Market Strategy Americas The Ins and Outs of The Labor Market

RESEARCH
10 May 2012
MARKET STRATEGY AMERICAS The ins and outs of the labor market
Economics
Outlook 3 Flows out of employment into unemployment have fallen sharply since the end of the recession; jobless claims and layoffs are close to pre-recession levels. However, flows out of unemployment into employment have not risen materially, despite a pickup in job openings.
Forecast and Summary of Views GDP Tracking Data Review and Preview Trade Portfolio Update Trade Recommendations Bond Yield Forecasts 2 5 6 34 39 43
Rates strategy
Treasuries: Another reason to worry 8 We remain wary of fading the rally, given a modest growth outlook and strengthening linkages between sovereigns and banks in Europe. We instead recommend shorting 7s versus the wings for normalization of QE expectations and intermediate supply ahead. Inflation-linked: A glance at foreign holdings 12 Foreign investors have become an important demand base for TIPS. The update to the annual TIC holdings report has provided some detail. These data show that foreign accounts owned $206bn TIPS as of June 2011, a figure we expect to continue to grow. Agencies: Back in black 15 With foreign interest in agency bellwethers returning, we examine the first Fannie Mae quarterly profit to taxpayers since conservatorship. While both GSEs could stay roughly profitable near term, a dividend-rate redefinition would remove significant uncertainty. Swaps: May 2010 all over again? 19 Given the return of European concerns, we believe that near-dated FRA-OIS wideners have attractive risk-reward profiles. They should benefit even if Libor rises for a few days in a row, and the downside is limited, in our view, given Libors recent stability. Futures: TU too rich 21 The front TU contract appears rich, driven by positioning; we recommend purchasing the two potential CTD securities basis heading into the roll month. In tandem, selling ATM straddles can be used to establish a position that performs well across scenarios. Volatility: Skew blues 24 The payer skew is higher than can be justified by rates or the delivered rate-vol relationship. We suggest knock-out payers to those looking for higher rate protection. BMA: Sell 3y ratios 27 We recommend selling 3y ratios ratios to earn carry and benefit from a drift higher in Libor. Money markets: Regulatory flanking maneuver 30 Money funds are at risk of being outflanked by regulators. Unhappy about the progress of the SECs reform efforts, press reports hint at an alternative regulatory tack that would declare money funds to be systemically important financial institutions (SIFIs).
Economics Dean Maki +1 212 526 1731 dean.maki@barcap.com
Interest Rates Strategy Ajay Rajadhyaksha +1 212 412 7669 ajay.rajadhyaksha@barcap.com www.barcap.com
PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 44
Barclays | Market Strategy Americas
FORECASTS
2011 % change q/q saar Real GDP Private consumption Public consump and invest. Residential investment Equip. & software investment Structures investment Net exports ($ bn, real) Net exports (contr to GDP, pp) Final sales Ch. inventories ($ bn, real) GDP price index Nominal GDP Industrial output Employment (avg mthly chg, K) Unemployment rate (%) CPI inflation (% y/y) Core CPI (% y/y) Core PCE price index (% y/y) Current account (% GDP) Federal budget bal. (% GDP) Federal funds rate (%) 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 Q1 0.4 2.1 -5.9 -2.4 8.7 -14.3 -424 -0.3 0.0 49.1 2.5 3.1 4.4 192 9.0 2.1 1.1 1.1 -3.2 Q2 1.3 0.7 -0.9 4.2 6.2 22.6 -416 0.2 1.6 39.1 -0.3 2.5 4.0 1.2 130 9.1 3.4 1.5 1.3 -3.3 Q3 1.8 1.7 -0.1 1.3 16.2 14.4 -403 0.4 3.2 -2.0 -1.4 2.6 4.4 5.6 128 9.1 3.8 1.9 1.6 -2.8 Q4 3.0 2.1 -4.2 11.6 7.5 -0.9 -411 -0.3 1.1 52.2 1.8 0.9 3.8 5.0 164 8.7 3.3 2.2 1.8 -3.2 Q1 2.2 2.9 -3.0 19.1 1.7 -12.0 -410 0.0 1.6 69.5 0.6 1.5 3.8 5.4 229 8.2 2.8 2.2 1.9 -2.9 2012 Q2 2.5 2.5 -3.0 8.0 10.0 10.0 -407 0.1 2.5 69.5 0.0 2.6 5.1 4.0 172 8.1 1.9 2.2 1.9 -2.9 Q3 3.0 3.0 -3.0 10.0 12.0 10.0 -408 -0.1 2.9 71.5 0.1 2.7 5.7 5.0 200 7.9 1.8 2.2 2.0 -2.9 Q4 3.0 3.0 -3.0 10.0 12.0 10.0 -409 -0.1 2.9 73.5 0.1 2.7 5.8 5.0 230 7.7 2.1 2.4 2.2 -2.8 Q1 2.0 2.0 -2.0 8.0 9.0 8.0 -408 0.0 2.1 77.5 0.1 2.7 4.7 4.0 170 7.6 2.1 2.6 2.3 -2.8 2013 Q2 2.5 2.5 -2.0 10.0 12.0 10.0 -414 -0.3 2.6 82.5 0.2 2.7 5.2 4.5 200 7.4 2.2 2.6 2.3 -2.8 Q3 2.5 2.5 -1.5 12.0 12.0 10.0 -424 -0.4 2.7 86.5 0.1 2.8 5.3 4.5 220 7.2 2.6 2.7 2.4 -2.8 Q4 3.0 3.0 -1.5 12.0 12.0 10.0 -434 -0.4 3.0 90.5 0.1 2.9 6.0 5.0 230 7.0 2.7 2.8 2.5 -2.8 Calendar year average 2011 1.7 2.2 -2.1 -1.3 10.4 4.6 -414 0.0 1.9 34.6 -0.2 2.1 3.9 4.1 153 8.9 3.2 1.7 1.4 -3.1 -8.7 2012 2013 2.4 2.4 -2.7 10.6 8.3 3.2 -408 0.0 2.2 71.0 0.3 2.0 4.5 4.7 208 8.0 2.2 2.3 2.0 -2.9 -7.1 2.5 2.6 -2.3 9.8 11.1 9.5 -420 -0.1 2.5 84.3 0.2 2.7 5.3 4.5 205 7.3 2.4 2.7 2.3 -2.8 -5.5
Ch. inventories (contr to GDP, pp) 0.3
Note: All numbers expressed in q/q saar % unless otherwise specified. The budget balance is fiscal year. Source: BEA, BLS, Federal Reserve, US Treasury, Barclays Research
SUMMARY OF VIEWS
Direction Curve/ Curvature Fiscal and European uncertainty likely to keep yields at current levels. Remain neutral on duration. Term premium in the front end is low, given the uncertainty about the economic outlook. Maintain vol-weighted 2s3s steepeners. Maintain 10s30s Treasury curve steepeners. Recommend hedging the mark-to-market risk by being short 10y TIPS. Remain neutral on the long 5s10s30s fly. Short the 5s7s10s fly, as the 7y sector look rich ahead of intermediate supply. Swap spreads Mar 13 FRA-OIS spread as a protection trade. 30y spread tighteners for asymmetric tightening risk. TY invoice spread tighteners hedged with 1y1y Libor-OIS for swapped issuance. Other spread sectors Front-end agencies have continued to outperform Treasuries; we recommend moving out to the 5-7y sector or owning front-end MTNs. Short-dated Bermudan callables offer an opportunity to fade the sell-off in rates and spike in vol. We remain constructive on Canadian covered bonds, given their relative isolation from Europe and continued significant spread pickup to agencies. Inflation Neutral on breakevens outside the very front end; overweight on 30y breakevens versus 10s. Long Apr13s covered BE hedged with energy. Long 10y relative TIPS ASWs, as the sector looks cheap. Long Apr17s versus Jan17s, as the floor premium on new 5s could rise with risk aversion. Volatility
Source: Barclays Research
Neutral 3m*10y, as there is little catalyst to push rates higher, but levels are already low. Short 2y*10y as low rate expectations push further out. 2y*10y is at 20%+ premium to 3m*10y.
10 May 2012
OUTLOOK
The ins and outs of the labor market

Peter Newland +1 212 526 3153 peter.newland@barcap.com
Flows out of employment into unemployment have fallen sharply since the end of the recession; jobless claims and layoffs are close to pre-recession levels. However, flows out of unemployment into employment have not risen materially, despite a pickup in job openings. We expect job growth to average about 200k per month, weak compared with previous recoveries from deep recessions but sufficient to push the unemployment rate lower.
Go with the flow

Job losses have eased considerably
Data on labor market flows (ie, the movement of workers between employment and unemployment and in and out of the labor force) can help illuminate shifts in payroll growth and the unemployment rate. For example, flows out of employment into unemployment have fallen consistently since the end of the recession, in line with the decline in initial jobless claims, which have reversed most of the increase during the recession (Figure 1). An alternative measure of job losses layoffs and discharges as measured in the JOLTS report paint a similar picture. Indeed, layoffs fell below pre-recession levels during 2011. In other words, the job loss side of the ledger looks much like one would expect for an economy three years into a recovery. However, the hiring side of the ledger remains very weak. In particular, the flow of workers from unemployment to employment, having stabilized in mid-2009, has barely risen since. Strikingly, this remains the case despite a significant pickup in job openings. The JOLTS measure of hiring tells a similar story (Figure 2). As we have written previously (see US Outlook: A not so refreshing Beveridge, 30 March 2012), we believe this in part reflects a mismatch between the supply of available labor (the unemployed) and the demand for labor (job openings). It also helps explain why long-term unemployment (defined as those out of work for six months or longer) has persisted at unprecedented high levels. This is particularly striking compared with the expansions that followed the deep recessions in the 1970s and 1980s (Figure 3) and is likely explained by the relatively weak pace of hiring in the current cycle. Taken together, the mismatch of available jobs and available workers and the persistence of Figure 2: Flow into employment yet to pick up significantly
ratio, 3mma 34 30 26 0.75 22 18 14 Jan-01 0.65 Outflow rate, unemployed to ratio, 3mma employed (lhs) 0.95 Ratio of openings to hires (rhs) 0.85
but hiring remains weak
and long-term unemployment very high
Figure 1: Flow from employment to unemployment falling

ratio, 3mma 2.2 2.0 1.8 1.6 1.4 1.2 1.0 Jan-01 Inflow rate, employed to unemployed (lhs) Initial jobless claims (rhs) 000s 700 650 600 550 500 450 400 350 300 250 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
0.55 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
Source: BLS, Labor dept, Barclays Research
Source: BLS, Barclays Research
10 May 2012
long-term unemployment suggest that the increase in unemployment during the downturn will prove partly structural, in our view.
Flow out of the labor force unlikely to be reversed in full
Job flow data can also shed light on movements in and out of the labor force. The outward flow, reflected in the decline in the labor force participation rate, has been notable in recent years. As we detailed in Dispelling an urban legend: US labor force participation will not stop the unemployment rate decline, 1 March 2012, we believe the majority of the decline can be explained by demographic factors, particularly the increasing retirement rates of the baby boom generation, and that a sharp rebound in participation (which would stall the downward trend in the unemployment rate) is very unlikely. The job flow data provide some supporting evidence: since the end of the recession, those leaving the labor force have increasingly been from employment (rather than unemployment). This is also reflected in the JOLTS data on separations, which show that layoffs and discharges have fallen sharply, while quits and other separations (including retirement) are now trending higher. On the flip side, those entering the labor market are increasingly doing so into employment, rather than into unemployment (Figure 4).
Layoffs have fallen as a share of separations
Where next for employment and the unemployment rate?

Employment growth likely to remain modest
Payroll growth reflects the net of new hires (those entering employment from unemployment or from outside the labor force) and job losses (either those entering unemployment due to layoffs or leaving the labor force due to retirement or for other reasons). With job losses having subsided, payroll growth will likely be driven by the hiring side of the equation. Hiring is picking up but has not kept pace with job openings. To the extent that this reflects structural factors, including the troubles of the long-term unemployed finding work, job growth is likely to remain modest compared with recoveries from previous deep recessions. We expect payroll growth of about 200k per month, in line with the recent trend (absent the likely boost from weather effects in the winter and subsequent payback in March and April). Meanwhile, flows into unemployment are, absent a shock to the broader economy, likely to continue to ease job losses have slowed, and we do not believe that a surge into unemployment from outside of the labor force is very likely. Combining these factors suggests that a modest pace of employment growth will be sufficient to push the unemployment rate lower.
but sufficient to push the unemployment rate lower
Figure 3: Long-term unemployment has barely declined

% unemployed 50 40 30 20 10 0 Jan-70 Long-term unemployed (lhs) Unemployment rate (rhs) % 12 10 8 6 4
Figure 4: Flows in and out of the labor force

000s, 3mma 4600 4400 4200 4000 3800 3600 3400
2
Flow from not in the labor force to employed Flow from employed to not in the labor force
Jan-80
Jan-90
Jan-00
Jan-10
3200 Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
10 May 2012
GDP TRACKING
Q1 GDP tracking 1.9%, Q2 tracking 2.5%

Peter Newland +1 212 526 3153 peter.newland@barcap.com
A deterioration in the trade balance in March was largely offset by an upward revision to February. Meanwhile, growth in wholesale inventories was weaker than expected in March. The net result was a one-tenth reduction in our Q1 GDP tracking estimate. The real trade in goods deficit widened more than the BEA had assumed at the time of the first Q1 GDP estimate. However, this was largely offset by an upward revision in February, suggesting that net trade will remain broadly neutral for Q1 GDP growth (Figures 2 and 3). Wholesale inventories outside of the auto sector rose a softer-than-expected 0.3% in March. This subtracted 0.1pp from our tracking estimate (Figure 1), although inventory accumulation is still likely to have added to growth in Q1. The April vehicle sales report remains the only hard data released for April. Sales rose to 14.4mn, broadly in line with the average in Q1. Our Q2 GDP tracking estimate stands at 2.5%. Figure 1: GDP tracking*
Release date 27-Apr 30-Apr 1-May 1-May 2-May 9-May 10-May 15-May 15-May 16-May
Indicator GDP Personal spending Construction spending Vehicle sales Factory orders Wholesale inventories Trade Retail sales Business inventories Housing starts
Period Q1-1st March March April March March March April March April
Q1 tracking 2.2 2.2 2.2 2.2 2.0 1.9 1.9
Q2 tracking
2.5 2.5 2.5 2.5
Figure 2: GDP growth contributions

Q4 3rd estimate % q/q (saar) Real GDP Consumption Govt. spending Res. investment E&S investment Structures Net exports, $bn Ch inventories, $bn 3.0 2.1 -4.1 11.7 7.5 -1.0 -411 52.2 1.5 -0.8 0.3 0.6 0.0 -0.2 1.7 Cont. (pp) Q1 1st estimate % q/q (saar) 2.2 2.9 -3.0 19.0 1.7 -12.0 -410 69.5 2.0 -0.6 0.4 0.1 -0.3 0.0 0.4 Cont. (pp)
Figure 3: Net trade

$bn (saar) -400 NIPA basis, quarterly -450 -500 -550 -600 -650 -700 -750 Jan-08 Customs values, monthly
Jan-09
Jan-10
Jan-11
Jan-12
Source: BEA, Barclays Research
Source: BEA, Census Bureau, Barclays Research
Note: *Our GDP tracking estimate is distinct from our published GDP forecast. It reflects the mechanical aggregation of monthly activity data that directly feed into the BEAs GDP calculation.
10 May 2012
DATA REVIEW & PREVIEW

Dean Maki, Michael Gapen, Peter Newland, Cooper Howes Review of last weeks data releases
Main indicators Consumer credit, chg, $ bn Wholesale inventories, % m/m Trade balance, $ bn Import prices, % m/m (y/y) Nonpetroleum import prices, % m/m (y/y) Treasury budget balance, $ bn Period Mar Mar Mar Apr Apr Apr Previous 9.3 R 0.9 -45.4 R 1.5 (3.6) R 0.3 (0.7) R -40.4 ('11) Barclays 8.5 0.5 -49.0 0.0 0.1 60.0 Actual Comments 21.4 0.3 -51.8 Continues to be driven by growth in student loans Small negative for our Q1 GDP tracking estimate Strong rise in non-petroleum goods imports
-0.5 (0.5) Largely reflected drop in petroleum prices 0.0 (0.3) Sharp decline in prices of industrial supplies 59.1 First monthly budget surplus since 2008
Preview of the next week

Monday 14 May Period Prev 2 Prev 1 Latest Forecast Consensus
No significant events or releases

Tuesday 15 May 8:30 8:30 8:30 8:30 8:30 8:30 8:30 9:00 Retail sales, % m/m Retail sales ex autos, % m/m Core retail sales, % m/m CPI, % m/m (y/y) Core CPI, % m/m (y/y) CPI, NSA index Empire State mfg, index Net long-term TIC flows, $ bn Period Apr Apr Apr Apr Apr Apr May Mar Mar May Prev 2 0.6 1.1 1.0 0.2 (2.9) 0.2 (2.3) 226.665 19.5 19.1 0.6 28 Prev 1 1.1 1 0.5 0.4 (2.9) 0.1 (2.2) 227.663 20.2 102.4 0.8 28 Latest 0.8 0.8 0.4 0.3 (2.7) 0.2 (2.3) 229.392 6.6 10.1 0.6 25 Forecast 0.2 0.2 0.4 0.0 (2.2) 0.2 (2.3) 229.9 11.0 0.4 27 Consensus 0.2 0.2 0.1 (2.4) 0.2 (2.3) 230.0 9.0 0.5 26
10:00 Business inventories, % m/m 10:00 NAHB housing market, index
Retail sales: We expect retail sales to increase 0.2% m/m in April. Within non-core components, we are looking for a small gain in auto sales (in line with the rise in unit sales reported by the main suppliers) to be largely offset by a decline in gasoline, in line with the decrease in prices relative to March on a seasonally adjusted basis. Elsewhere, we are also looking for a solid 0.4% gain in core sales, in line with the increase in March. CPI: We are looking for a flat m/m reading on the CPI in April, consistent with an NSA CPI index print of 229.9, up from 229.392 in March. Within this, we expect a negative contribution from energy (notably gasoline) prices and a small increase in food prices, alongside a 0.2% rise in the core CPI. We continue to believe that core price gains will be underpinned by persistent gains in the heavily weighted core services components, particularly shelter. Core goods prices are likely to be more volatile but we expect them to, on net, add to the core CPI over the coming months as well. Empire state mfg: While the Empire State manufacturing index declined in April, the new orders component was little changed and the employment index experienced a solid increase. Given that, we look for a rebound in the headline index to 11.0 in May. NAHB housing market: We look for the NAHB housing index to increase to 27 in May from a print of 25 in April. This would keep the index in line with levels that, until the boost likely caused by warm weather in the first few months of 2012, have not been seen since 2007.
10 May 2012
Barclays | Market Strategy Americas Wednesday 16 May 8:30 8:30 9:15 9:15 Housing starts, thous saar Building permits, thous saar Industrial production, % m/m Capacity utilization, % Period Apr Apr Apr Apr Prev 2 714 682 0.7 78.7 Prev 1 694 715 0.0 78.7 Latest 654 764 0.0 78.6 Forecast 685 0.4 79.0 Consensus 678 735 0.5 79.0
12:30 St. Louis Fed President Bullard (FOMC non-voter) speaks in Kentucky 14:00 Minutes of FOMC meeting released 24-Apr
Housing starts: We expect housing starts to rise 4.7% m/m in April to 685,000 units. While single-family starts were flat last month, multi-family starts fell 17% on the month. The strong 26% m/m increase in multi-family permits suggests that this will be reversed in the coming months, and we look for some of that to be reflected in the April report. A rise to 685,000 units would return starts to the Q1 average of 687,000 units and well above 2011 levels. It would also provide confirmation that improvements in homebuilder sentiment, falling inventory, and a robust rental market are translating into better start activity. We continue to expect residential construction to add to GDP growth in the coming quarters. IP: We are looking for a 0.4% m/m increase in industrial production and manufacturing output in April. Headline industrial production growth has been volatile in recent months, largely reflecting swings in the mining and utilities components, likely partly related to the warmer-than-usual weather over the winter. Excluding these, manufacturing output posted a small decline in March (-0.2%), following very strong gains in December, January, and February. Our forecast for a rebound in April reflects the increase in the production component of the ISM survey, as well as small gains in manufacturing employment and hours worked during the month. We also expect a small positive contribution from auto output, consistent with production schedule data. FOMC minutes: We read the tone of the April FOMC statement as indicating that the Fed does not expect to conduct further asset purchases or continue its maturity extension program beyond June. In addition, several participants brought forward the expected timing of the first rate increase. Therefore, we look for the minutes of the April FOMC meeting to provide additional insight into why Chairman Bernanke characterized monetary policy as being in the right place and how the committee came to adjust its forecast in favor of stronger growth (in 2012), higher inflation, and a lower unemployment rate. We also look for the minutes to provide further context about how the committee views the decline in the unemployment rate and what conditions would be necessary to begin further purchases of securities. One other aspect to watch will be whether a couple of members still judged that, in April, additional asset purchases may be warranted, as was the case in March.
Thursday 17 May 8:30 Initial jobless claims, thous (4wma) Period May-12 May Apr Prev 2 392 (383) 10.2 0.2 Prev 1 368 (384) 12.5 0.7 Latest 367 (379) 8.5 0.3 Forecast 365 (373) 10.5 0.2 Consensus 10.0 0.2
10:00 Philadelphia Fed mfg, index 10:00 Leading indicators index, % m/m
12:35 St. Louis Fed President Bullard (FOMC non-voter) speaks in Kentucky
Philadelphia Fed mfg: We expect the Philadelphia Fed manufacturing index to rise to 10.5 in May, partially offsetting the decline last month. Like the Empire State, the April Philadelphia Fed manufacturing index experienced only a small decline in the new orders index and a strong improvement in the employment index despite a headline decrease. Leading indicators: We look for the Conference Board's index of leading indicators to rise 0.2% in April. We expect interest rate spreads and building permits to provide solid positive contributions, but these will be largely offset by negative contributions from initial claims and consumer confidence.
Friday 18 May Period Prev 2 Prev 1 Latest Forecast Consensus
No significant events or releases
10 May 2012
TREASURIES
Another reason to worry

Anshul Pradhan +1 212 412 3681 anshul.pradhan@barcap.com
We remain wary of fading the rally, given a modest growth outlook and strengthening linkages between sovereigns and banks in Europe. We instead recommend shorting 7s versus the wings for normalization of QE expectations and intermediate supply ahead. Treasury yields gradually drifted lower as economic data weakened somewhat; our economists tracking estimate of Q1 GDP fell to 1.9% from 2.2% at the beginning of the month due to lower inventory accumulation, but mainly in response to higher uncertainty in Europe following the elections in France and Greece. The spread of French government yields to German yields has remained elevated and that of Italy and Spain has widened over the week (Figure 1). The latter was likely due to increased concerns about public finances being used to shore up the banking system.
European financial spreads have caught up with sovereign spreads given strengthening linkages between sovereigns and banks
Given the political uncertainty and even stronger linkages between European banks and sovereigns following the LTRO led bank demand for government securities, we remain wary of fading the rally. Figure 2 shows that since the beginning of the year, banks in Italy and Spain have increased their holdings of government securities by ~30%. In the recent flare up, spreads of European financials have caught up with sovereign spreads (Figure 3). Liquidity injected via the LTROs only helped financials outperform temporarily as the underlying sovereign concerns were not really addressed; CDS spreads on Spanish government debt are now trading at wider levels than late last year, and those of Italy and France have reversed 50% and 60% of the move, respectively. Another reason we are cautious in fading the rally is that expectations of USD L-OIS basis have more room to widen before they catch up with European financial spreads. Figure 4 shows that over the past few months, 1y fwd L-OIS expectations have been driven mainly by European bank credit risk. Even though the latter has reversed more than half of the move tighter, L-OIS expectations have not risen much; they could easily be 10bp higher. In such a scenario, US yields are unlikely to be higher (see the swaps piece for a discussion on how to best position for a flare up).
USD Libor-OIS expectations have room to widen, given the level of European financial spreads
Figure 1: Recent political changes in Europe have done little to alleviate uncertainty
Spreads of 10y Govt bonds vs Germany, % 5.5 5.0 4.5 4.0 3.5 3.0 2.5 Jan-1
Figure 2: Linkage between European banks and sovereign are even stronger now
$bn 350 325 300 275 250 225 200 175 150 Dec-10 Mar-11 Jun-11 Italian Banks Sep-11 Dec-11 Spanish Banks Mar-12 A 28% 28% in holdings of A increase in holdings of general general government government securities securities
1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9
Jan-22
Feb-12 Mar-4 Mar-25 Apr-15 Spain Italy France, rhs
0.8 May-6
Source: Bloomberg
Source: EUDATA, Haver Analytics
10 May 2012
Modest economic data in US do not argue for much higher yields
Finally, recent trends in US economic data do not justify much higher yields. Our economists Q1 real GDP growth tracking estimate is now 1.9% and real final sales over the last year have also grown at ~1.9%. While growth is indeed expected to pick up, consensus forecast is for 2.3% growth in 2012 and 2.5% in 2013; our models suggests that 2-2.5% growth is consistent with about spot 10y yields of 2%. In addition to the European sovereign risk, the downside potential from fiscal tightening next year should prevent investors from extrapolating upside surprises this year (please read Will the bond market selloff be sustained? March 22, 2012, for a detailed discussion). Such an outcome should keep the Fed in wait-and-see mode, with the outlook neither weak nor strong enough to announce any policy changes. Given that the markets expectations of further stimulus have risen substantially, as evident in the richness of the belly of the curve and the low level of real yields, we believe investors should position in the near term for a normalization of such expectations instead of position for much higher yields. At similar level of yields, the belly was much cheaper earlier this year. We recommend shorting the 5s7s10s fly, which should also benefit from intermediate sector supply. We also maintain our 10s30s steepener view as fundamentally the curve looks too flat given current expectations of monetary policy and the levels of long term inflation expectations, though investors should consider hedging it by shorting real yields to benefit from an unwind of QE expectations. While long-end supply being behind us argues for a near-term flattening as the concession is unwound, the setup that happened mainly in the morning heading into the auction has already been unwound, in our view. 30y yields rose 7bp until 1pm on Thursday but ended the day almost unchanged as the auction came through by 2.5bp. Similarly, the 10s30s curve steepened ~2bp until 1pm but ended the day slightly flatter. Hence, the risk of a flattening from a further unwind of the concession seems low.
We recommend shorting the 5s7s10s fly, as excessive expectations of further stimulus should normalize and the auction concession should build in the belly
We maintain our 10s30s steepener view, as the setup ahead of the bond auction already seems to have been unwound
RV opportunity in shorter maturity HC securities

With ongoing Fed sales in the front end but stable short-term yields, relative value opportunities in the high coupon space have gone unnoticed. We recommend switching from the rich high coupon issues, 9.875% Nov 15s, to the cheaper ones , 11.25% Feb 15s, as the latter have unduly cheapened after becoming eligible for Fed sales under Twist.
Figure 3: European bank spreads are now catching up with European sovereign spreads
400 350 300 250 200 150 100 50 0 Jan-10 May-10 Oct-10 Feb-11 Jul-11 Dec-11 Apr-12
Figure 4: Risk aversion, USD Libor-OIS spread, has room to rise

375 325 275 225 175 125 May-11 80 70 60 50 40 30 20 Jul-11 Sep-11 Nov-11 10 Jan-12 Mar-12 May-12
Average Sovereign 5y CDS Spreads, bp European Senior Financial 5y CDS Spreads, bp

Source: Bloomberg
European financials,5y CDS spreads, LHS, bp 1y fwd 3M LOIS Expectations, bp, RHS
Source: Bloomberg
10 May 2012
High coupon Feb 15s and May 16s are trading cheap and HC Nov 15s are trading rich
One way to judge the relative cheapness is to compare the discount at which P STRIPS from the high coupon (old 30y) series are trading versus their lower coupon (10y series) counterparts (Figure 5). There does not seem to be a consistent trend, and there is a fair bit of variation in how the high coupon issues are asset swapping versus the low coupon issues; Feb 15s/May 16s are ~2bp cheaper, whereas Nov 15s are 6bp richer. This was not always the case: Figure 6 shows that Feb 15s cheapened quite dramatically in February, when they first became eligible for sale, and May 16s also cheapened later, even though they are well beyond the 3y maturity. Nov 15s, on the other hand, have drifted steadily richer. While some of this variation can be explained by the difference in the available float, Feb 15s and Nov 15s are still outliers. Figure 7 plots the relative cheapness of high coupon issues against the available float (outstanding minus the amount held by the Fed). The higher the float, the cheaper the issue is. For instance, the cheapness of May 16s can be attributed to the almost $13.2bn available float as compared with a median float of $5.6bn. Still, Feb 15s look 2bp cheap and Nov 15s are 2bp rich. Even though Aug 15s float is $1bn lower and Feb 16s is only $0.2bn higher, they are ~3bp cheaper to Nov 15s. The cheapening of Feb 15s since the beginning of the year is only partly justified by sales under Operation Twist. The Fed has sold ~$2.2bn since February, increasing the float outstanding to $8bn. The Fed currently holds $2.5bn but with the recent declining trend of the amount sold and only two operations left, it is unlikely that the float will increase materially (Figure 8). It therefore seems odd that Feb 15s are trading at similarly cheap levels of May 16s. We therefore recommend investors switch from 9.875% Nov 15s to 11.25% Feb 15s (in whole bond or STRIPS space); we expect the yield spread of P STRIPS to compress by 4bp.
Feb 15s appear cheap and Nov 15s rich, even after controlling for the level of available float
We recommend switching from HC Nov 15s to HC Feb 15s
Figure 5: No consistent trend in the relative pricing of high coupon Issues

-20 -22 -24 -26 -28 -30 -32 -34 -36 -38 Feb-15 Nov-15 May-16 Ps ASW - 30y series May-17 May-18 Ps ASW - 10y series
Figure 6: HC Feb 15s cheapened recently as they became eligible for Fed sales; spread versus LC counterpart
4 2 0 -2 -4 -6 -8 Jan-12
Feb-12 Feb 15s
Mar-12 Nov 15s
Apr-12 May 16s
May-12
10 May 2012
10
Figure 7: Feb 15s look cheap and Nov 15s rich, even after accounting for the differences in available float
Discount of 30y P STRIPS to 10y P STRIPS 3 Feb 15s 2 1 0 -1 -2 -3 -4 -5 -6 0 2 y = 0.55x - 4.95 Nov 15s 4 6 8 R = 0.64 10 12 14 Available Float, $bn
2
Figure 8: Fed sales of HC Feb 15s have declined quite sharply; not much of a risk to a long view
$bn 1.6 1.4 1.444
May 16s
1.2 1.0 0.8 0.6 0.4 0.2 0.0 2/23/12 3/29/12 4/27/12 5/29/12 June Amount Sold of 11.25% Feb 15s
Source: New York Fed, Barclays Research
0.661
0.11
10 May 2012
11
INFLATION-LINKED MARKETS
A glance at foreign holdings

Michael Pond +1 212 412 5051 michael.pond@barcap.com Chirag Mirani +1 212 412 6819 chirag.mirani@barcap.com
Foreign investors have become an important demand base in the TIPS market. The update to the annual TIC holdings report has finally provided some detail. These data show that foreign accounts owned $206bn TIPS as of June 2011, a figure we expect to continue to grow.
Finally, some outside data

In early 2009, when the 10y breakeven got near zero, foreign investors came in to buy. This in itself was not an oddity because there had been tactical trading from that demand base before and we also viewed breakevens as cheap to fundamentals. The surprise was that even once breakevens recovered, not only did those positions not get unwound, but buying continued. Whereas before 2009 there were few foreign official institutions with structural allocations to the TIPS market, they seemed to have been drawn in by relative value, but became structural buyers because of diversification and concerns about the potential for a declining USD. Others also realized that a neutral weight to TIPS was at least some level above zero, given that TIPS make up about 7.5% of outstanding Treasuries. While we have discussed this changing demand base, there has been little official data as evidence to which we could point. Finally, the Treasury has included a breakout of TIPS in its update of its annual TIC holdings survey of foreign investors, and it shows some interesting results. As of June 30, 2011, the data show that foreign accounts owned $206bn in TIPS, of which $136bn was held by foreign official institutions. This means that whereas foreign accounts own about 50% of all US Treasuries, they owned only about 27% of the TIPS market. Foreign official accounts, which owned about 18% of the TIPS market, had a lower relative holding: they accounted for about 75% of total foreign-owned Treasuries, whereas they only accounted for about 66% of foreign-owned TIPS holdings.
As of June 30, 2011, the TIC data show that foreign accounts owned $206bn in TIPS
Figure 1: Foreign holdings of Treasuries as of June 30, 2011 Top 10 holders of TIPS
Treasury long-term debt (1) Treasury short-term debt 5 72 2 7 64 64 4 13 12 36 5
Countries and Regions China, mainland Middle East oil-exporters Taiwan Singapore Japan Cayman Islands Brazil United Kingdom Switzerland Luxembourg Australia
Total 1,307 189 147 64 882 111 216 130 118 124 21
Total 1,302 117 144 58 818 47 212 118 106 88 17
of which: Nominal 1,266 97 125 40 805 36 201 108 97 81 11
of which: TIPS 37 20 20 18 13 11 11 10 10 7 6
TIPS as % TIPS as a of Total % of LT 2.8% 10.6% 13.3% 28.3% 1.5% 9.9% 4.9% 7.5% 8.2% 5.3% 27.2% 2.8% 17.2% 13.6% 31.5% 1.6% 23.5% 5.0% 8.3% 9.1% 7.5% 35.0%
Note: (1) Long Term (LT) denotes original maturity of over one year. Source: US Treasury
10 May 2012
12
A few data highlights stick out. China is reported to have owned the most TIPS among foreign accounts at $37bn, though this is only 2.8% of Treasury holdings, whereas TIPS accounted for about 4% of total foreign ownership of Treasuries (Figure 1). Middle East oil exporters, Taiwan, and Singapore come in a close second, third and fourth with about $20bn each in TIPS holdings. Singapore, Australia and Malaysia have over 30% of long-term Treasury holdings in TIPS, and Denmark is not far behind with a 26% allocation. Of its $151bn in Treasury holdings, Russia owns just $21mn in TIPS.
The regional breakout (Figure 2) shows that Asia owned the most TIPS, at $117bn
The regional breakout (Figure 2) shows that Asia owned the most TIPS at $117bn; we believe this largely represents foreign official holdings. Europe and the Caribbean owned $44bn and $15bn, and we believe this is held mostly by money managers and hedge funds. If foreign accounts were to move to a market neutral weight, which would be about 7.5% of total Treasuries, this would mean holding about $350bn, or about $147bn more than June 2011 levels. We would argue that foreign accounts should actually hold greater than a market weight allocation to TIPS because they offer a de facto currency hedge relative to nominal Treasuries. Therefore, while structural buying has been strong and the Treasury has responded to additional demand through increased issuance, we believe structural foreign demand will continue to grow with the market. We hope more detail will follow on the history on foreign ownership of TIPS, but are happy to have gotten some hard data.
Figure 2: Foreign holdings of Treasuries as of June 30, 2011 regional breakdown

Treasury long-term debt (1) of which: Nominal 3,843 of which: TIPS 206 Treasury shortterm debt 658 TIPS as % of Total 4% TIPS as a % of LT 5%
Countries and Regions Total of which: Holdings of foreign official institutions Total Africa Total Asia Total Caribbean Total Europe Total Latin America Canada Total Other Countries Country Unknown International and Regional Organizations
Total 4,708
Total 4,049
3,518 36 2,962 212 1,041 318 45 25 0 68
3,103 24 2,658 111 851 288 36 19 0 63
2,968 24 2,540 96 807 273 31 13 0 59
136 0 117 15 44 15 4 6 0 4
414 12 304 101 190 30 9 6 0 6
4% 0% 4% 7% 4% 5% 9% 24% 16% 6%
4% 0% 4% 14% 5% 5% 12% 32% 19% 7%
Note: (1) Long Term (LT) denotes original maturity of over one year. Source: US Treasury
Buying at auction accounts for less than half of holdings

Also providing evidence of increased foreign involvement in the TIPS market are the Treasurys auction allotment data. Since 2009, foreign accounts have bought an average of $1.27bn at 5y TIPS offerings, compared with about $730mn before 2009 (Figure 3). Similarly, the average 10y auction takedown by foreign and international accounts has been $1.5bn, whereas before 2009 it had been $668mn (Figure 4). However, the sum of all TIPS bought by foreign and international accounts since 2000 is about $70bn. The total holdings data of $206bn as of June 2011 indicate that this was only a small part of the demand coming from abroad.
10 May 2012
13
Figure 3: 5y TIPS auction allotment to foreign accounts ($mn)

2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 Oct-05 Apr-07 Oct-08 Apr-10 Aug-11
Figure 4: 10y TIPS auction allotment to foreign accounts ($mn)

3,000 2,500 2,000 1,500 1,000 500 0 Apr-06 Jul-07 Oct-08 Jan-10 Jan-11 Nov-11
Foreign and international

Source: US Treasury Source: US Treasury
Foreign and international
10 May 2012
14
AGENCIES
Back in black
James Ma +1 212 412 2563 james.ma@barcap.com Rajiv Setia +1 212 412 5507 rajiv.setia@barcap.com
With foreign interest in agency bellwethers returning, we examine the first Fannie Mae quarterly profit to taxpayers since conservatorship. While both GSEs could stay roughly profitable near term, a dividend-rate redefinition would remove significant uncertainty.
Foreign participation remains robust; opportunities remain

Well above average foreign participation in recent 5y bellwether issuance, in our view, reflects market participants comfort with GSE credit, which Fannie Maes (FNM) 1Q12 results should boost. At +27bp to matched-date Treasuries, we believe the 5y sector still has tightening potential, as does the 7y point at T+33bp (Figure 1). We concur in our base-case view that the remaining $125bn/$150bn in post-2012 capital support will more than suffice to support the GSEs over the next few years, as the high credit quality, post-conservatorship vintages have become a 55%-and-growing share of the guarantee books (Figure 2). This should allow enough time for Congress to hammer out housing finance reform. Furthermore, the Treasury can unilaterally increase the margin of safety, and time, by modifying the senior preferred dividend rate.
We expect remaining PSPA capacity post-YE12 to more than suffice
Fannie Mae 1Q12 financials: The beginning of the end (of provisions)
FNM avoided a loss to taxpayers for the first time since postconservatorship
Fannie Mae posted net income of $2.7bn in 1Q12 after a $2.4bn loss in 4Q11, the first positive quarter since 4Q10, before paying $2.8bn in senior preferred dividends to the Treasury. Owing to a mark-up in AOCI, FNM did not make a request for more capital during the period, the first such quarter since the conservatorship. Factors in the improvement occurred across the board: a reduction in credit loss provisions, increase in net interest income, and modest MTM gains on derivatives all contributed.
Credit provisioning reduces sharply; reserves expected to suffice

FNM provisioned just $2.0bn for credit losses in 1Q12 after $5.5bn in 4Q10, as single-family loss severities decreased to 33% after reaching 37% in late 2011. In our view, this seems in line with the sharp recent reduction in serious delinquency rates at FNM. Notably, FNM Figure 1: Agency-Treasury spread curve stays steep
A-T Spd, bp 50 40 30 20 10 0 0 2 4 6 8 10
Figure 2: Guarantee book quality varies sharply by vintage

780 760 740 720 700 680 660 <=2004 2006 2008 2010 1Q12 120% 100% 80% 60% 40% 20% 0%
Maturity, y FNM
MTM LTV FNM, R

FHLB
MTM LTV FRE, R FICO FRE, L
FRE
FICO FNM, L
10 May 2012
15
Figure 3: Provisions approach our estimated total needs

180 160 140 120 100 80 60 40 20 0 FHLMC Loss provision
Figure 4: NPA balances increase, but more slowly

in 000 loans FNM 651 114 629 219 1,613 17,738 9.10% 298 10.70% FRE 401 59 314 123 897 11,425 7.90% 166 9.50% Total 1,052 173 943 342 2,510 29,163 8.60% 464 10.30%
$bn
165
90d+ Delinquencies, as of 1Q12 REO on Balance Sheet, 1Q12 Cum REO Liquidations, 3Q081Q12
85 160
Cum Short Sales/DIL, 3Q08-112 Total NPA Loans, as of 1Q12 Total Loans Serviced As a % of Guarantees Total NPA Loans, in $bn
79
FNMA Barclays' estimated credit loss
As a % of Guarantees in $bn
estimates that with the $2.0bn in credit provisioning it recognized this quarter, its balance of loan loss reserves would be sufficient to cover future losses on the legacy guarantee book. With this balance at $75bn, the $85bn in cumulative charge-offs since 2008 imply total legacy guarantee losses of $160bn; this is roughly in line with our own estimates. 1 This dovetails with FNMs expectation that credit-related expenses will be less in 2012 than 2011 (which were $26bn). The same calculation at FRE gives $83bn in guarantee losses from $38bn in reserve balances and $45bn in charge-offs (also close to our estimates, Figure 3).
Balance of loss reserves and cumulative charge-offs in line with our projections
Recall that our estimates were based on cumulative NPA reaching $550bn at both GSEs with a 45% severity rate, for combined credit losses of $250bn. Our view was partly predicated on lower recovery from the MIs, to which FNM/FRE have $90bn and $40bn of exposure, respectively. As of Q1, the GSEs have recognized $464bn (Figure 4). If housing rebounds strongly, it is possible our default and severity estimates may prove high. The fact that the GSEs provisioning has been in line with our more punitive estimates indicates that FNM/FRE have been conservative in provisioning for losses on their legacy book of business.
Net interest income stays stable; MTM items swing to gains

Net interest income improves, but we see reasons for portfolio revenues to erode
Net interest income improved in 1Q12 at FNM to $5.2bn, after totalling $4.5bn the previous quarter, as funding costs fell. Along with slow prepayments, this has made the portfolios a profitable revenue stream for the GSEs (Figure 5), a pattern likely to continue over the next few years. However, in the medium term, mandatory portfolio shrinkage (at least 10% per year), increasing NPA, and rising funding costs could all erode net interest income. Derivatives positions led to a MTM $280mn gain at FNM in Q1, up from the $800mn loss in 4Q11 (note that FRE booked a $1bn loss in Q1). The level of rates should remain a large source of volatility in GSE earnings: for instance, the 5y swap rate has rallied 20bp quarterto-date, a move that would likely lead to a FAS 133-related charge in Q2. OTTI has remained minimal at $60mn recognized in income. Also, AOCI in owners equity was marked up $400mn, leading to the zero draw in Q1. We are less sanguine about such markups to offset taxpayer lossesat currently high dollar prices/low durations, the retained portfolios higher-coupon MBS have more limited scope for price appreciation.
US Agencies Outlook 2012 Achtung baby, 13 December 2011
10 May 2012
16
A pause in draws bolsters our views on GSE credit

By making no draw this period, FNM has kept its balance of senior preferreds outstanding at $117bn through 1Q12 (FRE has also stayed stable at $72bn). We would not be surprised to see FNM stay just at the cusp of profitability for the balance of 2012, but would anticipate sustainable profits once loss provisioning for legacy guarantee losses ceases in 2013. Consider the below stylized GSE income statement (Figure 5): We assume the guarantee books stay stable at $4.7trn combined (ie, the GSEs maintain market share) and fee rates stay at 25bp the Treasury has diverted revenues from the last fee hike (10bp) to fund the payroll tax cut extension, and we expect any future fee hikes to be similarly siphoned. This leaves $11.75bn/year in revenues, assuming minimal prospective credit losses. At a 180bp NIM and $1.3trn size, the retained portfolio throws off $23bn in net interest income in 2012; however, as the portfolio is mandated to shrink 10%/year, this revenue stream decreases, for instance to $20.7bn in 2013. With credit provisioning finished in 2012, the main source of expenses will be the senior preferred dividend payments, which at 10%/year is near $20bn combined.
We expect GSE profitability to be ultimately temporary, requiring Treasury action
This simplistic exercise implies that the GSEs could become profitable for a period in the medium term in our base case, even assuming a 10% preferred dividend. However, draws would continue if: a) NIM compresses, b) the portfolios shrink, or c) both occur. Thus, to increase the margin of safety in case of a double dip in the economy, we recommend the Treasury redefine the senior preferred dividend to the lesser of 10% or all the net income in a period. Note that no congressional approval would be needed for this; pending the outcome of the elections, this may occur as early as December.
Stress case scenario and implications for the future of housing finance
In this vein, we have received increasing inquiries on how long the remaining capital ($125bn at the larger FNM) would last after YE12 in a stress case. Using a stylized example: The $125bn in capital remaining post-YE12 supports a mortgage portfolio of about $2.8trnthis would be exhausted with roughly 5% losses on the post-conservatorship book. Assuming severity rates near the current 40%, the implied default rate is 12.5%. Figure 5: Stylized GSE income statement
Projections, $mn Guarantee income (25bp on $4.7trn) Net interest income (1.8% on $1.3-> $1.15trn) Expenses ($0.5bn/quarter each) Credit provisioning (est) Net income before senior pfd dividend Senior preferred dividend Net income to the taxpayer 2012 11,750 23,400 -4,000 -14,000 17,150 -19,400 -2,250 2013 11,750 20,700 -4,000 0 28,450 -19,625 8,825
Figure 6: GSEs continue to short fund

70% 60% 50% 40% 30% 20% 10% 0% Jan-01 Jan-03 Jan-05 Jan-07 Bullet Jan-09 Jan-11 Callable
Short-term
Source: Barclays Research Source: Barclays Research
10 May 2012
17
Per our colleagues in residential credit strategy, this is consistent with another 20% HPI decline and/or a spike in unemployment to 13-14%; as the underlying mortgages are higher-quality origination, the latter would be more significant.
A stress case scenario may not need to occur for GSE funding to be disrupted
We think a stress scenario such as the one above is not particularly useful. The fact remains that in the event that market shocks tighten financial conditions and lead investors to conclude that another double-dip in housing is likely, a lack of capital support at the GSEs will trigger market instability even before credit losses materialize. The simple fact is that the GSEs funding is still extremely reliant on continued market access. Consider that about 40% of the GSEs funding is either discount notes or callable debt (Figure 6); FNM/FRE would face refunding difficulties well in advance of their capital being drawn down. We also believe the entrenched interests in FNM/FRE, including Fed ownership of $950bn in their debt and MBS, are too great for the government not to act to prevent any adverse outcome such as the above. Further, in the near term, given that there are no viable alternatives to the GSEs for housing finance, any market shock would have severe ripple effects on global capital markets. For instance, foreign capital would likely flee the mortgage market. By our measures, foreigners hold about $1trn in agency MBS and debt combined. Moreover, in this macro environment, banking sector losses would also be substantial and require government support. Given the numerous steps taken by policymakers to support housing thus far, the scenario above is far-fetched.
We continue believe the simplest way to increase the margin of safety is a dividend redefinition
Despite our base case view that the GSEs will become profitable before preferred dividends by next year, we continue to recommend that the Treasury adjust the preferred coupon, preferably to the lower of 10% or all net income in any given quarter. In our view, this would increase the margin of safety available to debt/MBS investors, and ensure that: Future dividends are not paid with still more draws, a problem in past quarters. The credit and capital situation at FNM/FRE cannot become a cause of financial instability and investor concern. Windfall gains are not given to junior preferred and common equity holders. In our view, such a course of action would buy sufficient time for true housing finance reform, both for Congress to agree on replacements and for household and bank balance sheets to heal enough to accommodate a new system. While the 1Q12 FNM result is a positive and squares well with our loss estimates, the GSE business model is not sustainable in the long run. Therefore, we expect the government to act sooner rather than later to address some of these concerns and prevent undue turbulence in global markets. We believe it would be prudent to do so before YE12, when the PSPA limits return.
10 May 2012
18
SWAPS
May 2010 all over again?

Amrut Nashikkar +1 212 412 1848 amrut.nashikkar@barcap.com
Given the return of European concerns, we believe that near-dated FRA-OIS wideners have attractive risk-reward profiles. They should benefit even if Libor rises for a few days in a row, and the downside is limited, in our view, given Libors recent stability. Greek and French election results last week sparked renewed concerns about a crisis in Europe, sparking a flight to quality and a widening of front-end swap spreads. Libor registered its first increase in two weeks, even though it was a tenth of a basis point and driven by the Libor setting of only one bank. Given the extreme degree of uncertainty until the middle of June, when Greece has payments due, we still recommend buying protection in the form of Libor-OIS spread wideners.
The resurgence of European sovereign risk has led protection trades to perform well
The optimal point for buying protection is now at the very front end
In Simmers of Discontent, published on April 12, we introduced two metrics to determine the optimal forward starting point for buying Libor protection: The ratio of the upside to the 1y range in putting on a widener, assuming a move in FRA-OIS comparable with that of September last year over the next three months, after accounting for roll-down. A higher ratio means that the point is further away from the high of last year and closer to the lower end of the range. The risk in the trade, represented by the volatility of the particular forward Libor-OIS spread over the past year. Based on these metrics, we recommended Libor-OIS wideners with 2y forward starting dates. However, over the past four weeks, there has been a widening of this spread, and from a rolldown point of view, the trade is no longer as attractive (Figure 1). In fact, long-dated forward Libor-OIS spreads are now wider than at the peak of last year. Figure 1 suggests that the risk reward of buying FRA-OIS protection at the very front end, has improved significantly. The market is pricing in only a 1bp widening in spot Libor-OIS
Figure 1: 3m3m Libor-OIS wideners now offer a better risk reward profile than spreads further out
Upside/1y range 75% 70% 65% 60% 55% 50% 45% 40% 1m3m
Figure 2: The average European bank has higher Libor sets than the average non-European bank
60 58 56 54 52 50 48 46 44 42 40 Feb-12
Mar-12 Avg US bank setting Avg EUR bank setting
Apr-12
May-12
3m3m
6m3m 1y3m 9-May-12
2y3m
Avg UK bank setting
10 May 2012
19
spreads over the next month. A short-term widener would benefit from any risk flare but should not lose too much otherwise, considering that Libor has been stable at its current levels and the European crisis is likely to continue. Furthermore, given the momentum the market prices in the forward spread curve once Libor begins to widen, a 1m or a 3m forward starting widener should do well even if Libor merely rises for three or four days in a row. We believe that the chances of that happening are high, and the trade can be reevaluated at that stage. The question is whether a near-term increase in Libor that would make these trades perform is possible.
However, it might now make sense to initiate neardated FRA-OIS wideners rather than long-dated ones
The link between Libor-OIS and sovereign risk

Since the beginning of the financial crisis in 2007, the Libor settings of European banks have generally been higher than those of US banks. This can be seen in Figure 2 while the Libor sets of US and UK banks declined significantly over the past three months, those of European banks have lagged. This is because of a dollar asset-liability mismatch in Europe and because Europe has experienced the sovereign and the associated banking crisis. This can be seen in Figure 3, which shows that the average USD Libor setting of banks belonging to a particular country is higher if the sovereign CDS of the country trades at a higher level. This relationship is as true today as it was three months ago. For instance, while French sovereign CDS has deteriorated, the average French bank 3m Libor setting has not risen. This, in itself, suggests that a rise in Libor is possible.
The increase in sovereign and bank CDS spreads over the past month suggests that a nearterm rise in Libor is possible
Furthermore, the recent increase in European banks CDS has yet to be reflected in their Libor settings. This can be seen from Figure 4, which shows a plot of spot 3m Libor-OIS spreads against European financial CDS spreads. Since 2009, an increase in CDS spreads has usually preceded a rise in Libor, and a decrease in CDS has preceded a fall in Libor. When viewed in this light, a rise in Libor back to the levels of January 2012 does not appear farfetched. With a one-month lag, a monthly increase of 40bp in European bank CDS spreads should lead to a 1m rise in Libor of 5bp. Considering that this is comparable with the increase in bank CDS spreads over the past month, it would be consistent with the historical pattern if Libor rose by 5bp.
Figure 3: Libor settings of banks are strongly related to the health of their sovereigns
Avg Libor set (bp) 65 60 55 50 45 US 40 35 25 Swiss UK 75 125 Sov. CDS (bp)
Figure 4: Changes in the European financial CDS index precede changes in 3m Libor-OIS by about a month
3mLOIS MoM
30
France 3 months ago Current Japan Germany
20 10 0 -10 -20 -30 -100
-50
50
100
175
225
Itraxx- SNRFIN 5y (MoM 1m lagged)

10 May 2012
20
FUTURES
TU too rich
Amrut Nashikkar +1 212 412 1848 amrut.nashikkar@barcap.com Vivek Shukla +1 212 412 2532 vivek.s.shukla@barclays.com
The front TU contract appears rich, driven by positioning; we recommend purchasing the two potential CTD securities basis heading into the roll month. In tandem, selling ATM straddles can be used to establish a position that performs well across scenarios. As the front TU front contract enters the M2-U2 roll month, it appears rich, as evidenced by a negative net CTD basis (Figure 1) and high implied repo rates. One possible reason is the recent increase in long positions by asset managers and other reportable investors, because these tend to be less price sensitive categories. The two classes of investors have increased their net long positions, as a percentage of open interest, by 30pp and 5pp, respectively, since the end of March (Figure 2).
Trade outline and rationale

Given the richness of the TU contract, we think going long the basis of either of TUM2s close CTDs. The risk-return profile is even better if we combine basis positions in the two close CTDs. Assuming a notional of $10mn, we recommend buying $10mn par of 1.75% Mar14s, buying 10mn par of 1.25% Mar14s and selling 93 TUM2 ($200k notional) contracts against the cash securities. Since basis positions are effectively options on the yield curve and slope, the combined position is effectively a long straddle position, while taking advantage of the current richness of the contract. The position benefits from the net basis increasing to zero at expiration. Further, considering the recent long build-up by asset managers and other traders, there could be cheapening pressure on TUM2 during the roll, so this is a good time to establish the position, in our view.
Implied repo rates and the net bases of the two CTD contenders suggest that TUM2 is rich
Since the combined basis position has a payoff at expiry similar to that of an option straddle, we can monetise it by selling straddles with an offsetting payoff. Specifically, against the basis positions highlighted earlier, we recommend selling five TUN2 call options struck at 110.25 (ATM) and five TUN2 put options struck at 110.25 (ATM).
Figure 1: TUM2 net basis for the two potential CTDs appears rich (32nd)
2.0 1.5 1.0 0.5 (0.5) (1.0) (1.5) (2.0) (2.5) 05-Apr 12-Apr 19-Apr 26-Apr 03-May -1.4
Figure 2: CFTC reports shows that asset managers and other reportables have increased their net longs in the TU contract
As % of open interest 20% 10% 0% -10% -20% -30% 13-Mar 22-Mar 31-Mar 09-Apr 18-Apr 27-Apr
1.75% Mar14s Net Basis

1.25% Mar14s Net Basis
Dealer Net Long Asset Manager Net Long Leveraged Money Net Long Other Reportables Net Long
Source: CFTC, Barclays Research
10 May 2012
21
CTD switch under different yield curve and slope scenarios

Two securities can be the CTD at the time of last delivery date for the TUM2 contract: 1.75% Mar14s (current implied repo of 40bp) and 1.25% Mar14s (current implied repo of 41bp). Under scenarios of an increase in 2y rates or a 2s3s curve steepening, the former is more likely to be the CTD, given that it has slightly higher modified duration, while the opposite is true for the latter.
In our view, a combined basis position in the two CTDs is attractive across rate scenarios
Based on the historical relationship between 2y yields and the 2s3s curve, where the curve steepens 0.7bp for every 1bp sell-off, and vice versa, we have considered scenarios of 2y yields declining 25bp or increasing to 55bp in increments of 5bp, and 2s3s curve steepening 8-30bp correspondingly. We use these scenarios to judge the performance of the proposed trade in Trade Details below. Before we proceed with the analysis of the trade, it is reasonable to ask what range of changes in the level of 2s and the slope of 2s3s we can expect over the next 50 days (ie, until the futures delivery date). Over the past year, with the Fed firmly indicating that it expects to keep target rates at exceptionally low levels, 2y rates have been range-bound between 55bp and 15bp. Thus, the ranges considered above are reasonable. No other security, apart from 1.75% Mar14s and 1.25% Mar14s, comes close to being the CTD in any of the scenarios.
Trade details
Instead of putting on a vanilla long CTD basis position, combining the 1.25% Mar14 and 1.75% Mar14 basis positions makes more sense, in our view. Under scenarios where one of the two securities happens to be CTD, its net basis is zero. However, the other security will have a positive net basis, as it is not the CTD. Thus, these two basis positions can be combined using appropriate weights to produce the desired risk-return profiles. Simplistically, combining these two basis positions in a 1:1 ratio produces the net basis at expiration profile outlined in Figure 3. Intuitively, when futures prices are below 110.2 (ie, in sell-offs and curve steepenings), 1.75% Mar14 becomes the CTD; hence, its net basis at expiration is 0. In these scenarios, the overall P&L is driven by the richening of the basis of 1.25% Mar14s (in addition to benefiting from the basis of the CTD increasing from the current -1.3 ticks to zero). The opposite is true for rates rallies or curve flattenings. The Figure 3: Net basis at expiration of recommended trade in each of the considered rate scenarios
Basis, 32nd 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 109.4 109.6 109.8 110.0 110.1 110.3
Figure 4: Combined payoff of options + futures position
32nd 2.00 1.50 1.00 0.50 (0.50) (1.00) (1.50) (2.00) 109.4 109.6 109.8 110.0 110.1 110.3 Futures Price Options position payoff
Futures Price
Basis payoff
Net
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22
trade also earns carry on the long cash note position in both legs. We have assumed that the positions can be financed at overnight repo rates until expiration at 13bp.
Given the straddle-like payoff of the combined basis position, one can also sell TUM2 straddles to monetise its positive convexity, in addition to benefiting from the richness of the futures
Further, this payoff profile can be monetized using options on TUM2 contracts; hence, the premium can be collected upfront. For the scenarios considered, Figure 4 outlines the payoff from selling five ATM (strike 110.25) TUN2 straddles for every 100 long futures positions, collecting an upfront premium of 0.21 ticks. It also shows the combined payoff at expiration from the overall strategy (ie, long two basis positions, short two options). The net payoff line is close to zero at expiration. In other words, this position does not depend on which of the assumed scenarios is realized. The total payoff will be the option premium collected, plus the profits from the net basis increasing to 0 from negative levels.
10 May 2012
23
VOLATILITY
Skew blues
Piyush Goyal +1 212 412 6793 piyush.goyal@barcap.com
The payer skew is higher than can be justified by rates or the delivered rate-vol relationship. We suggest knock-out payers to those looking for higher rate protection. The payer skew on 10y tails has richened lately, reflecting market worries about higher rates (Figure 1). We think some of this is justified, given low rate levels; nonetheless, it may have gone a bit too far and warrants monetization. Fundamentally, payer skew is an argument about "lognormal rates." If rates are low, the possibility of a 10bp decline is not the same as a 10bp rise, so rates are lognormal. This holds true for front-end rates or for those in Japan. But 10y rates in US, especially in forward space, while historically low, are not low enough to justify such lognormal expectations. For example, the 3y forward 10y swap rate is 2.92%, clearly not low enough to suggest a 10bp decline is not as possible as a 10bp rise, or even a +/- 50bp change.
US skew is high
The fair comparison, from a purely rates perspective, is with the EUR market, where 10y rates are quite similar. For example, the 3y10y EUR swap rate is roughly 2.7%, which is actually lower than the USD rate. Even so, the EUR skew is not as high as the US skew (Figure 1). To be fair, EUR skew has been richening rapidly, but even so, the USD skew is now almost as high as it was in H2 09, when there was significant demand for high-rate positioning. That demand was also manifested as higher vol: 3y*10y was roughly 30bp/y higher than current levels. This brings us to the questions whether there should be any skew, and how much. The answer to the first is easier: the current level for US rates is unambiguously low, and the risk of a large sell-off (say, 200bp) is more than a large rate rally. So there should be some skew. To quantify the size of the skew, we looked at delivered skew over the past few years. Figure 2 plots the daily change in 3y*10y normal vol, along with 3y10y swap rate since the beginning of 2009. We use early 2009 as the start date because the Fed eased to near zero on fed funds, and even longer rates fell to historical lows. The period since then shares the generally low rate environment to which skew has been subjected. Figure 1: USD payer skew has richened, is much higher than EUR where rates are similar
3y*10y 100bp HS - 100bp LS skew (bp/y) 30 25 20 15 10 5 0 -5 -10 -15 Nov-04 Nov-05 Nov-06 Nov-07 US
Nov-08 EUR
Nov-09
Nov-10
Nov-11
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There are two key takeaways. There is a conspicuous relationship between rate and vol: higher vol has generally escorted a rise in rates. Two, even during the past few months (starting September 2011), when a sell-off has eluded rates, there has seen a visible relationship. So as already argued, some skew is justified. But the regression since September 2011 suggests a 100bp change in rates leads to only a 3bp/y change in vol. So the fair value of a 200bp wide skew is perhaps 6bp/y, much lower than the 19bp/y that it is priced. Even with the longer history since January 2009, the value for the 200bp wide skew is not justifiable beyond 14bp/y.
While some skew should exist, current levels are higher than can be justified by the delivered rate/vol relationship
However, the markets pricing in much higher payer skew reflects the presence of flows. Most likely, there continues to be demand for higher rate protection, with investors positioning for/hedging the specter of higher rates via out-of-the-money payer swaptions. Also, 1x2 receiver ladders are in vogue. For example, a 3y*10y 1x2 receiver ladder (2.5 vs. 1.95) costs nothing and does not incur a loss unless the 10y swap rate is lower than 1.4% three years out. With the Fed fighting deflation, it is not unreasonable to expect 10y swaps to end higher than 1.4%. These ladders also carry well. As investors buy high-strike payers or sell low-strike receivers via the 1x2 receiver ladders, the skew ends richer than can be fundamentally justified. Overall, skew is higher than can be justified by the rate backdrop or the rate/vol correlation. Therefore, we recommend monetizing the same.
Skewering the skew

Investors looking for higher rate protection should exploit the skew valuations with knock-out payers
Investors looking for higher rate protection should consider knock-out payers. A 3y*10y 3% payer that knocks out at 5% (so no pay-off if rates are higher than 5% three years later) is 40%+ cheaper than a comparable 3y*10y 3%-5% payer spread (Figure 4). The lower cost improves the pay-off from the structure. The payer spread has a risk-reward of ~1:4.5, while the knock-out payer has a risk-reward of more than 1:8.
Figure 2: 100bp rise in rates means ~7bp/y rise in 3y*10y vol

Daily change 3y*10y (bp/y) 10 8 6 4 2 0 -2 -4 -6 -8 -60 -40 -20 0 20 y = 0.070x - 0.008 R = 0.178
2
Figure 3: More recently, 100bp corresponds to 6.4bp/y

Daily change 3y*10y (bp/y) 4 3 2 1 0 -1 -2 -3 -4 -40 y = 0.032x - 0.059 R = 0.093 -30 -20 -10 0 10 20 30
2
40
60
Daily change in 3y10y rate (bp)

Note: Data period: January 1, 2009-May 10, 2012. The chart shows that daily changes in normal 3y*10y vol is noticeably correlated with rates. Source: Barclays Research
Daily change in 3y10y rate (bp)

Data period: September 1, 2011-May 10, 2012. Source: Barclays Research
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Figure 4: Knock-out payer has attractive risk-reward due to high payer skew
3y10y 3% vs. 5% payer spread Spot 10y rate 3y fwd 10y swap rate Cost (cts) Cost (bp swap01) Max pay-off Risk-reward 2.02% 2.90% 386 45 200 1:4.5 3y10y 3% payer KO = 5% 2.02% 2.90% 211 25 200 1:8.1 3y10y 3% payer KO = 5%, if payer skew = 0 2.02% 2.90% 343 40 200 1:5
Note: Pricing as of May 10, 2012. Source: Barclays Research
Further, this pay-off is attractive only because the payer skew is high. To quantify this effect, consider this: if the payer skew were flat, ie, high-strike options were priced at the same vol as low-strike ones, the same knock-out payer would have required 60% more premium outlay, meaning a much smaller risk-reward of 1:5 (Figure 4).
10 May 2012
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BMA
Sell 3y ratios
Piyush Goyal +1 212 412 6793 piyush.goyal@barcap.com James Ma +1 212 412 2563 james.ma@barcap.com
SIFMA is setting lower than Libor than is priced by front-end ratios. Sell 3y ratios to earn carry and benefit from a drift higher in Libor. Long-end ratios could come off as municipal yields catch up with sentiment in Treasuries. Sell 15y15y outright or as a 15y-30y flattener. Across the curve, BMA ratios have been stuck in a range for many weeks. 2y and 5y ratios have traded within 60-62bp and 76-78bp, respectively, for the past two months. At the same time, 30y ratios have drifted marginally higher from 90 to 92 ratios. Clearly, the level of rates matters, and as rates have been range-bound for multiple months, ratios have failed to deliver a large change. Long-end ratios, we believe, could catch up with the shorter-end ratios, leading to a lower and flatter BMA ratio curve. Therefore, we like a 15y-30y ratio flattener, which also happens to be at attractive entry levels. Separately, Libor has started drifting higher, and may cause front-end ratios to take another leg lower. So, we like selling 2y-5y ratios, with 3y ratios offering the best carry/realized vol ratios. We begin by focusing on the front-end.
Low for long

Front-end BMA ratios are low in a historical context as SIFMA is low relative to libor
Selling the front-end BMA ratio has been a clear trade for the past few months. 1y ratios nosedived in the second half of last year from roughly 90bp to 40bp, before inching higher and stabilizing at c.50 ratios in the past couple of months. Alongside, 2y and 5y ratios have been pulled lower (Figure 1). This has been the result of a spike in Libor relative to SIFMA last year (Figure 2). Essentially, Libor represents the credit risk of the 18 banks in the Libor panel, more than half of which are European. Whereas, SIFMA is a combination of a pristine municipal issuer and (mostly American) bank credit risk. Given that the Euro zone is the epicenter of the sovereign crisis, a low SIFMA set alongside Libor shooting higher is fathomable, in our view.
Figure 1: Front-end ratios plummeted, then stabilized

100 90 80 70 60 50 40 Jan-10 61 51 77
Figure 2: SIFMA did not participate in the rise of Libor

0.6 0.5 0.4 0.3 0.2 0.1 0.0 Dec-09
Jul-10
Jan-11 1y
Jul-11 2y 5y
Jan-12
Jun-10 SIFMA
Dec-10
Jun-11
Dec-11 3m OIS
3m Libor
Note: Last data point as of May 9, 2012. Source: Bloomberg
Note: Last data point as of May 9, 2012. Source: Barclays Research
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Even if SIFMA continues to set within 20-25bp for many months, at current 50 ratio levels, a short position in 1y BMA would generate gains, as long as 3m Libor sets higher than 45bp2. That Libor has already started inching higher suggests to us that even 50 ratios may prove high for 1y. It is noteworthy the Eurodollar futures market is pricing 49bp on 3m Libor by mid-June and 53bp+ by September this year. Higher-than-expected Libor sets will only bring the ratio further lower.
Front-end ratios could decline further due to higher Libor sets; sell 3y
Admittedly, for 1y, levels are already low. Therefore, we like selling 2y-5y ratios. To pick the best point, we look for the highest 3m carry to realized vol ratio along the curve. The one with the highest ratio is the most attractive, as it has the highest carry along with the best probability of making that carry (ie, lowest realized vol). Figure 3 shows the results: 3y ratios offer the best carry adjusted for realized vol. So we like selling 3y ratios to earn carry as well as benefit from higher Libor set.
The tide is turning

The long-end ratios, we think, may be peaking out too. Fundamentally, long-end ratios are driven by the level of rates higher rates imply lower ratios and vice versa. Figure 4 plots the level of 30y BMA versus 30y Treasuries for the past seven years. There are two key takeaways from this chart. One, higher rates mean lower ratios and vice versa. Two, recently, for the same level of Treasury yields, ratios have been somewhat lower.
Long-end ratios could come off too
The latter can be explained by the outperformance of municipal yields relative to Treasury yields in the first quarter of the year. Figure 5 plots the 30y Treasury yield and 30y MMA yield alongside the ratio of the two. Around mid-2011, municipal yields lagged the decline in Treasury yields, which is a typical price action in a flight-to-quality-related rally in Treasuries. However, Treasury yields have stayed range-bound since, and municipal yields have declined more, reflected as a lower ratio.
Figure 3: 3y ratios offer the best carry/realized vol ratio

2y Spot 3m Fwd 3m Carry 60 Realized vol (%/day) 3m Carry/ realized vol ratio 61.0 64.5 3.5 0.44 8.0 3y 67.9 70.7 2.8 0.28 9.9 4y 73.6 75.3 1.7 0.25 6.8 5y 76.8 77.9 1.1 0.24 4.5
Figure 4: Higher rates mean lower ratios and vice versa

30y BMA 120 110 100 90 80 y = -12.463x + 138.71 70 60 2 3 4 30y Treasury 5 6 Jan '05 - Dec '12 2012 YTD Regression
Note: As of May 9, 2012. 3y ratios offer the best carry/realized vol ratio. 3m forward 3y ratio = 70.7, implying 2.8 ratios as three-month carry (= 70.7 67.9). The 60-day realized vol is 0.28 ratios/day, implying that the three-month carry is 9.9 times the realized vol. Source: Barclays Research
Note: Data period: January 1, 2005 to May 8, 2012. Source: Barclays Research
receive 50% of 45bp vs. pay an average 22.5bp on SIFMA , assuming SIFMA sets within 20-25bp
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The Treasury yields would likely stay low for a very long time, maybe for all of 2012 and possibly further out. The collapse in short-dated vol is reflective of such market expectations. 3m*10y has fallen from 120bpy+ in mid-November last year to about 75bp/y now, which also happens to be its lowest level since the Lehman crisis in 2008. Incidentally, very recently, 3m*10y pierced through 85bp/y, a level it had previously bounced off five times since the crisis. Such low levels of short-dated vol point to the low-for-long expectations for Treasury/ swap yields.
.as the supply-demand dynamic in municipal bonds is positive; implying municipal yields could catch up with the low-for-long sentiment in Treasuries
With such sentiment in Treasuries, we think it is only a matter of time that the municipal yields catch up with the Treasury yields. We would have thought otherwise, but the supplydemand dynamic in municipals is positive too as the issuance is quite low and inflows into the municipal bond funds are still positive (Figure 6). Accordingly, as the ratio of municipal to Treasury yields come off, a lower BMA ratio is in the offing. Those who are wary of a blow up in the Eurozone and therefore are not convinced of a short in long-end BMA, can hedge the short in 30y with a short in 3y ratios, or consider a 15-30y ratio curve flattener, which also happens to be at good entry levels.
Figure 5: Municipal yields are set to catch up with Treasuries

5.5 5.0 4.5 4.0 3.5 3.0 2.5 Jan-10 170 155 140 125 110 95 80 Jul-10 30y tsy Jan-11 30y mma Jul-11 Jan-12 30y mma / tsy ratio
Figure 6: Municpal bonds funds are seeing inflows

3 2 1 0 -1 -2 -3 -4 -5 -6 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11
Muni fund flows ($bn)

Source: Haver Analytics
Source: Bloomberg. Barclays Research
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MONEY MARKETS
Regulatory flanking maneuver

Joseph Abate +1 212 412 6810 joseph.abate@barcap.com
Money funds are at risk of being outflanked by regulators. Unhappy about the progress of the SECs reform efforts, press reports hint at an alternative regulatory tack that would declare money funds to be systemically important financial institutions (SIFIs).3 Section 165 of Dodd-Frank would give the Federal Reserve Board broad and discretionary authority to set prudential standards covering capital, liquidity, and counterparty exposure limits. A SIFI designation might require significantly higher money fund capital buffers than the 1-3% the SEC has advocated. Money funds would be subject to tighter counterparty credit exposure limits. Unlike current SEC mandates, these limits are insensitive to counterparty credit rating or collateral type. It is unclear if an expanded regulatory role for the Federal Reserve might also include redemption gates or floating NAVs. We suspect that talk of SIFI designation and Dodd-Frank Sec 165 is primarily meant to bring the SEC and the industry back to the negotiating table.
Getting nowhere
The SEC was expected to release a follow-up to its May 2010 money market reforms sometime in the first quarter of 2012. But so far, the SEC has yet to put any official proposal on the table for addressing destabilizing flight risk from (largely) institutional investors in money funds. Regulators are interested in requiring money funds to shift to a floating NAV structure or mandating that stable NAV funds maintain capital buffers (of 1-3%) and redemptions gates (of perhaps, 3% for 30 days).4
Figure 1: Top 10 borrowing banks (% taxable fund balances)

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 A B C D E F G H I J
Figure 2: Top 10 complexes (% total industry assets)

18 16 14 12 10 8 6 4 2 0 A B C D E F G H I J
Source: Cranes Data, Barclays Research

3 4
Source: Federal Reserve, Barclays Research See, Regulators Seek Plan B on Money Funds, A. Ackerman and V. McGrane, Wall Street Journal, May 8, 2012 See, Money Market Fund Reform: State of Play, Market Strategy Americas, April 5, 2012
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Regulators, the industry and SEC are divided about further MMF reform
Unsurprisingly the industry has consistently expressed its unhappiness with these proposals for a number of reasons including the prohibitive cost and the potential for investors to leave the industry all together. At the same time, Congress has entered the fray with two members of the House Committee on Financial Services expressing concern that the SEC has not done enough spade work regarding the consequences of these radical reforms.5 Curiously, even the SECs five commissioners are divided: as near as we can tell, there appears to be an even divide between supporters and opponents of additional requirements with the fifth member (Aguilar) reportedly as yet undecided. In short, additional regulatory reform of money funds seems to have stalled.
Plan B
Are money funds SIFIs?
Unhappy with the lack of progress and the concerned that systemic risk stemming from money fund investor behavior has not been adequately addressed, regulators appear to be considering a different tack that is, declaring money funds to be SIFIs and subjecting them to Section 165 of the Dodd-Frank Act. This section of Dodd-Frank governs non-bank financial companies and places them under enhanced supervision and prudential (regulatory) standards from the Feds Board of Governors. It is unclear at what level Sec 165 would apply the individual money fund or the overall complex, although this weeks Wall Street Journal article seems to imply the latter. This is potentially fairly significant because there are very few individual money funds with more than $50bn in assets. By contrast, applying this at the sponsor level would capture most of the taxable fund industry given the high degree of asset concentration at only a few large money fund complexes. The top 10 money fund families hold 75% of industry assets or $1.8trn, and two-thirds of these holdings are concentrated at the biggest five money funds (Figure 1). Applying the $50bn threshold at the sponsor level would cover the top 14 money funds or 85% of industry assets. In addition, it isnt clear how the $50bn Section 165 threshold would be applied. The systemic risk from government-only funds or money funds that cater mostly to retail investors is significantly lower than it might be for prime funds with institutional investors. But prime institutional funds account for 39% of the industrys assets although, like the broader industry, these assets are also highly concentrated at a handful of complexes. Of course, shoehorning all money funds into the same regulation regardless of asset and investor composition is probably not an efficient way of managing systemic risk.
Plan B let the Board of Governors regulate money funds
Regulatory Plan B, would give the Board of Governors a fair bit of oversight in setting prudential regulatory standards for governing money funds. These standards would cover everything from minimum capital requirements to enhanced public disclosures and limits on leverage and short-term borrowings. Clearly, for money funds, leverage and restrictions on the issuance of short-term debt arent particularly meaningful. However, we believe that the key areas where Sec 165 really starts to bite are with respect to its capital and counterparty mandates.6 But, would the application of Sec 165 really make much difference to an already conservatively managed and tightly regulated industry?
Big capital buffers

Money funds might need to hold capital buffers greater than 3%
Under Sec 165, a non-bank financial would be required to hold capital something money funds do not currently have to do and something they strongly oppose. But unlike the SECs draft proposal, which points to a capital buffer of between 1% and 3%, the minimum capital requirement under Dodd-Frank could be considerably larger. Dodd-Frank requires that non5 6
See, J. Hensarling and M. Baucus letter to M. Schapiro, April 17, 2012 It should be noted here that we are not lawyers, so we may miss the finer points of law implied by Dodd-Frank.
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bank financial companies have the same risk-based capital requirements as traditional banks (Sec 171). This would mean that money funds would need to have Tier 1 capital of 4% and total risk-based capital of 8%. The Board of Governors could decide not to impose such a stringent capital requirement if it felt that money funds were already subject to sufficiently prudent regulation. Moreover, there is a bit of legal ambiguity in interpreting the capital requirement under Dodd-Frank and whether it is applies to an investment company where the assets are under management and not owned by the fund. But given the Boards well publicized concerns about systemic risk we doubt that it would agree to any buffer less than 1%. Nonetheless, and given the fair amount of discretion the Board of Governors has with respect to setting capital buffers, we would not expect that money funds will ever be required to hold an 8% risk based buffer. That said, given the opposition money funds have to the SECs proposal, we suspect that a capital buffer exceeding 3% would inspire even more vehement objections.
Counterparty exposure limits

And concentration limits would be sharply lower
Just as difficult is the potential for money funds to be subject to counterparty exposure limits imposed under Dodd-Frank. The maximum exposure would be limited to 25% of the capital stock of the fund. Even allowing for a relatively high (in our judgment at least) required capital buffer of 3%, Dodd-Frank limits concentration to just 0.75%. Moreover, the concentration limit is the same regardless of the credit rating of the counterparty or if it is collateralized with government securities. This is considerably more restrictive than current SEC mandates, which allow money funds to hold up to 5% of their assets in the securities of any particularly issuer (although most funds are no where near that upper boundary). Instead, the numerical example above (assuming a 3% capital buffer) would point to an upper limit on counterparty exposure that is only marginally higher than the current 0.5% limit for Tier 2 counterparties. The top 10 borrowers together account for 27.1% of all taxable money fund assets or nearly 3% on average for each well over the estimated Dodd-Frank limit for each borrower of 0.75% (Figure 2). We assume that the Board would exempt government repo from the calculation of concentration limits, although this is by no means certain.7 Removing government repo from the total lowers money fund concentration against the top 10 borrowers to 15% of overall taxable assets still well over the limits that would apply if Sec 165 was fully applied. As we have written elsewhere, the sharp reduction in government paper (particularly Agency discount notes) alongside the shrinkage in dealer repo balance sheets has created a problem for money funds looking for product in which to invest their $2.4trn. Shrinking it further by imposing tight restrictions on concentration risk might make running a prime fund prohibitively unattractive.
Dodd-Frank says nothing about floating NAVs or redemptions gates
Dodd-Frank says nothing about floating NAVs and redemption gates. But, given the broad discretion Dodd-Frank gives to the Board of Governors to set prudential standards this doesnt completely eliminate gates and floating NAVs from the regulatory menu. A number of Fed officials at the Board and elsewhere have expressed strong interest in both gates and floating NAVs.8 Consequently, while not mentioned and likely to face stiff opposition from the industry, such regulations might still be applied under Dodd-Frank.
The Fed is also concerned about repo market funding beyond the issue of intra-day credit in tri-party markets. See, for instance, Regulatory Reform since the Financial Crisis, D. Tarullo, Council on Foreign Relations speech, May 2, 2012
8
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Carrot or stick?
Is SIFI status meant to motivate negotiation
Of course, any move to declare money funds SIFIs would be met with a stiff legal challenge and presumably some political pressure. A recent posting to the Presidents Working Group on Money Market Fund Reform raised legal questions and inconsistencies in the application of Dodd-Frank Sec 165 to money funds.9 Moreover, broad-brush regulation and the application of bank minimum (risk based) capital standards along with counterparty exposure limits might be less efficient ways of addressing flight risk at money funds. And given the generally dim view the Fed takes of the industry as evidenced by the proliferation of papers on the financial crisis and the role of money market funds and repo as intensifying and contagion factors, money funds might prefer to engage the SEC now to craft regulations that are potentially less onerous that what would be the case under Dodd-Frank. As a result, we strongly suspect that press reports about SIFI designation are meant primarily to encourage money funds and the SEC back to the negotiating table.
See, John Hawke letter to the SEC, May 4, 2012
10 May 2012
33
TRADE PORTFOLIO UPDATE
Still trading sideways

The portfolio gained $110k over the past week. It is up $2.69mn for 2012 and has gained $42.8mn since inception.10 Figure 1: Mark-to-market performance of the portfolio Cumulative P&L, $mn
Millions 45 40 35 30 25 20 15 10 5 0 Jan-09 Aug-09 Feb-10 Sep-10 Mar-11 Oct-11 Apr-12 $42.8
Note: As of May 10, 2012. Portfolio stop loss = $10mn. Given this total loss allowed, we allocate $500k as the stop-loss for high-conviction trades and less for low-conviction trades. Source: Barclays Research
Total equity = $100mn, stop-loss = $10mn

We estimate an initial and variation margin for each derivative trade and a haircut for cash trades. The total of all such margins and haircuts is less than $100mn. In other words, the portfolio is assumed to have $100mn of equity. Thus, all returns are computed on a base of $100mn. Any unused equity is invested in fed funds and assumed to earn the daily funds rate.
10
Since January 2009.
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Trade Portfolio
New Positions
Inception Date Treasury 5/10/2012 5/10/2012 BMA 5/10/2012 Theme Relative Value Fading 7yr Trade Short HC Nov '15 Ps vs. HC Feb '15 Ps Short 5yr - 7yr - 10yr Weights/Notional Amount $50k dv01 $50k dv01 Levels @ Inception 6.25bp -12.2bp Current Level 5.75bp -12.4bp Net Change (Gain (+) /Loss (-)) ($25,000) ($10,000) Total Stop Loss (bp) ($500,000) ($500,000) Horizon 1m 1m Initial Margin Variation Margin $25,000 $10,000 Total Margin
$2,000,000 $2,000,000
$2,025,000 $2,010,000
Sell Front-end Ratios
Short 3y ratio
$200mn
67.375
68
($20,000)
($250,000)
6m
$800,000
$20,000
$820,000
Note: All prices as of May 10, 2012. Source: Barclays Research
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Trades Outstanding
Inception Date TIPS 8/5/2011 11/2/2011 1/12/2012 3/29/2012 4/19/2012 Theme Trade Weights/Notional Amount 12k dv01, Short 40 XBH2 (XBM2) $30k dv01; 45 contracts $500mn 45k dv01 $50k dv01 Levels @ Inception -60.5bp, 267.76 -103bp, -36bp, 249.83 Libor - 13bp 33bp 6bp Current Level Net Gain (+) /Loss (-) $711,000 $585,000 $450,000 $17,000 $0 Stop Loss (bp) Horizon Initial Margin Variation Margin ($711,000) ($585,000) ($450,000) ($17,000) $0 Balance Sheet Used $6,987,000 $289,000 $1,565,000 $2,050,000 $1,483,000 $1,600,000
Long TIPS Normalization Front-end Asset Swap Tightener Relative Value Eurozone contagion
Long July'12 TIPS energy hedged; bought 20 XBM2 on 4/6/12 for 327.66 Long Apr' 13 TIPS vs. sell 2% CPI cap and sell XBH3 Long Jan '14 TIPS ASW Long TII Jan 22 Relative Asset Swap Long Apr '17 vs Jan '17
-369bp, 300 -108bp, -19bp, 267 Libor - 13bp 29bp 5bp
$0 ($500,000) ($250,000) ($500,000) ($500,000)
1y Maturity 6m 6m 1y
$1,000,000 $2,150,000 $2,500,000 $1,500,000 $1,600,000
Treasury 4/20/2012 4/26/2012 Low front-end term premium Bond auction concession Vol weighted 2y - 3y steepener 10y-30y tsy curve steepener $80k dv01: ($50k dv01) $50k dv01 -2bp 117.2bp -4.5bp 120.2bp ($125,000) $150,000 ($500,000) ($500,000) 1m 2m $2,000,000 $1,000,000 $125,000 ($150,000)
$2,975,000 $2,125,000 $850,000
Swaps / Futures 1/6/2012 4/6/2012 4/19/2012
$7,177,500 Issuance Front-end spd widener Relative Value Sell 30y spreads March '14 FRA-ois (USFOSC8) widener Sell TYM2 Invoice spread vs. 1/3rd dv01 1y1y libor-OIS $50k dv01 $50k dv01 $50k DV01 -31bp 38.5bp 12.15bp -27.5bp 39.25bp 18.7bp ($175,000) $37,500 ($327,500) ($250,000) ($250,000) ($500,000) 4m 3m 1m $1,812,500 $2,000,000 $2,900,000 $175,000 ($37,500) $327,500 $1,987,500 $1,962,500 $3,227,500
Options 1/15/2009 Longer Rates could Rise Buy 5y*10yr Payr Spd (ATM vs 100 bp high), $100mm: - $100mm added the short CMS cap @ 5% on 7/2/10 ; sell 6w*10y payer @ 2.75% on Nov 10 '11 Short 5x10 US caps @ 8% vs Long 5x10 EUR ($75mm): EUR 50mm caps @ 5% Buy 3y*10y payer @ 5% Sell 3y SL 10y CMS $50mn: ($350mn) Cap @ 5% Sell TYM2 straddles 100 Sell TYM2 straddles Sell TYM2 straddles Sell TYM2 straddles Sell TYN2 straddles Sell TYN2 straddles Long 1y2y payer spread vs 1y10y payer spread Long 6m1y payer spread vs. short 6m7y payer spread Long 3m1y payer spread vs. short 3m7y payer spread Long 1y1y payer spread (0.55% vs 1.05%) 200 100 100 100 100 $90mn: $20mn $490mn: ($100mn) $490mn: ($100mn) $100mn ($1,924,000) ($885,000) $1,039,000 ($250,000) 4y $2,892,500 ($1,039,000)
$21,894,225 $1,853,500
10/15/2009 2/17/2011 3/9/2012 3/29/2012 4/6/2012 4/12/2012 4/19/2012 4/26/2012 8/18/2011 1/6/2012 2/9/2012 2/3/2012
Cross -currency Relative Value Sell US Gamma Sell US Gamma Sell US Gamma Sell US Gamma Sell US Gamma Sell US Gamma Eurozone contagion Eurozone Contagion Eurozone contagion Eurozone contagion
($200,000) ($100,000) ($245,313) ($440,625) ($190,625) ($193,750) ($221,875) ($192,188) ($130,000) ($340,000) ($110,000) $105,000
$370,000 $0 ($230,313) ($560,625) ($190,625) ($183,750) ($186,875) ($192,188) ($10,000) ($40,000) $270,000 $105,000
$570,000 $100,000 $15,000 ($120,000) $0 $10,000 $35,000 $20,000 $120,000 $300,000 $380,000 $0
($500,000) ($500,000) ($100,000) ($100,000) ($100,000) ($100,000) ($100,000) ($100,000) ($500,000) ($500,000) ($500,000) ($50,000)
3y 2y Expiry Expiry Expiry Expiry Expiry Expiry 1y Expiry Expired Expiry
$1,378,125 $1,105,000 $270,000 $540,000 $270,000 $270,000 $270,000 $270,000 $1,033,600 $4,860,000 $4,860,000 $220,000
($570,000) ($100,000) ($15,000) $120,000 $0 ($10,000) ($35,000) ($20,000) ($120,000) ($300,000) ($380,000) $0
$808,125 $1,005,000 $255,000 $660,000 $270,000 $260,000 $235,000 $250,000 $913,600 $4,560,000 $4,480,000 $220,000
10 May 2012
36

Inception Date Options 2/9/2012 2/23/2012 3/22/2012 4/26/2012 EUR Options 11/17/2011 3/9/2012 Eurozone Contagion Capped steepener EUR 225mn: (EUR50mn) 2y5y vs 2y30y bear steepener, short 2y SL 5y(EUR 90mn: EUR 30y curve cap @ 75bp 20mn: (EUR 400mn) Buy EUR 3m*5y payer 1.55% KO 2.05% EUR 100mn Buy 6m2y payr spd vs 6m10y payr spd $0 ($1,032,000) $0 ($972,000) $0 $60,000 ($500,000) ($500,000) Unwound Expiry $2,635,200 $2,210,000 $0 ($60,000) Weights/Notional Amount ($300mn): $200mn: ($60mn) $100mn $20mn:($20mn) $100mn:(2000) Levels @ Inception ($30,000) $570,000 $1,540,000 $1,500,000 Net Gain (+) /Loss (-) ($50,000) ($530,000) ($105,000) $130,000 Variation Margin $50,000 $530,000 $105,000 ($130,000) Balance Sheet Used $21,894,225 $1,514,000 $730,000 $1,700,000 $2,180,000
Theme
Trade
Current Level
Stop Loss (bp)
Horizon
Initial Margin
Hike expectations Higher rates Rangebound rates Rangebound rates
Long 1y*1y - 1y*3y - 1y*5y payer fly Buy 3m*10y payer 2.25% KO 2.75% Long 1y30y @ 3.1% vs short 3m30y @ 3.1% Long 1y5y straddles vs 3EM2 straddles
($80,000) $40,000 $1,435,000 $1,630,000
($500,000) ($500,000) ($500,000) ($500,000)
6m Unwound 3m 2m
$1,464,000 $200,000 $1,595,000 $2,310,000
$6,481,050 $2,635,200 $2,150,000
4/13/2012
Higher rates
$560,000
$220,000
($340,000)
($500,000)
Expiry
$1,355,850
$340,000
$1,695,850
Crosscurrency 1/26/2012 2/3/2012 4/20/2012 5/4/2012
$3,437,416 Cross -currency Cross -currency Long EUR vs. US gamma Tactical Long EUR 4m*7y vs TYM2 straddles Long EUR 3y10y P @ 4% vs USD 3y10y P @ 4% Long EUR 4m*7y std vs. TYU2 std Long EUR 6m*2y payer vs GBP 6m*2y payer EUR 10mn: (100) EUR 10mn: (13mn) EUR 50mn: (750) EUR 100mn :(GBP82mn) ($20,000) ($90,000) ($945,000) $0 $130,000 ($130,000) ($695,000) $15,000 $150,000 ($40,000) $250,000 $15,000 ($500,000) ($500,000) ($500,000) ($250,000) Expiry Expiry Expiry 3m $271,700 $450,840 $1,358,500 $1,731,376 ($150,000) $40,000 ($250,000) ($15,000) $121,700 $490,840 $1,108,500 $1,716,376
BMA 1/12/2012 Sell Front-end Ratios Long 3m1y BMA ratio vs short 3y1y ratio; 3m1y matured on 4/12 at 1y ratio = 50, implying p&l -$42k $200mn : ($200mn) 54, 84 50, 80 $100,000 ($250,000) 6m $800,000 ($100,000)
$700,000 $700,000
Cash Cash Used as Collateral/ Haircut Fed Funds (residual cash) Return on Fed Funds Return on trades Total
5/4/2012 $49,369,915 $53,232,106 $24,521
5/10/2012 $49,652,191 $53,061,716 $25,907 $2,688,000 $102,713,907
10 May 2012
37
Trades Unwound
Inception Date TIPS 9/29/2011 1/6/2012 10/20/2011 3/9/2012 1/27/2012 6/16/2011 Unwound Date 1/12/2012 1/19/2012 2/23/2012 3/28/2012 4/6/2012 4/19/2012 Theme Front-end Asset Swap Tightener Supply Trade Relative Value Relative Value Dovish Fed Eurozone contagion Trade Long Jan '12 TIPS ASW Sell Apr '16 - Jul '21 - Apr '28 10y-30y breakeven steepener Long Apr '14 - Apr '15 breakeven Long 5y5y breakevens Long the belly Jan '16 - Apr '16 - July '16 real yield fly Weights/Notional Amount $500mn $25k dv01 $20k dv01 $30k dv01 $20k dv01 $20k dv01 Levels @ Inception Libor 15.75bp 20bp 21.5bp 165bp 232bp 5.5bp Levels @ Unwind Libor - 34bp 21bp 5bp 185bp 251bp 7bp Net Change (Gain (+) /Loss (-)) $170,000 $25,000 ($260,000) $500,000 $250,000 ($20,000) Total Stop Loss (bp) ($250,000) ($500,000) ($250,000) $200,000 $300,000 ($75,000) Horizon Unwound Unwound Stopped -out Unwound Unwound Unwound
Treasury 1/12/2012 1/19/2012 2/9/2012 3/1/2012 3/29/2012 3/1/2012 3/1/2012 3/16/2012 Swaps/ Futures 1/19/2012 1/6/2012 3/16/2012 Options 10/7/2011 10/7/2011 10/20/2011 1/19/2012 11/18/2010 3/10/2011 5/19/2011
1/26/2012 1/26/2012 2/23/2012 3/9/2012 4/6/2012 4/19/2012 4/19/2012 4/19/2012
Fed-on-hold Dovish Fed Unwind of auction concession Bond auction concession Bond auction concession Increase in odds of QE3 Fading 7yr Dovish Fed
Long 2y-5y-10y treasury fly 10y-30y tsy curve steepener 7y-30y tsy curve flattener 10y-30y tsy curve steepener 10y-30y tsy curve steepener Long 5y-10y-30y fly Short 5yr - 7yr - 10yr Long ct2
$50kdv01 $50k dv01 $50k dv01 $50k dv01 $50k dv01 $50k dv01 $50k dv01 75k dv01
-49.5bp 106.25 bp 177.75bp 111.5bp 111.5bp 1.75bp -4.5bp 36.9bp
-66.5bp 117.25 bp 174.75bp 116.25bp 117.5bp -1.7bp -11.8bp 26.7bp
$850,000 $550,000 $150,000 $237,500 $305,000 $172,500 ($365,000) $865,000
($500,000) ($500,000) ($500,000) ($500,000) ($500,000) ($500,000) ($500,000) ($500,000)
Unwound Unwound Unwound Unwound Unwound Unwound Unwound Unwound
2/23/2012 3/15/2012 4/6/2012
Calendar roll Eurozone Contagion Spread widener
USH2 invoice spread widener Short EDU2 Long EDU4 FV invoice spread widener
$100k dv01 2000 contracts $50k dv01
0.45bp 47.75bp 17.75bp
-2.4bp 54.75bp 28.25bp
($285,000) ($525,000) $525,000
($500,000) ($500,000) ($500,000)
Unwound Stop-out Unwound
1/9/2012 1/9/2012 1/20/2012 1/26/2012 2/3/2012 2/3/2012 2/3/2012
Sell GBP Gamma Sell EUR Gamma Sell US Gamma Steepener Fed on hold Fed on hold Hedge to Fed on hold
Sell 3m5y straddles Sell EUR 3m2y straddles Sell 3m*10y straddles Long 4m30y payer spread (1.8 vs 2.1) and short TYM2 puts @ 128.5 long 1y1y collar
GBP 25mn EUR 25mn $10mn $100mn: (2400) $300mm:($300mm)
($650,000) ($225,000) ($420,000) ($100,000) $1,546,000 ($150,000) $0
($491,000) ($175,000) ($285,000) $700,000 $2,069,000 $108,000 $100,000
$159,000 $50,000 $135,000 $800,000 $523,000 $258,000 $100,000
($500,000) ($100,000) ($125,000) ($500,000) ($500,000) ($250,000) ($250,000)
Expired Expired Expired Unwound Unwound Unwound Unwound
7/8/2011 2/4/2011 11/4/2011 11/17/2011 12/2/2011 12/15/2011 11/10/2011 2/3/2012 2/16/2012 2/9/2012 2/23/2012 3/1/2012 11/4/2011
2/3/2012 2/9/2012 2/6/2012 2/17/2012 3/2/2012 2/24/2012 3/9/2012 3/22/2012 3/22/2012 3/23/2012 4/20/2012 4/20/2012 5/4/2012
GBP options Fed on hold Sell US Gamma Sell US Gamma Sell US Gamma Sell US Gamma Eurozone contagion Steepener Steepener Sell US Gamma Sell US Gamma Sell US Gamma Eurozone contagion
1y5y covered call $10mn Long 1y*2y payer spread (atm vs 100bp $240mn: ($100mn) high-strike) and sell high-strike 1y*5y payer; unwound the long 1y2y payer on 9/2/11 1y1y vs 1y5y bear flat; unwound the long 470mn: (100mn) 1y1y payer on Sep 22 '11 Rec 1y1y and sell 25bp low 1y*1y recr $100mn Sell 3m*10y straddles Sell 3m*10y straddles Sell 3m*10y straddles Sell TYH2 straddles 6m 10y-30y CMS Bull Flattener 5y*2y vs 5y*30y bear steepener 2y*10y vs 2y*30y bear steepener Sell TYJ2 straddles Sell TYK2 straddles Sell TYK2 straddles Long 6m1y payer spread vs. short 6m5y payer spread $10mn $10mn $10mn 100 $50k dv01 ($200mn):$20mn ($112.5.mn): $50mn 100 100 100 $485mn: ($100mn)
($125,000) ($225,000) ($431,000) ($440,000) ($393,000) ($284,375) $225,000 ($90,000) ($20,000) ($201,000) ($232,813) ($212,500) $0
$517,000 $249,000 ($233,000) ($134,000) ($259,000) ($64,375) ($350,000) ($630,000) ($560,000) ($150,000) ($67,813) ($117,500) $0
$642,000 $474,000 $198,000 $306,000 $134,000 $220,000 ($575,000) ($540,000) ($540,000) $51,000 $165,000 $95,000 $0
($250,000) ($250,000) ($250,000) ($250,000) ($250,000) ($100,000) ($500,000) ($500,000) ($500,000) ($100,000) ($100,000) ($100,000) ($250,000)
Unwound Expired Expired Expired Expired Expired Stop-out Stop-out Stop-out Expired Expired Expired Expired
10 May 2012
38
TRADE RECOMMENDATIONS
New trades
TIPS
No new trades.
Treasury
Relative value
Short $50k dv01 high-coupon Nov15 Ps vs high-coupon Feb15 Ps, initiated on May 10, 2012, P&L -$25k. We recommend that investors switch from the rich 9.875% Nov15s to the cheaper issue 11.25% Feb15s, as the latter have cheapened unduly after becoming eligible for Fed sales under Operation Twist. Short $50k dv01 5y-5y-10y Treasury fly, initiated on May 10, 2012, P&L -$10k. To position for a normalization of QE expectations, as well as to benefit from the shift in the auction concession to the belly of the curve.
Swaps/Treasury futures
No new trades.
BMA
Macro
Sell $200mn 3y ratio, initiated on May 10, 2012, P&L -$20k. SIFMA should set low for a long time, relative to Libor.
Options
No new trades.
Current trades
TIPS
Macro
Buy $12k dv01 Jul12 TIPS, hedged with short 40 XBH2, initiated on August 5, 2011, bought back 20 XBM2 on April 6, 2012, P&L $711k. Front-end breakevens are pricing very little inflation, despite the upturn in core CPI. Buy $500mn Jan14 TIPS asset swap, initiated on January 12, 2012, P&L $450k. A significant yield pickup vs other assets in the short end.
Relative Value
Long 10y TIPS asset swap vs short nominal 10y asset swap, $11k dv01, initiated on March 29, 2012, P&L $17k. The 10y TIPS sector is cheap relative to nominals on an asset swap basis.
Theme: Normalization
Buy $30k dv01 Apr13 TIPS hedged with 25 XBH3 and short CPI caps at 2%, initiated on November 2, 2011, P&L $585k. Front-end breakevens have lagged the recent move in risky assets.
10 May 2012
39
Theme: Euro area contagion risk
Buy $50k dv01 Apr17 vs Jan17, initiated on April 19, 2012, P&L $0k.
Treasury
Theme: Low front-end premium
Initiate $80kdv01 vs $50kdv01 2y-3y steepener, initiated on April 20, 2012, P&L -$125k.
Theme: bond auction concession
Initiate $50k dv01 10y-30y steepener, initiated on April 26, 2012, P&L $150k. Lower probability of Operation Twist, along with the bond concession, should steepen the long-end curve.
Swaps/Treasury futures
Macro
Sell $50k dv01 30y swap spreads, initiated on January 6, 2012, P&L -$175k. Corporate issuance in the new year should tighten long-end swap spreads. $50kdv01 March 2014 FRA-OIS widener, initiated on April 6, 2012, P&L $37.5k. Eurozone concerns should widen the front-end spreads.
Relative Value
Sell TY invoice spread hedged with one-third 1y1y Libor-OIS widener, initiated on April 19, 2012, P&L -$327.5k.
Options
Macro
Sell 100 TYM2 straddles at 130.5, initiated on March 9, 2012, P&L $15k. Part of the systematic short gamma program. Sell 200 TYM2 straddles at 130, initiated on March 29, 2012, P&L -$120k. Part of the systematic short gamma program. Sell 100 TYM2 straddles at 131, initiated on April 6, 2012, P&L $0k. Part of the systematic short gamma program. Sell 100 TYM2 straddles at 131, initiated on April 12, 2012, P&L $10k. Part of the systematic short gamma program. Sell 100 TYN2 straddles at 130.5, initiated on April 19, 2012, P&L $35k. Part of the systematic short gamma program. Sell 100 TYN2 straddles at 131, initiated on April 26, 2012, P&L $20k. Part of the systematic short gamma program.
Cross-currency
Short USD75mn 5x10 caps at 8% vs long EUR50mn 5x10 caps at 5%, initiated on October 15, 2009, P&L $570k. The trade benefits if US inflation concerns remain contained for several months. Short 100 TYM2 straddles at 131 vs EUR100mn 4m*7y straddles, initiated on January 26, 2012, P&L $150k. EUR vol should be higher than US vol.
40
10 May 2012
Long EUR 10mn 3y*10y payer at 4% vs USD 13mn 3y*10y payer at 4%, initiated on February 3, 2012, P&L -$40k. EUR vol and skew should richen relative to US. Short 750 TYU2 straddles @ 130.5 vs EUR50mn 8/24/12 ->7y straddles, initiated on April 19, 2012, P&L $250k. Both EUR and US rates would remain range-bound. But EUR vol is cheaper than US vol. Buy EUR 100mn 6m*2y payer 0.95% versus GBP 82mn 6m*2y payer 1.48%, initiated on May 4, 2012, P&L $15k. This is a tactical trade to position for some normalization of short rates in both currencies.
Relative value
Buy $50mn 3y*10y payer at 5% vs sell $350mn single-look 10y CMS cap at 5%, initiated on February 17, 2011, P&L $100k. We look to monetize the high convexity adjustment. Long $20mn 1y*30y straddles @ 3.1% vs short $20mn 3m*30y straddles @ 3.1%, initiated on March 22 2012, P&L -$105k. Limited-loss way to position for rangebound rates. Long $100mn 1y*5y straddles vs. 2000 3EM2 straddles, initiated on April 26th 2012, P&L +$130k. The trade aims to gain from range bound rates.
Theme: Eurozone contagion
Buy $90mn 1y*2y ATM vs 50bp high-strike payer spread vs sell $20mn 1y*10y ATM vs 50bp high-strike payer spread, initiated on August 18, 2011, P&L $120k. The trade seeks to keep the premium intake from initiation. Buy $490mn 6m*1y payer spread vs sell $100mn 6m*7y payer spread, initiated on January 6, 2012, P&L $300k. Libor-OIS widening and the pushing out of hike expectations should benefit the trade. Long $100mn 1y*1y payer spread (0.55% versus 1.05%), initiated on February 3, 2012, P&L $0k. 1y tails are cheap and FRA-OIS should eventually widen. Buy $490mn 3m*1y payer spread vs $100mn 3m*7y payer spread, initiated on February 9, 2012, P&L $380k. FRA-OIS should eventually widen.
Theme: Hike expectations
Buy 1y*1y-1y*3y-1y*5y payer fly, initiated on February 9, 2012, P&L -$50k. A repricing of hike expectations should cause the fly to cheapen in a sell-off.
Theme: Higher longer rates
1x1 $100mn 5y*10y payer spread, initiated on January 15, 2009, P&L $1,039k. We added the short CMS cap at 5% on July 2, 2010. We sold $100mn 3m*10y payer at 2.75%, on September 8, 2011. We sold $75mn 6w*10y payer at 2.75% on November 10, 2011. The trade is short duration and long vol. We like the risk profile, so we continue to hold the trade. Buy $100mn 3m*10y payer @ 2.25% KO @ 2.75%, initiated on February 23, 2012, P&L -$530k. We stop ourselves out of this trade.
EUR options
10 May 2012 41
EUR 90mn vs. 20mn 2y5y vs 2y30y bear steepener, sell EUR 210mn 2y single-look 5y-30y curve cap @ 75bp, initiated on March 9, 2012, P&L $10k. The trade exploits high 2y*5y vol and aims to generate positive carry.
BMA
Macro
Buy 3m forward 1y ratio and sell notional neutral 3y forward 1y ratio, initiated on January 12, 2012, P&L $100k. SIFMA should set low for a long time, although we see the possibility of a near-term downward drift in Libor.
10 May 2012
42
BOND YIELD FORECASTS

US Treasuries Fed funds Q2 12 Q3 12 Q4 12 Q1 13 0.00-0.25 0.00-0.25 0.00-0.25 0.00-0.25 3m Libor 0.40 0.35 0.35 0.35 2y 0.30 0.30 0.30 0.30 5y 1.10 1.00 1.00 1.00 10y 2.25 2.00 2.00 2.00 30y 3.40 3.40 3.40 3.40 10y RY -0.20 -0.40 -0.35 -0.35 Q2 12 Q3 12 Q4 12 Q1 13 US swap spreads 2y 35 35 30 30 5y 30 30 25 25 10y 10 10 5 5 30y -30 -35 -40 -40
10 May 2012
43
US ECONOMICS RESEARCH AND MARKET STRATEGY RESEARCH

Larry Kantor Head of Research +1 212 412 1458 larry.kantor@barclays.com Joseph Abate US Fixed Income Research +1 212 412 6810 joseph.abate@barclays.com
Cooper Howes US Economist +1 212 526 3099 cooper.howes@barclays.com
Dean Maki Head of US Economics Research +1 212 526 1731 dean.maki@barclays.com Michael Gapen US Economics Research +1 212 526 8536 michael.gapen@barclays.com James Ma Fixed Income Strategy +1 212 412 2563 james.ma@barclays.com Peter Newland US Economics Research +1 212 526 3153 peter.newland@barclays.com Rajiv Setia Fixed Income Strategy +1 212 412 5507 rajiv.setia@barclays.com
Ajay Rajadhyaksha Head of Rates and Securitised Products Strategy +1 212 412 7669 ajay.rajadhyaksha@barclays.com Piyush Goyal Fixed Income Strategy +1 212 412 6793 piyush.goyal@barclays.com Chirag Mirani Treasury and Inflation-linked Strategy +1 212 412 6819 chirag.mirani@barclays.com Michael Pond Treasury and Inflation-linked Strategy +1 212 412 5051 michael.pond@barclays.com Vivek Shukla Fixed Income Strategy +1 212 412 2532 vivek.shukla@barclays.com
Amrut Nashikkar Fixed Income Strategy +1 212 412 1848 amrut.nashikkar@barclays.com Anshul Pradhan Treasury and Inflation-linked Strategy +1 212 412 3681 anshul.pradhan@barclays.com Igor Zoubarev Fixed Income Strategy +1 212 526 5518 igor.zoubarev @barclays.com
10 May 2012
44
Analyst Certification(s) We, Michael Gapen, Cooper Howes, Dean Maki, Peter Newland, Anshul Pradhan, Chirag Mirani, Michael Pond, James Ma, Rajiv Setia, Amrut Nashikkar, Vivek Shukla, Piyush Goyal, Joseph Abate and Giuseppe Maraffino, hereby certify (1) that the views expressed in this research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this research report and (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this research report. Important Disclosures Barclays Research is a part of the Corporate and Investment Banking division of Barclays Bank PLC and its affiliates (collectively and each individually, "Barclays"). For current important disclosures regarding companies that are the subject of this research report, please send a written request to: Barclays Research Compliance, 745 Seventh Avenue, 17th Floor, New York, NY 10019 or refer to http://publicresearch.barcap.com or call 212-526-1072. Barclays Capital Inc. and/or one of its affiliates does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Barclays may have a conflict of interest that could affect the objectivity of this report. Barclays Capital Inc. and/or one of its affiliates regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). Barclays trading desks may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, Barclays fixed income research analyst(s) regularly interact with its trading desk personnel to determine current prices of fixed income securities. Barclays fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income, Currencies & Commodities Division ("FICC") and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. To the extent that any historical pricing information was obtained from Barclays trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. The Corporate and Investment Banking division of Barclays produces a variety of research products including, but not limited to, fundamental analysis, equity-linked analysis, quantitative analysis, and trade ideas. Recommendations contained in one type of research product may differ from recommendations contained in other types of research products, whether as a result of differing time horizons, methodologies, or otherwise. In order to access Barclays Statement regarding Research Dissemination Policies and Procedures, please refer to https://live.barcap.com/publiccp/RSR/nyfipubs/disclaimer/disclaimer-research-dissemination.html.
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Market Strategy Americas The Ins and Outs of The Labor Market

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Market Strategy Americas The Ins and Outs of The Labor Market

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RESEARCH

Economics Dean Maki +1 212 526 1731 dean.maki@barcap.com

Barclays | Market Strategy Americas

Ch. inventories (contr to GDP, pp) 0.3

Barclays | Market Strategy Americas

The ins and outs of the labor market

Go with the flow

but hiring remains weak

and long-term unemployment very high

Figure 1: Flow from employment to unemployment falling

0.55 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

Source: BLS, Labor dept, Barclays Research

Source: BLS, Barclays Research

Barclays | Market Strategy Americas

Layoffs have fallen as a share of separations

Where next for employment and the unemployment rate?

but sufficient to push the unemployment rate lower

Figure 3: Long-term unemployment has barely declined

Figure 4: Flows in and out of the labor force

Source: BLS, Barclays Research

Source: BLS, Barclays Research

Barclays | Market Strategy Americas

Q1 GDP tracking 1.9%, Q2 tracking 2.5%

Q1 tracking 2.2 2.2 2.2 2.2 2.0 1.9 1.9

2.5 2.5 2.5 2.5

Figure 2: GDP growth contributions

Figure 3: Net trade

Source: BEA, Barclays Research

Source: BEA, Census Bureau, Barclays Research

Barclays | Market Strategy Americas

DATA REVIEW & PREVIEW

Preview of the next week

No significant events or releases

10:00 Business inventories, % m/m 10:00 NAHB housing market, index

No significant events or releases

Barclays | Market Strategy Americas

Another reason to worry

1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9

Feb-12 Mar-4 Mar-25 Apr-15 Spain Italy France, rhs

Source: EUDATA, Haver Analytics

Barclays | Market Strategy Americas

Modest economic data in US do not argue for much higher yields

RV opportunity in shorter maturity HC securities

Figure 4: Risk aversion, USD Libor-OIS spread, has room to rise

Average Sovereign 5y CDS Spreads, bp European Senior Financial 5y CDS Spreads, bp

Barclays | Market Strategy Americas

We recommend switching from HC Nov 15s to HC Feb 15s

Figure 5: No consistent trend in the relative pricing of high coupon Issues

Feb-12 Feb 15s

Mar-12 Nov 15s

Apr-12 May 16s

Source: Barclays Research

Source: Barclays Research

Barclays | Market Strategy Americas

Source: Barclays Research

Barclays | Market Strategy Americas

A glance at foreign holdings

Finally, some outside data

Total 1,302 117 144 58 818 47 212 118 106 88 17

of which: Nominal 1,266 97 125 40 805 36 201 108 97 81 11

Barclays | Market Strategy Americas

Figure 2: Foreign holdings of Treasuries as of June 30, 2011 regional breakdown