +44 20 7995 8952 EUR money market strategies

‘Shorter-winged’ flies such as H10-Z10-U11, M10-Z10-M11 or those with Sep10

20.0 2.45 - 147.04

May-09 May -09 09 09 09 A ug-09 09

Source: Banc of America Securities - Merrill Lynch

Antonio Villarroya +44 20 7995 8952 Europe cross-country strategies

Accordingly, it could be interesting to structure a UK-into-Euro trade through 6m

Accordingly, if we weight the trade according to delivered (Exponential walk)

80 6m10y Payers Profit

Source: Banc of America Securities - Merrill Lynch

 Buy £100mln 13-Feb-11 maturity, GBP 10y Payer, k=4.4485% ( = ATMf),

0 We think that some tightening vs the refi rate is possible in coming

Buy £100mln 13-Feb-11 maturity, GBP 10y Payer, k=4.4485% ( = ATMf),