MARKET MOVER - BNP PARIBAS - Investment Services India

Market Economics | Interest Rate Strategy | Forex Strategy 28 July 2011 

Market Mover 

Market Outlook 2-3 

Fundamentals 4-24 

• US: Much More Adjustment Needed 4-6 

• Eurozone Summit: The Reaction 7-9 

• France: Budget Consolidation Is On 10-11 

Track 

• France: About Credibility and Debt 

Brake 

www.GlobalMarkets.bnpparibas.com 

12 

• UK GDP: You Cannot Be Serious! 13-14 

• Japan: How to Finance It All 15-18 

• Japan: Exports to China Remain 19-21 

Low 

• Australia: Excessive Volatility 22-24 

Interest Rate Strategy 25-54 

• US/EUR Spreads: Impact of a US 25 

Downgrade 

• US: Impact of a Potential US 

Downgrade 

• US: Missed Payments Shocking 

Front USTs 

26-33 

34 

• MBS: Staying Underweight 35-37 

• EUR: OIS/BOR Spreads Still Wider 38 

• EMU Debt Monitor: CDS, RV 39-41 

Charts, Redemptions 

• UK: Trading BoE on Hold for Longer 42 

• JGBs: Negative Factors to Increase 43 

• Global Inflation Watch 44-47 

• Inflation: Unequal In Face Of Debt 48-49 

• USDi: Sell 5y5y Forward Inflation 50-53 

• Trade Reviews 54 

FX Strategy 55-62 

• FX: So What if the US Loses its 55-56 

AAA Status? 

• Little Justification For BoJ 

Intervention 

57-58 

• AUD: The Future is Rosy 59-60 

• Factors Behind The Soaring Bird Set 61-62 

to Hold 

Forecasts & Calendars 63-77 

• 1 Week Economic Calendar 63-64 

• Key Data Preview 65-71 

• 4 Week Calendar 72 

• Treasury & SAS Issuance 73-74 

• Central Bank Watch 75 

• Economic & Interest Rate Forecasts 76 

• FX Forecasts 77 

Contacts 78 

• The agreement at the Eurozone Summit was a major step 

forward but some of the spread tightening has unwound – we 

discuss the reasons why in the following pages. 

• Securing an agreement on the US debt ceiling is proving 

difficult, let alone delivering a longer-term plan credible 

enough to allay S&P’s concerns. 

• The uncertainty is not helping the US economy, as is 

evident from the latest Beige Book and data flow. 

• It is also adding to tensions in markets, with stress on 

USD liquidity increasing. Our strategy recommendation is to 

pay OIS/BOR spreads. 

• Core EGBs have room to richen in ASW terms as well as 

against US Treasuries. The probability of a US downgrade has 

increased, which should keep the 10-year T-Note/Bund spread 

on a widening bias. 

• At the upcoming ECB press conference, Mr Trichet is 

likely to be enthusiastic about the summit agreement, cooperative 

on liquidity provision but cagey on the SMP. 

• The flow of news suggests greater emphasis on the 

downside risks to growth and higher uncertainty, potentially 

opening the door to a pause in policy normalisation. 

• JGB yields should continue to test their downside over the 

coming days, given latent demand. 

• In forex, the see-saw between the EUR and the USD has 

continued. Our bias for EURUSD is upwards, but a last-minute 

US debt deal would see the USD spike temporarily. 

• Recent rallies in the AUD, NZD and CAD should continue 

as investors seek alternatives to the G3 majors. 

Market Views 

UST 10y T-note Yield (%) 

2y/10y Spread (bp) 

EGB 10y Bund Yield (%) 


JGB 10y JGB Yield (%) 

Forex 


EUR/USD 

USD/JPY 

Current 1 Week 1 Month 

2.96 ↑ ↔ 

254 ↑ ↔ 

2.63 ↔↓ ↔↑ 

139 ↔↓ ↔ 

1.08 ↓ ↑ 

92 ↓ ↑ 

1.4305 ↓ ↑ 

77.84 ↑ ↓ 

IMPORTANT NOTICE. Please refer to important disclosures found at the end of 

this report. Some sections of this report have been written by our strategy teams 

(shown in blue). Such reports do not purport to be an exhaustive analysis and may 

be subject to conflicts of interest resulting from their interaction with sales and 

trading which could affect the objectivity of this report.

Market Outlook 

Fiscal issues remain in 

focus in the eurozone… 

…and the US 

Uncertainty is not helpful 

for growth 

ECB to welcome the 

summit agreement… 

As we wrote last week, the agreement at the eurozone summit was a major 

step forward in dealing with the debt crisis. The improved terms for the new 

loans to Greece are evidence of a much more constructive way of providing 

assistance, while the greater flexibility of the European Financial Stability 

Facility (EFSF) demonstrates a greater political determination to address 

contagion risk. 

So why then has some of the initial spread tightening unwound? There are 

various reasons for this, which we discuss in the article “Eurozone Summit: 

The Reaction”. One is that, while the framework is clear, some of the details 

need to be fleshed out. 

The changes to the EFSF’s scope require parliamentary approval in several 

participating member states. Securing support we do not see as a problem 

but the fact that summer recesses are upon us will extend the process. 

Regarding yield spreads, we see room for a stabilisation between core and 

peripheral eurozone markets. Liquidity spreads remain more at risk. The 

situation in the US is adding to tensions, with stress on USD liquidity rising. 

Our strategy recommendation is to pay OIS/BOR spreads. 

Core EGBs still have room to richen in ASW terms as well as against US 

Treasuries. The chances of a downgrade of the sovereign rating for the US 

have increased and this should keep the 10-year T-Note/Bund spread on a 

widening bias for some time. 

At the time of writing, the US political negotiations are in flux and securing a 

deal on the debt ceiling is proving difficult, let alone delivering a longer-term 

plan credible enough to allay S&P’s concerns (see US articles for more 

details). 

Against this backdrop, signs of market stress are showing up. We still 

believe the anticipation of a downgrade will keep the pressure on the 30- 

year. But, if it happens, we would be surprised if the sell-off were much more 

than 25bp because, for now, we think the market retains enough confidence 

to treat a 25-50bp sell-off as a buying opportunity. 

The uncertainty about the fiscal outlook is not helping the US economy, 

which is already battling against a number of headwinds. The latest Beige 

Book showed a softening of activity in half of the districts in the report, while 

our weakness indicator – a measure of shifts in the tone of the Beige Book – 

has also deteriorated markedly. That manufacturing and business 

investment, two of the brighter spots, are losing traction is a concern. 

We have been aiming low on the business surveys in the eurozone given the 

increase in market jitters, and the slide in sentiment continues apace. The 

latest Bank Lending Survey from the ECB also showed a further softening of 

loan demand from households. 

The focus of the upcoming press conference Q&A session will probably be 

the ECB’s attitude to the agreement on Greece and its willingness to offer 

further support – to Greece’s banks in the event of a selective default, or via 

a restart of the SMP. Mr Trichet is likely to be enthusiastic about the summit 

agreement, co-operative on liquidity provision but cagey on the SMP. 

Regarding the outlook for policy rates, markets will be scrutinising the macro 

assessment for evidence that the ECB is more inclined towards a wait-andsee 

view than pressing on with its quarter-per-quarter normalisation. 

Ken Wattret 28 July 2011 

Market Mover 

2 

www.GlobalMarkets.bnpparibas.com

…but weaker data point to 

a potential pause 

High uncertainty in the UK 

means the MPC will wait 

and see 

JGB yields to test the 

downside 

EUR and USD see-saw 

continues, with AUD, NZD 

and CAD favoured 

The flow of news suggests more emphasis on downside risks to growth and 

the higher level of uncertainty. This would increase the probability that the 

ECB skips the rate hike we had factored in for October. That the hard activity 

data in the eurozone will be “catching down” to the weaker surveys between 

now and the September/October meetings leans in the same direction. The 

ECB’s assessment of risks to price stability will remain to the upside, 

however, suggesting that the underlying bias will still be towards tightening – 

implying normalisation could be postponed rather than cancelled. 

In the UK, the GDP figures for Q2 held up a bit better than we forecast. The 

problem is gauging the underlying trend as there are so many distortions to 

the data right now. The majority of MPC members are likely to carry on with 

their wait-and-see strategy given uncertainty about those distortions and 

other matters. The key issue for the Inflation Report in August will be 

whether the risks to inflation are still judged as balanced over the medium 

term. We see grounds for a shift to the downside but the Q2 GDP data may 

have reduced the chances of that. 

In Japan, the government's policies for post-quake reconstruction will include 

around JPY 23trn for rebuilding over the next decade, of which JPY 19trn is 

to be spent in the first five years. JPY 10.5trn is to be raised via issuance of 

special reconstruction bonds that will supposedly be repaid by temporarily 

hiking household and corporate income tax rates. 

The JPY is back near its all-time high versus the USD amid concerns about 

a US downgrade, while signs of a global economic slowdown are also 

supporting JGBs. Domestic trading remains exceptionally thin and with latent 

demand for yen bonds likely to prevent any major price dips, we expect JGB 

yields to continue to test their downside over the coming days. 

The see-saw continued this week between the EUR and the USD with no 

currency appearing dominant. Our base-case scenario for a last-minute deal 

to raise the US debt ceiling would probably see the USD spike higher, albeit 

temporarily. The EUR has traded sideways, in line with the rise in Italian and 

Spanish bond yields as the market awaits more details post-Summit. Given 

the political will in the eurozone to move things forward, we believe that 

EURUSD will continue to be biased higher while the USD will continue to 

trend lower as markets expect the Fed to remain on hold and FX reserve 

diversification continues. Regarding other G10 currencies, we expect recent 

rallies in AUD, NZD and CAD to continue as investors seek alternatives to 

the G3 majors. 

Ken Wattret 28 July 2011 

Market Mover 

3 


US: Much More Adjustment Needed 

• We see a good chance of a US downgrade, a 

rising chance of the 2 August “deadline” being 

missed and a very small risk of a technical 

default. 

Chart 1: Federal Debt Held by Public Under 

CBO’s Long-Term Budget Scenarios 

• These are all immediate questions and are 

significant. We do not underestimate them, as 

Congress appears to. 

• Just as important is the fact that the US is 

miles away from being fiscally sustainable in the 

long run. 

• The packages that have been proposed are 

all based on a far too optimistic baseline. None 

of them go anywhere near enough toward 

achieving long-term sustainability. 

• A recent IMF study showed that to cut its 

debt-to-GDP ratio to 60% by 2030, the US needs 

to adjust its primary fiscal balance by more than 

Greece, Ireland or Portugal, and by over three 

times as much as Italy. This largely reflects a 

rapid run up in support programs for an aging 

population. 

• The drama over the debt ceiling gives rise to 

legitimate concerns that if US politicians cannot 

agree on something simple, how much more 

difficult might it be to adjust the primary fiscal 

balance by over 17% of GDP? 

• Uncertainties may well remain until after the 

2012 elections. 

There are four important questions bouncing around 

the markets about the US fiscal position: 

• Will there be a downgrade? 

• Will the 2 August deadline to lift the debt ceiling 

be met? 

• Will there be a technical default? 

• How much does the US have to do fiscally to 

become sustainable? 

Probably too much attention is being given to the first 

two questions and not enough to the last, where 

there is generally a poor appreciation of how 

Herculean is the task facing the US. On some 

reckoning, it needs to adjust its budget by more than 

Greece! 

Downgrade chances high 

The chances of a downgrade by at least one ratings 

agency have increased substantially in recent 

Source: Congressional Budget Office 

months. The IMF showed the gross debt-to-GDP 

ratio of general government at 91.6% of GDP last 

year. It is likely that this figure will pierce the 100% 

barrier this year. That is more significant for some 

agencies than others (e.g., it is a key metric for S&P, 

whereas Moody’s looks more at debt interest relative 

to tax revenues, and current low rates mean this 

remains low). 

The process of lifting the debt ceiling and negotiating 

a longer-term reduction in the deficit has been caught 

up in politics. With many politicians, ahead of 

primaries, playing to their core supporters rather than 

looking for compromise, the process has looked to 

be all checks and no balance. No one would argue 

that the process will have increased the willingness 

of investors to buy Treasuries (unless there is a 

general disaster and flight to quality, which is another 

kettle of fish). With S&P having put the US on 

negative watch, something very positive has to 

happen to avoid a downgrade. 

A notch below AAA would still be a very high rating 

so we do not think there will be a very big impact on 

the bond market, nor on other securities that would 

be subject to a trickle-down downgrade (e.g. munis, 

agencies). In net terms though, a downgrade would 

probably push Treasury yields up by only 25bp or so 

according to our strategists. 

The Congressional Budget Office has reckoned that 

a one tenth of one percent increase in Treasury 

yields would increase government debt interest 

payments over the next decade by USD 130bn 

(http://cboblog.cbo.gov/). So it is not exactly a matter 

of indifference in the Treasury building as to whether 

or not there is a downgrade – which could cost 

USD 300bn over a decade. 

Paul Mortimer-Lee 28 July 2011 

Market Mover 

4 


From a longer-term perspective, the political 

wrangling will have increased worries that the US 

could someday monetise its debt, even if it did not 

default, in order to square its challenging fiscal 

arithmetic. 

Missing the 2 August deadline? Chances rising 

The incentives are very strong for politicians to reach 

a compromise on the ceiling before 2 August, the 

date the Treasury had said was it would run out of 

flexibility, and cash. Much of the wrangling is still 

likely to be political theatrics and positioning, 

although it certainly feels like a closer call as the date 

draws near. Better than expected revenues over the 

past few months mean that this deadline is likely not 

iron-hard, and the temptation for politicians to stray 

beyond it is high. By our own estimates, they can 

probably make it into the second week of August 

before running out of cash, but would certainly do so 

before 15 August when a large interest payment is 

due. It looks increasingly likely that we will have to 

see if a compromise is thrashed out over the 

weekend (how very European!) to see whether or not 

the Tuesday deadline will be met. If it is not, we are 

likely to see: 

• Increased speculation that there will be a 

technical default; 

• More pressure on politicians to come up with at 

least a temporary raising of the debt ceiling; 

• Higher risk premia on risk assets, giving lower 

stock prices; 

• Mixed pressures on Treasuries. There would be 

pressure for higher yields (more worries about 

defaults, concerns about money market funds’ 

and others’ reactions), but weaker risk assets 

would work to mitigate this. 

As a rough guide, an extra 50bp of risk premia on 

equities might cut stock prices by about 5%. 

Our assessment is that even if no agreement were 

reached by 2 August, one would be soon after, with a 

probability of 95%. 

Technical default – chances low but not zero 

After the US hit the debt ceiling in 1979, a limited 

number of cheques to pay redeeming Treasury bills 

did not get paid. Can we rule this out? It does not 

seem sensible for politicians to push things to this 

point, since it could create lasting damage. However, 

getting agreement on the short-term issue of the 

ceiling is entwined with the long-term issue of fiscal 

strategy, which is very tough (see next page). 

Moreover, we saw politicians in Europe push the 

Greek crisis far enough to do lasting damage (e.g., to 

liquidity in peripheral bond markets). And remember 

that it was not particularly sensible for the US to pull 

the plug on Lehman, but it happened. The fact is, 

when you play Russian roulette with budgetary 

matters, it occasionally ends with a less than optimal 

solution. 

The CBO’s views of the consequences of a default 

make salutary reading: 

“That shock could trigger large swings in stock 

prices, private interest rates, and the value of the 

dollar relative to other currencies; it might also 

generate massive disruptions and damage to the 

payments system and the flow of credit; and it would 

probably weaken the economy and reduce output 

and employment relative to what they would 

otherwise be. Indeed, the lack of a plan for 

increasing the debt ceiling may already be hurting 

household and business confidence, and default 

would reduce confidence further and increase 

uncertainty about future government policies, which 

would lower spending even apart from the effects of 

changes in asset prices and interest rates.” 

Some research suggested that the technical default 

in 1979 added 60bp to Treasury yields at the time 

and up to six months after the event. Given a bigger 

debt burden now, a very wide deficit and fiscal 

concerns more generally heightened by the eurozone 

crisis, there is a good chance we could see a bigger 

addition to yields – perhaps up to 100bp. Whether 

this would stick or not would depend on what 

happened to risk assets – Treasuries could even end 

up lower if there were turmoil in risk assets. 

With additional risk premia on stocks, we might see 

equity prices down by more than 10%. 

Growth prospects would be diminished in 2012. 

Given that our forecast is on the weak side of 

consensus, we would see a risk of falling below the 

“stall speed” of the economy. A technical default 

might knock 1% off growth. 

A technical default by the US would have adverse 

consequences globally – it would be unlikely to 

improve confidence in the eurozone, for example, or 

be good for global equities or peripheral spreads. For 

that reason, it might not harm the USD as much as 

might be thought. The extent of the damage would 

depend on whether there were any response from 

the Fed to stabilise the bond market – i.e., QE3. If 

there were, this would aggravate expectations that 

the US could address its fiscal problems by printing 

money. 

A long way from sustainability 

We’ve all grown used to seeing this or that budget 

plan in the US described as generating savings of so 

many trillions over a 10-year period. What we do 

here is put the long term position into the same 


Market Mover 

5 


parlance as people have grown used to with the 

eurozone crisis – i.e. how much adjustment is 

required in the primary balance to achieve 

sustainability? 

One of the great difficulties in addressing this 

problem is deciding what the baseline is. The 

Congressional Budget Office provides what it calls 

“the extended baseline scenario” and the “alternative 

fiscal scenario”. The first is what CBO believes would 

happen according to current law. 

However, it is pretty clear that the rest of us should 

not take this as our central case, but should adopt 

the “alternative fiscal scenario” (see Chart 1). This, 

according to the CBO, “incorporates several changes 

to current law that are widely expected to occur or 

that would modify some provisions of law that might 

be difficult to sustain over a long period” 

(http://www.cbo.gov/ftpdocs/122xx/doc12253/06-23- 

LTBOTestimony.pdf). 

It is noteworthy that all the various plans with their 

trillions of savings are relative the baseline scenario, 

which is almost certainly too optimistic. In other 

words, there is not agreement on plans that already 

started off inadequate because they come from a 

baseline that incorporates far too optimistic 

assumptions. Remember also that the US fiscal 

debate tends to concentrate on the Federal 

government, whereas general government is the 

concept used in most international comparisons. 

That creates a bigger problem to address. 

Perhaps the best way to illustrate how much the US 

has to do to achieve sustainability is to take the 

international comparisons in the excellent IMF Fiscal 

Monitor, from which we take Table 1. This shows the 

starting point for adjustment as 2010, and the 

adjustment in the primary deficit necessary to bring 

the debt-to-GDP ratio to 60% by 2020. For Japan, a 

target of 80% of GDP is assumed, which 

corresponds to a target for gross debt of 200%. 

What is striking is how high the US required 

adjustment is, both in absolute terms and relative to 

other countries. If we ignore age-related spending 

then there is a required adjustment in the underlying 

primary balance of 11.3% of GDP, or five points 

larger than Portugal and nearly three times as much 

as Italy. Only Japan has a larger required 

adjustment. It is noteworthy that the IMF reckons the 

US needs more adjustment than Greece. 

When the IMF takes account of age-related 

spending, the US required adjustment increases by 

over 50% – to 17.5% of GDP, which is the largest of 

any country and a full three-and-a-half points more 

than Greece, three points more than Ireland and 

seven points more than Portugal. 

The sheer scale of this adjustment is staggering. The 

fact that it is more than in the periphery is extremely 

concerning. It also explains why the political battles 

are so intense. The OECD calculates that total US 

general government receipts are about 30% of GDP 

and that disbursements of general government are 

40% of GDP. So the required adjustment in the 

primary balance is more than 50% of current receipts 

and almost 50% of outlays. 

This is the real import of the current debt ceiling 

debate. If US politicians cannot agree on the simple 

matter of raising the debt ceiling what should markets 

take as being the prospect of agreeing on measures 

to achieve the massive scale of fiscal adjustment that 

the US needs to achieve? Will they, as the 

Europeans were over Greece, be forced to go into 

crisis before they act? These are legitimate questions 

that will keep market participants concerned for some 

time, probably until after the elections next year, after 

which, hopefully, a coherent long-term plan will 

emerge. 

Table 2: Advanced Economics: Needed Fiscal Adjustment – An Illustrative Scenario (Percent of GDP) 

Current WEO Projections, 2010 Illustrative Fiscal Adjustment Strategy to Achieve Debt Target in 2030 

Gross Debt Primary Balance 

Cyclically Adjusted 

PB 

Cyclically Adjusted PB in 

2020-30 

Required Adjustment 

between 2010 and 2020 

Required Adjustment and Age- 

Related Spending, 2010-30 

Austria 69.9 -1.9 -0.9 1.5 2.4 6.7 

Belgium 97.1 -1.3 0.4 3.4 3.1 8.7 

France 81.8 -4.8 -3.2 3.0 6.2 8.4 

Germany 80.0 -1.1 -0.3 1.9 2.2 4.4 

Greece 142.0 -3.2 -3.1 7.4 10.5 14.0 

Ireland 96.1 -29.7 -6.1 6.3 12.4 14.4 

Italy 119.0 -0.3 1.4 4.6 3.2 4.6 

Japan 220.3 -8.4 -6.7 6.6 13.3 14.0 

Netherlands 63.7 -3.7 -2.7 1.4 4.2 9.5 

Portugal 83.3 -4.6 -3.1 3.3 6.4 10.6 

Spain 60.1 -7.8 -6.3 1.9 8.2 10.3 

United Kingdom 77.2 -7.8 -5.9 3.4 9.3 13.5 

United States 91.6 -8.9 -6.2 5.1 11.3 17.5 

Average (PPP-weighted) 96.6 -5.9 -4.0 3.8 7.8 11.8 

G-20 102.9 -6.4 -4.5 4.1 8.6 12.8 

Source: IMF 


Market Mover 

6 


Eurozone Summit: The Reaction 

• Our take on the EU Summit has been 

positive – we view it as a potential turning point 

in the debt crisis. 

• However, after an initially positive reaction, 

market tensions have resumed, with spreads of 

Italian and Spanish bonds widening again. 

• In this note, we look at possible factors 

underlying this unenthusiastic reaction. 

• Increased concern about the impact of a 

possible US debt downgrade has played an 

important role. 

• Criticism of the scale of up-front debt 

reduction for Greece undervalues, in our view, 

the relief provided by the radically modified 

interest rate structure. 

• Lingering uncertainty over some technical 

aspects of the deal, including the private sector 

involvement (PSI), has been another important 

factor. 

• Implementation is also a potential issue. In 

particular, the changes to the scope of the 

European Financial Stability Facility (EFSF) 

require parliamentary approval in several 

countries. 

• We do not see this as a problem but it will 

require time. 

• Meanwhile, it would be very helpful if the 

ECB were to resume its bond purchases 

through the Security Markets Programme. 

• Overall, some of these uncertainties are 

likely to persist in the short term but we are 

confident that, over time, the implications of the 

EU Summit will be properly acknowledged… 

• …paving the way to an easing of market 

tensions. 

In the notes “Eurozone Summit: A Major Step 

Forward”, 21 July 2011 

and “Eurozone Summit: 

A Yorktown Moment? ”, 25 July 2011, we argue 

that the outcome of the EU emergency Summit on 21 

July is a potential turning point in the eurozone debt 

crisis. 

Spreads over bunds of Greece, Ireland and Portugal 

tightened considerably but following a short-lived 

positive reaction, those of Italian and Spanish bonds 

Chart 1: Spread to Bunds (bp) 

Source: Reuters EcoWin Pro 

have widened again and are trading only a tad below 

their pre-Summit highs. 

In this note, we look at the possible factors 

underlying this unenthusiastic reaction. In particular, 

we emphasise three factors. First is the prolonged 

and so far fruitless, debate over the US debt ceiling. 

Concern has increased about a downgrade of the US 

sovereign debt. While we believe the impact of a 

possible downgrade will not be significant, the 

current climate of uncertainty is not beneficial for 

peripheral spreads. 

A second important factor is uncertainty about a 

number of technical details of the Greek deal, 

including the private sector involvement (PSI). A 

quick clarification of some of the pending issues 

would be beneficial, but we would argue that to focus 

on details would be to underestimate the bigger 

picture of the political commitment from the EU 

Summit. 

Finally, sceptics have expressed doubts about the 

ability of the EFSF potentially to deal with other 

countries such as Spain and Italy, should this be 

needed. Implementation of the changes to the 

EFSF’s scope is a potential issue, as it requires 

parliamentary approval in several countries. We do 

not see this is a major problem but it will require time. 

More generally, we believe Italy’s position is more 

balanced than recent market tensions would imply. 

A US debt downgrade? 

We deal with this aspect in more detail in the article 

“US: Much More Adjustment Needed”. In a nutshell, 

we see a good chance of a US downgrade, a rising 

chance of the 2 August deadline being missed and a 

very small risk of a technical default. We do not think 

this will have a significant impact on the bond market, 

Luigi Speranza/Paul Mortimer-Lee/Kenneth Wattret 28 July 2011 

Market Mover 

7 


nor on other securities that would experience a 

trickle-down downgrade, such as agencies. But the 

underlying problem – that a significant adjustment is 

required in order to bring the debt back on to a more 

sustainable trajectory – remains. The increased 

uncertainty stemming from the US has been an 

important factor underlying recent market dynamics 

in the eurozone. We suspect uncertainty on the US 

front will persist, probably at least until the 2012 

elections. 

Greek plan: lingering uncertainties 

One of the arguments used by the sceptics is that the 

plan agreed at the 21 July EU Summit does not 

tackle Greece’s main problem, which is the high level 

of the public debt. Implementation risk, the sceptics 

argue, therefore remains very high. 

In our view, this argument undervalues the significant 

debt relief coming, over time, from lower interest 

rates. Other things being equal, a reduction in 

interest rates of 100bp implies a reduction in the 

primary surplus needed to bring the debt back on to 

a sustainable path of around 1.5% of GDP. The 

upfront reduction in the Greek debt is limited (EUR 

33.5bn, or 15% of GDP) but, as we argue in more 

detail in the note “Greece: Improved Debt 

Sustainability” , 25 July 2011, the decisions 

taken at the EU Summit will lead to a significant 

improvement in Greece’s debt sustainability. 

Combined with the lengthening of the debt maturity, 

the reduction in interest rates reduces the possible 

implications of limited slippages in the fiscal targets. 

In contrast, a significant upfront reduction of the debt 

would have very probably reduced the government’s 

incentive to make structural changes in the economy. 

Another important factor underlying the 

unenthusiastic market reaction to the EU Summit is 

probably lingering uncertainty about a number of 

details of the plan including: 

1. The IMF’s participation. The language of the 

statement (“We call on the IMF to continue to 

contribute to the financing of the new Greek 

programme”) was conspicuously vague, suggesting 

the lack of a definitive agreement on the IMF’s share. 

The press has speculated about the increasing 

reluctance of a number of representatives in the 

Fund to contribute to the same extent as in the first 

round (which was split 73/27% between the EU and 

the IMF). Note, however, that the commitment to total 

official financing of EUR 109bn expressed in the 

statement is not conditional. Therefore, while a swift 

confirmation of IMF support would be helpful, a lower 

contribution than in the past would not be a major 

issue. 

2. The extent of private sector involvement (PSI). 

The IIF assumes the participation rate will be 90%. 

This would imply a contribution from the private 

sector of EUR 93bn, net of credit enhancement, of 

which EUR 37bn will be contributed in the period 

2011-2014. Doubts have been expressed by some 

about the ability to achieve such a level of 

participation. We would highlight such a contribution 

would be in line with previous experiences of similar 

plans such as Uruguay. As highlighted by the French 

Finance Minister François Baroin, the contributions 

from French banks will cover all EUR 15bn of their 

Greek exposure maturing by 2020. The 90% 

participation rate is feasible in our view. 

Stabilisation tools 

Together with Greece, the 21 July EU Summit dealt 

with the more general problem of contagion, with a 

number of stabilisation measures based on 

increased flexibility in the EFSF/European Stability 

Mechanism framework. The EFSF and the ESM 

have been allowed to: 

i. Finance recapitalisation of financial institutions 

through loans to governments including in non 

programme countries; and 

ii. Intervene in the secondary market if risks to 

financial stability are detected. 

The former is particularly important for Spain, where 

uncertainty about the health of the banking sector 

has contributed greatly to underlying concern over 

sovereign risk. The measure has the potential to 

break any adverse loop between sovereign and bank 

risks. The latter is potentially important for Italy. 

Given the size of Italy’s public debt, an escalation of 

the tensions in its bond market would necessarily be 

systemic. 

The decision of the EU is important in a number of 

ways. First, once implemented, it will relieve the ECB 

from the task of supporting the market. The role 

played by the SMP in stabilising the eurozone bond 

market has been crucial in our view. The ECB, 

however, took this role reluctantly and had recently 

backed away, which was one of the triggers of the 

escalation of market tensions. One of the motivations 

behind this reluctance is that the ECB viewed such 

interventions as interfering in the fiscal sphere, which 

would risk jeopardising its credibility. This risk was 

emphasised by the debate about a possible Greek 

default. Such an occurrence would have caused 

losses for the eurosystem, probably forcing a 

recapitalisation. Highlighting the cost for the taxpayer 

of the SMP’s market interventions, a recapitalisation 

would have exposed the ECB to the criticism of 

having gone beyond its mandate, by in effect 

implementing fiscal transfers without a formal political 

endorsement. Against this background, the EU 


Market Mover 

8 


decision was very important, as it provides the 

political backing. Why, then, the poor market 

reaction? 

The sceptics have highlighted potential problems in 

the implementation of the decision. The changes to 

the scope of the EFSF will have to be ratified at the 

national level. In most countries, this requires 

parliamentary approval and could take a few months, 

with the imminent summer recesses in national 

parliaments an additional complication. But, while the 

process may be long, we are confident that approval 

will eventually be gained. It must also be noted that, 

once approved in principle, the decision to intervene 

in the secondary markets will have to be taken by 

“mutual agreement” of EFSF/ESM member states 

and not by unanimity. This reduces the scope for 

delay caused by possible opposition in a limited 

number of countries. 

Another potential issue is the lending ability of the 

EFSF. The new loans to Greece leave the EFSF’s 

lending capacity at around EUR 323bn. This could be 

further reduced if Portugal and Ireland are not able to 

access the markets as planned and need further 

support over the next two years. With Italy’s yearly 

funding needs being in the region of EUR 225bn, the 

EFSF’s ammunition, some have argued, might not be 

sufficient. We would argue, however, that only small 

interventions might be needed to stabilise the 

markets. The EFSF can always be increased at a 

second stage if needed, as it already has been once. 

Finally, the political backing given by the EU Summit 

for purchases in the secondary market might allow 

the ECB to temporarily resume its SMP purchases, 

possibly under the agreement that the EFSF will buy 

back the bonds from the ECB at a later stage. We 

believe that an ECB announcement in this direction 

would be very beneficial. It would be evidence of a 

concerted effort against contagion risk and 

significantly reduce the risk premia attached to bonds 

of other countries currently under the market 

spotlight including Italy. 

Another argument used by sceptics is that, even if 

approved in due course, the EFSF’s ability to 

intervene in the secondary market would only offer a 

temporary relief but would not deal with the 

underlying problem, which is Italy’s high public debt. 

Under these circumstances, the argument goes, a 

shock to interest rates, whatever the reason, 

becomes a self-fulfilling prophecy, as it significantly 

increases the interest burden, pushing the debt on to 

an unsustainable trajectory. 

That the Italian public debt is very high is beyond 

doubt. But we would argue that Italy’s position is 

more balanced than recent market tensions would 

imply. While structurally low growth is an impediment 

to a swift reduction of the debt, especially when 

compounded with political fragility, Italy, unlike other 

so-called peripherals, can count on the sounder 

position of its private sector, founded on very low 

household indebtedness. This, in turn, is associated 

with a much more balanced external position than 

other economies currently under the market spotlight. 

The fiscal adjustment required to stabilise the debtto-GDP 

ratio is also lower – around 2% of GDP on 

our estimates. Finally, the argument that higher 

interest rates could cause a spiral underestimates 

the fact that the average life of Italy’s public debt, at 

7.8 years, is relatively high. This means that a shock 

would take time to fully affect the interest burden. A 

100bp permanent upward shift in the yield curve 

would, over time, increase the interest burden by 

around 1.2% of GDP. But in the short term the 

impact is much more limited – 0.2% of GDP in the 

first year and around 0.4% in the second. 

Conclusion 

As we have emphasised in previous notes, we saw 

the agreement at the Eurozone Summit as a major 

step forward in dealing with the debt crisis. The 

improved terms for the new loans to Greece are 

evidence of a more constructive way of providing 

assistance, while the greater flexibility of the EFSF 

demonstrates a greater political determination to 

address contagion risk. The market reaction to the 

deal has been, however, unenthusiastic. 

One reason for this reaction is heightened 

uncertainty related to the US debt ceiling debate. 

Uncertainty about a number of elements of the Greek 

plan is also playing an important role. A swift 

clarification of some of the pending issues would be 

highly beneficial. 

Implementation is also an issue. The changes to the 

EFSF’s scope require parliamentary approval in 

several participating member states. We do not see 

this as a problem, but it will require time. 

Meanwhile, it would be very helpful if the ECB were 

to resume its bond purchases through the SMP. 

More fundamentally, the criticism coming from 

sceptics that the plan does not deal with Greece’s 

main problem, its high debt, undervalues the debt 

relief that will be provided over time by lower interest 

rates. Similarly, we find that Italy’s position is much 

more balanced than recent market movements would 

imply. 

Some of these uncertainties are likely to persist in 

the short term but we are confident that, over time, 

the implications of the EU Summit will be properly 

acknowledged, paving the way for an easing of 

market tensions. 


Market Mover 

9 


France: Budget Consolidation Is On Track 

• The central budget is comfortably in line 

with its target. The deficit of other public 

administrations looks mixed, but adjustment 

measures are being taken. 

• The government has reduced this year's 

budget deficit target from 6.0% of GDP to 5.7%. 

• We believe the final deficit is likely to 

undershoot the target again this year. 

0 

-20 

-40 

-60 

-80 

-100 

-120 

Chart 1: Central Budget Balance 

(Cumulative, EUR bn) 

2011 

2009 

2010 

2008 

The central deficit is better than it looks 

Over the first five months of this year, the State 

budget deficit widened by EUR 0.5bn to EUR 68.4bn 

(Chart 1). But this figure is misleading, central 

government spending declined 3.0% y/y (the full-year 

target is a rise of 1.2%) and income increased by 

6.3% (target 5.2%) implying a reduction in the deficit 

of EUR 11.1bn. 

With spending down and revenue up, the widening of 

the actual budget deficit is due to the special 

account. This account had to pay in January and 

March for two tranches of the rescue package for 

Greece (another one is due in July). This plan is 

included in the French public accounts but not in the 

Maastricht definition of the deficit. In addition, this 

account transferred cash to local authorities earlier 

than in previous years, distorting the year-on-year 

comparison in the early months of the year. 

Looking at the breakdown of income, the picture is 

reassuring (Chart 2). The main gain is on corporate 

tax which is recovering from the recession-induced 

collapse. Net corporate tax income jumped 65.5% y/y 

and most of this impressive performance is 

sustainable this year. In fact, income is still 47.5% 

below the pre-crisis level (of January-May 2008). 

Meanwhile, income tax rose by 2.3% y/y in the first 

five months of the year, and the rise should 

accelerate because households this year are paying 

tax based on their 2010 income which rose by 2.1% 

and there are fewer tax breaks this year. VAT 

revenue is up 3.9% y/y. The increase will slow given 

reduced car sales following the removal of public 

incentives for car purchases, although some offset is 

provided by the removal of the cost of the incentive 

for the government. Altogether, the normalisation of 

tax income will continue and the fiscal tightening will 

further support tax revenues. 

Looking at the expenditure side, the strongest 

increase is for debt service, up EUR 2.4bn or 

-140 

-160 

EUR bn, cumulative 

Jan. Mar. May July Sept. Nov. 

Source: MoF, BNP Paribas 

Chart 2: Budget Revenue (% y/y) 

-15 0 15 30 45 60 75 


Jan-May 

2011 (% y/y) 

Net Receipts 

Net Tax Receipts 

Non Tax Receipts 

Other Taxes 

Tax on Oil Products 

VAT 

Corporate Tax 

Income Tax 

14.6% y/y. This is the result of a combination of 

slightly higher interest rates and rising debt. The 

situation will worsen in July when higher inflation 

(2.06% in June 2011 versus 1.43% in June 2010) will 

raise the value of index-linked debt (this rise is 

accounted as a cost, although there is no immediate 

disbursement). The 2011 decline in overall spending 

is due to a base effect, as 2010 spending included a 

one-off transfer to local authorities. However, since 

2008, expenditure has risen just 1.2% per annum, on 

average, showing that the stimulus policy, which is 

now completely over, consisted of measures that had 

only a transitory impact on spending. In particular, 

expenditure on personnel was unchanged for the 

third consecutive year (job cuts and wage restraint 

have helped to compensate for the upward drift of 

wages due to promotions). 

Overall, the central budget is clearly under control. 

The situation of other administrations is more difficult 

to assess but, again, the target is likely to be met. 

Dominique Barbet 28 July 2011 

Market Mover 

10 


... but other accounts look mixed 

We do not have monthly or quarterly accounts for 

other public administrations which are included in the 

Maastricht definition of the public deficit. However, 

INSEE provides, for each quarter, the level of debt 

for social security, local administrations and other 

central administration bodies (i.e. excluding the 

State). We have adjusted the data for seasonal 

variations (Chart 4). 

90 

80 

70 

60 

50 

40 

Chart 3: Public Debt Breakdown 

(% of GDP, NSA) 

60% 

State 

Total 

The main issue is clearly social security accounts. 

The debt ratio rose by 0.9pp of GDP in Q1. Health 

spending is recovering after a slower increase during 

the recession (as people postponed non-urgent and 

poorly compensated care, in particular for dentistry, 

glasses and hearing aids). With fewer people at 

work, compensation for work accidents have 

declined in recent years, but are increasing again this 

year. Conversely the deficit of the unemployment 

benefits system declined. However, a stabilisation of 

unemployment after the recent fall may slow the 

pace of this decline. 

The problem on the social security accounts is being 

addressed. Healthcare spending cuts have been 

agreed and more will be implemented in the coming 

months. Most importantly, the 2010 pension reform 

will start to bear fruit in Q3 and Q4 when people will 

delay their leaving of the labour market. This will be 

reflected in both lower expenditure and higher 

income (although the latter will depend upon how the 

increase in the active population is split between 

employment and unemployment). This reform is also 

a key element of 2012’s decline in the deficit. 

In Q1, the debt ratio of local administrations was the 

same as in Q1 2010. The ratio fell slightly from Q4 

2010 (-0.03pp), while the government had expected 

a 0.1pp rise per quarter in 2011. Local 

administrations’ debt rose during the recession for 

three reasons: 

• Lower tax income because of fewer property 

transactions; 

• Higher social expenditure because of the 

recession; and 

• Stronger investment spending, with some help 

from the central government, to support activity. 

These factors are disappearing and local 

administration debt is likely to continue to decline, 

especially if house sales continue to recover. 

Other public administration debt declined much more 

significantly, down 0.32pp of GDP versus last year, 

including 0.18pp over the first quarter. This trend is 

likely to continue but at a slower pace because of the 

need to increase investment in the railway network. 

Altogether, the debt-to-GDP ratio of social security, 

local authorities and other administrations rose 0.7pp 

30 

20 

10 

0 

Miscellaneous 

Local Admin. 

Social Security 

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 

Source: INSEE, Reuters EcoWin Pro 

10 

9 

8 

7 

6 

5 

4 

3 

2 

1 

0 

Mar-99 

Chart 4: Public Debt 

(% of GDP, SA by BNP Paribas) 

Mar-00 

Local Admin. 

Mar-01 

Source: BNP Paribas 

Mar-02 

Mar-03 

Mar-04 

Social Security 

in Q1. This is less favourable than the government 

target of 0.4pp per quarter on average. However, the 

situation should improve in the second half of the 

year and we believe the final target will be met. 

2011 should be another year when the final 

deficit is smaller than the target 

The government has reduced this year's budget 

deficit target from 6.0% of GDP to 5.7%. We believe 

the final deficit is likely to be even lower than this 

revised goal at 5.6% of GDP. The main favourable 

factors are stronger than expected fiscal receipts, 

thanks to a cautious initial forecast as in 2010, 

although the extent to which the deficit is below the 

target is unlikely to be as large as in 2009 or 2010. 

For 2012, the government has already said that the 

central budget, which should be presented on 

28 September, will include more fiscal tightening than 

has already been announced last year. The current 

policy of cutting tax breaks will be continued. On the 

expenditure side, the cut in central administration 

employment will also continue. The wage freeze 

decided for this year will also benefit the 2012 budget 

thanks to the absence of a carryover. Thus France 

remains on track to meet its budget targets. 

Mar-05 

Mar-06 

Mar-07 

Mar-08 

ODAC 

Mar-09 

Mar-10 

Mar-11 

NB: ODAC = Central Administration excl. State 


Market Mover 

11 


France: Fiscal Credibility and Debt Brake 

• The French version of the German ‘debt 

brake’ is ready for approval. 

• Formal implementation may have to wait for 

the next parliament, but it is already boosting 

the credibility of fiscal decisions. 

• Moreover, fiscal consolidation is garnering 

wider political support ahead of the elections. 

The golden rule has been prepared… 

The President knows he has no choice but to build 

his political platform around a fiscal consolidation 

policy. This is why he managed to get the upper and 

lower houses of Parliament to approve on 11 and 13 

July respectively, the French ‘debt brake’ rule that is 

aimed at being included in the Constitution (see 

“France: Obstinately Seeking Credibility”, Market 

Mover, 10 February 2011). 

The French version of the golden rule is different to 

Germany’s. In line with the stability plan, the 

government would have to prepare a three-year plan 

with a ceiling for spending and a minimum threshold 

for income. Any annual budget or mini-budget would 

have to comply with the three-year law (otherwise it 

would be blocked by the constitutional court). Any 

additional expenditure would be financed by 

spending cuts. Similarly, no tax cut would be allowed 

without offsetting measures. 

… but formal approval may take some time 

The next – and final – step required to make the rule 

part of the Constitution is either a referendum or a 

joint approval of the text by Congress (i.e. both 

houses) with a 60% majority. 

A referendum is highly unlikely as it would probably 

result in a ‘no’ vote, in a personal vote against the 

President rather than in response to the question. 

Similarly the timing is poor for an approval by 

Congress. The ruling coalition currently has a 56% 

majority. This should narrow after the upper house 

elections on 25 September (when 75k elected 

officials will vote in 170 of the 348 Senate members). 

The approval of Congress would thus require some 

of the left-wing opposition MPs to vote with the 

current majority, which is highly unlikely a few 

months before general elections. Calling a meeting of 

Congress in order to be able to win a political battle 

and divide the opposition or, alternatively, to stick a 

"pro-deficit" tag on the Socialist Party would be a 

dangerous game in present market conditions. We 

believe such a Congress is more likely to occur after 

the elections when the chances of getting the debt 

brake rule introduced in the Constitution are 

Chart 1: General Budget Deficit and Public Debt 

90 

85 

80 

75 

70 

65 

60 

55 

50 

General Gov't Deficit (% of GDP, RHS) 

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 


Total Public Debt (% of GDP) 

Gov't 

Forecast 

considerably higher. The preparation work done by 

Parliament can still be politically useful before the 

elections. 

Politics: support for fiscal consolidation is rising 

The government’s determination to meet at least the 

target for this year's budget deficit is very high. The 

President knows this achievement will be published 

before the 2012 presidential elections and it will be 

important for his credibility at that time. For the same 

reason, the 2012 budget, which should be presented 

on 28 September, also has to be credible. This will 

be verified by European authorities. European 

authorities will also have to approve the next stability 

plan that will include a 3.0%-of-GDP maximum deficit 

for 2013 (as did the preceding two plans). By then, 

we also expect the primary budget to show a surplus. 

Last Wednesday, the IMF report on France 

highlighted that there is no other option but to stick to 

the stability plan. When she was MoF, Mrs Lagarde 

said France would do "whatever it takes" to meet the 

stability plan goals even if growth falls below target. 

The policy has not changed since then. 

More importantly, the markets should be reassured 

about the longer-term outlook. The current majority 

and the two main contenders for the investiture of the 

socialist party, Martine Aubry and François Hollande, 

have accepted the target of a 3%-of-GDP budget 

deficit in 2013. That acceptance occurred before the 

most recent agreement to solve the eurozone 

sovereign debt crisis, showing that their commitment 

is not a temporary position taken in reaction to 

Sarkozy's success in achieving a deal on this issue. 

The change of public opinion on the budget deficit 

and debt is a significant development. A majority now 

consider the budget deficit and debt to be excessive 

and see this as an important issue. That will help to 

ensure that economic policy is tight throughout the 

next parliament. 

9.0 

8.0 

7.0 

6.0 

5.0 

4.0 

3.0 

2.0 

1.0 

0.0 


Market Mover 

12 


UK GDP: You Cannot Be Serious! 

• ONS estimates suggest that GDP growth 

would have reached 0.7% q/q in Q2 had it not 

been for various distortions to activity. This 

looks counter to other evidence of the 

underlying trend of the economy. 

Chart 1: CIPS Services and Index of Production 

• However, the estimate probably gives the 

hawks at the BoE a case for staying hawkish 

and for the “don’t knows” to continue sitting on 

the fence. 

ONS estimate of underlying growth looks far too 

high… 

Mark Twain was one of those who popularised the 

saying “There are three kinds of lies: lies; damned 

lies and statistics”. He might have added, “and then 

there’s the Q2 2011 estimate of underlying UK 

growth”. This came in at 0.7% q/q. Either the Q2 

estimate of GDP growth will be revised down, or the 

estimated downward distortion to growth will be 

revised down, or both. But when the statistics are 

revised and refined, we see scant chance that Q2 

2011 will be judged to be a quarter when underlying 

growth was 0.7% q/q. 

We struggle a bit with the ONS estimate that GDP 

growth was 0.2% q/q in Q2. It’s a bit stronger than 

we had estimated but in line with the consensus. If 

we accept for a moment that 0.2% is the proper 

figure, then we have an issue with the estimate that 

various distortions to the data (effects on supply of 

Japanese earthquake, the royal wedding and warm 

weather) reduced GDP by 0.5% in Q2. 

This estimate of the impact of distortions implies that, 

despite the rest of the world slowing down, the UK’s 

underlying rate of growth accelerated in Q2 from zero 

in the previous two quarters to 0.7%. Just where did 

this miracle renaissance of the economy come from 

– consumption? Have you looked at consumer 

confidence recently? Government consumption? Not 

with spending restraint beginning to bite. From 

exports? Not when global trade has clearly been 

slowing, not accelerating. 

If underlying Q2 growth really was 0.7% q/q, then we 

should presumably expect nirvana to arrive in Q3. On 

top of the 0.7% q/q growth the trend should lead us 

to expect, there should be a bounce-back of 0.5pp 

from the reduction to Q2 growth, giving us the 

expectation, if such maths is to be believed, of 

1.2% GDP q/q growth in Q3. If this happens then 


expect to see Gloucester Old Spots flying over 11 

Downing Street. 

What we find very odd about the estimate is that 

there is little evidence of a widespread effect of the 

size of disruption the ONS claims in the month-tomonth 

data outside those coming from their own 

index for services. We do see it in manufacturing and 

foreign trade, and in the ONS’s own series “Index of 

Services” However, retail sales and especially the 

surveys show a much smoother pattern. 

We have long forecast that GDP would be subdued 

in April because of the unusual run of bank holidays. 

As a result of a late Easter and the royal wedding, 

many people used the bridging days between the 

holidays to have eleven consecutive days away from 

work while using only three days’ leave. If 10% of the 

population took an extra three days’ leave, and if the 

loss of their production was accurately recorded, 

then GDP would have been about 1.5% lower in April 

than otherwise, and Q2 GDP would have been 0.5% 

down on where it would otherwise have been. 

The problem is that this just does not show in much 

of the data – May and June do not look better than 

April in the CIPS services or in retail sales. The 

former is important because the Index of Services 

from the ONS showed a 1.4% m/m rise in May after 

a weak April. There was a similar pattern in 

manufacturing. This had been flat in February and 

March and dropped by 1.6% in April before bouncing 

back by 1.8% in May. However, most of the estimate 

of the GDP shortfall (80% of it in fact) comes from 

services, which accounts for 74% of GDP. It appears 

to us that there is excess volatility in the monthly 

services index (Chart 1). We admit that some 

services directly linked to manufacturing output 

(transport and distribution, for example) should have 


Market Mover 

13 


followed the same pattern of manufacturing 

production. We also see that imports and exports 

both fell in April, bouncing back in May. So there is 

definitely an effect to be seen in the data. Our bet is 

that the June Index of Production will come in weaker 

than has been factored in the Q2 release. 

Retail sales that give some indication of where 

consumption might go (retail sales comprise about 

40% of consumption) seem to have been boosted in 

April by the weather and the royal wedding – rising 

by 1.2% m/m in April followed by a fall of 1.3% in 

May and a rise of 0.7% in June induced by heavy 

discounting and early summer sales. We find it 

difficult to see that consumption in underlying terms 

would have been 0.75% higher in Q2 than Q1 had it 

not been for special effects, when retail sales were 

less than 0.5% higher, even though April probably 

benefited from distortions. Consumption is much 

smoother than retail sales and we expect it to have 

been much weaker than retail sales Q2. 

Chart 2: Consumption vs. Consumer 

Confidence 


Chart 3: GfK Consumer Confidence and Real 

Earnings 

Given the relationship between consumer confidence 

and consumption in the national accounts (Chart 2) it 

does not make much sense to expect that, in 

underlying terms, consumption was strong in Q2. 

Real income developments (Chart 3) just do not 

make this a sensible assumption. 

Our own estimate of the downward distortion to Q2 

activity is lower than the ONS’s estimate – probably 

0.3%. Still, we have difficulty in believing what this 

would imply for underlying growth in Q2 – 0.5% q/q. 

This is because it is clear that from Q1 to Q2: 

• The manufacturing CIPS output index fell from 

58.3 to 52.7; 

• CIPS services fell from 57.1 to 53.9; 

• Government services look to have been flat; and 

• Retail sales rose 0.5% despite being boosted by 

good weather in April. 

So we estimate that GDP will be revised down (when 

is uncertain). Overall then, we do not trust the GDP 

figures for Q2. An underlying growth rate of 0.7% just 

does not tie in with where we believe the economy 

was during Q2, with weaker surveys, slowing global 

trade, with a continued squeeze on the consumer 

and pretty miserable consumer confidence. 

…but does give hawks at the BoE a case for 

postponing QE 

Unfortunately, all this matters a lot. If the BoE buys 

the story that underlying growth is 0.7% q/q, then 

QE’s chances are reduced a lot. This GDP release 

gives the hawks everything they could want, almost, 

and will avoid the Bank having to revise down its 

short-term growth forecast. The view that we took in 


Table 1: UK Economic Data 

Feb Mar Apr May 

Manufacturing 

Production (% m/m) 

-0.1 0.1 -1.6 1.8 

Retail Sales Inc Auto 

Fuel (% m/m) 

-1.1 0.0 1.2 -1.3 

CIPS Services 52.6 57.1 54.3 53.8 

CIPS Manufacturing 60.9 56.7 54.4 52.0 

Real Imports (Goods exerratics, 

% m/m) 

Real Exports (Goods, 

ex-erratics, % m/m) 


-2.8 -0.7 -1.7 5.6 

1.5 -2.8 -3.3 2.5 

Gilt Complex last week – that there was a good case 

for QE but that we did not think the BoE would be 

bold enough to take the opportunity until after 

inflation has peaked – has been reinforced. If 

underlying growth is above trend and inflation is still 

headed higher, any prudent central bank would hold 

its fire. 


Market Mover 

14 


Japan: How to Finance It All 

• In addition to the indeterminable costs 

stemming from the Fukushima crisis, the 

authorities must procure revenue to pay for 

welfare/fiscal reform, reconstruction and HBV 

compensation. 

• Welfare/fiscal reform should be the top 

priority in our view, as a 1½-year delay in 

initiating reforms will generate budget deficits 

equal to the entire cost of reconstruction. 

• While higher taxes should ultimately pay for 

all three, the consumption tax is most 

appropriate when a permanent source of 

revenue is required e.g. for welfare reform. 

• Income and/or corporate taxes are 

theoretically more appropriate when increased 

revenue is needed only temporarily, e.g. for 

reconstruction and hepatitis B virus (HBV) 

compensation. 

• To generate the requisite JPY 16.1 trillion for 

reconstruction and HBV compensation, income 

and corporate taxes would have to be raised to 

prohibitive levels. 

• If reconstruction and HBV compensation 

were financed using income taxes and 

corporate taxes, concurrently raising the 

consumption tax to finance social welfare/fiscal 

reform would likely prove impossible. 

• But putting welfare/fiscal reform on hold 

during the time needed to finance 

reconstruction and HBV compensation could 

cause Japan’s fiscal predicament to reach 

critical mass before reforms can begin. 

• A realistic way to tackle all of these 

problems at once involves progressively hiking 

the consumption tax to 10% between FY 2013 

and FY 2015, and then earmarking just 0.5pp of 

the tax increase for financing reconstruction 

and HBV compensation. 

Authorities must come up with revenue for three 

pressing issues 

The price tag for reconstructing devastated 

northeastern Japan is becoming clear. According to 

media reports, spending during the first five years of 

intensive reconstruction could total roughly JPY 19 

trillion. While this figure accords with the high end of 

our own estimate (JPY 14.1-20.0trn, see “Japan: The 

Cost of Reconstruction”, Market Mover, 16 June), it 

represents the total spending package, with actual 

Chart 1: Trend of Consumption Tax and Social 

Welfare Benefits for Aged 

20 

18 

16 

14 

12 

10 

8 

6 

4 

2 

0 

Revenue shortfall 

Consumption tax revenue 

Cost of 3 expense items for aged 

13.3 

12.8 

11.8 12.1 

10.4 11.0 

9.6 

10.1 

8.8 9.0 

4.6 4.7 5.3 5.8 

1.5 2.1 2.4 3.2 3.8 4.3 

9.1 9.8 

7.3 6.9 7.1 6.9 6.7 6.7 7.2 7.4 7.5 7.5 7.1 6.8 7.2 

spending by the government amounting to roughly 

JPY 15trn (including JPY 6trn from the two extra 

budgets already enacted). The authorities intend to 

raise taxes to finance roughly JPY 10trn, with the 

remainder coming from the sale of state property and 

other assets as well as the tapping of surpluses in 

special accounts. 

The bill for reconstruction is not the only claim on 

state funding. The authorities must also find the 

revenue to pay for social welfare/fiscal reform as well 

as compensation for the victims of hepatitis B 

infections (caused by the reusing of syringes in group 

vaccinations; the government had maintained the 

practice was safe despite overseas evidence to the 

contrary). 

Welfare/fiscal reform requires roughly JPY 13trn 

each year, reconstruction will require JPY 15trn over 

five years, and HBV compensation will require 

JPY 1.1trn over five years. Needless to say, huge 

16.2 

16.6 

17.2 

99 00 01 02 03 04 05 06 07 08 09 10 11 

Source: MOF, BNP Paribas * FY2011 is original budget. 

Chart 2: Milestones on Route to Fiscal 

Soundness 

GoalMilestones (example) 

(1) Set medium-term spending framework 

for FY2011-FY2013 

(2) Cut primary balance deficit (as % of 

GDP) in half 

10.0 

Timeframe 

FY2013 

FY2015 

(3) Achieve primary balance surplus FY2020 

(4) Debt-to-GDP ratio must be steadily 

reduced (stock target) and the primary 

balance must achieve a requisite surplus 

(flow target) 

From FY2021 

Source: Prepared by BNP Paribas from National Policy Office's 

Recommendations of the “Medium-Term Fiscal Management Task Force” 

Ryutaro Kono 28 July 2011 

Market Mover 

15 


amounts of money will also be needed in connection 

with the Fukushima crisis (clean-up costs, 

compensation claims etc), but the monetary figures 

cannot be estimated at this juncture, Hence this 

issue will have to be dealt with separately. Thus, with 

the government being pressed to finance these three 

issues – welfare/fiscal reform, reconstruction and 

HBV compensation – the question is, can they be 

tackled simultaneously? 

Maximin principle 

When faced with a number of problems, the fact that 

decisions must be made within a limited amount of 

time and with limited financial resources means it is 

important to concentrate on minimising damage (the 

Maximin principle). Consequently, while it would be 

best if some way could be found to simultaneously 

deal with all three issues, reality dictates that the 

Japanese authorities may have to choose based on 

some clear order of priority. 

Welfare/fiscal reform should have higher priority 

While other nations might shelve policies if funding 

cannot be secured for them, this doesn’t usually 

happen in Japan. Consequently, if all three of these 

issues are to be tackled, which should receive the 

highest priority in securing a stable source of 

funding? We would argue social welfare/fiscal reform, 

as the amount of money involved is so large. 

For instance, since FY 1999, the government has 

exclusively used consumption tax revenue (excluding 

the local consumption tax and transfers to local 

governments) for three expense items for the aged 

(basic pension, health care programmes and nursing 

care programmes). But tax receipts from this source 

in FY 2010 fell JPY 10 trillion short of the amount 

needed; hence the current welfare system is underfunded 

by more than JPY 10 trillion a year. 

Welfare essentially operates on budget deficits 

Japan’s social welfare systems are essentially 

structured to operate on budget deficits. Thus, 

putting off social welfare/fiscal reform by just 1½ 

years will generate public deficits equal to the entire 

cost of reconstruction. In terms of stopping the public 

debt from constantly swelling, it is clear that 

welfare/fiscal reform should be the top priority for 

securing stable revenue. 

Fiscal consolidation targets have been forgotten 

Japanese politicians seem to be unaware that 

delaying social welfare/fiscal reform will make it 

impossible to achieve the nation’s fiscal consolidation 

targets. In June 2010, the government unveiled its 

long-term strategy for fiscal management, setting as 

its targets the halving of the primary deficit by 2015 

and achieving a primary surplus by 2020. If nothing is 

Chart 3: Breakdown of National Taxes 

(JPY bn) 

Gasoline tax, 2,634 

Tobacco tax, 816 

Liquor tax, 1,348 

Consumption 

tax, 

10,199 

Others, 2,168 

Property tax 

(includes inheritance tax), 2,480 

Source: MOF, BNP Paribas 

300 

250 

200 

150 

100 

50 

Total 

\40.927 trillion 

(FY 2011 

budget figures) 

Income tax, 13,490 

Corporate tax, 

7,792 

Chart 4: Combined Central and Local 

Government Debt (% of GDP, FY) 

* Figures after FY2010 are our estimates. 

0 

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 22 

Source: MOF, Cabinet Office, BNP Paribas 

done to stop the welfare system from generating 

annual shortfalls of JPY 10 trillion, halving the 

primary deficit by 2015 will prove impossible – even if 

budgetary outlays are cut. The Kan government 

originally wanted to raise the consumption tax to 10% 

“by fiscal 2015” from its current level of 5% as part of 

its integrated social security/fiscal reforms, but 

opposition within the ruling DPJ forced that plan to be 

watered down with the vaguer expression of raising 

the tax “by the middle of the 2010s.” 

Sticking to the fiscal consolidation targets 

Even if welfare/fiscal reforms are initiated, financing 

reconstruction could make the fiscal reform targets 

hard to achieve. Thus, if it is felt that the targets 

cannot be realised, the government should either 

modify them or announce that financing 

reconstruction will be handled separately from longterm 

fiscal management. 

Doing one or the other is probably inevitable given 

that the trajectory of the primary deficit has deviated 

so greatly from the baseline scenario due to an event 

beyond anyone’s control. So when the government’s 

fiscal management strategy comes up for periodic 


Market Mover 

16 


eview, whether the target dates are retained, with 

reconstruction costs being handled separately, or 

modified because of 11 March is not the real issue. 

The really issue would come if the targets were 

abandoned entirely. 

Which taxes should be hiked? 

Which taxes ought to be raised to pay for welfare 

reform, reconstruction and HBV compensation? Even 

if reconstruction is financed using special bonds, 

there must be a clear source of revenue for 

redeeming those bonds. In FY 2011, the authorities 

expect to receive JPY 13.492trn in income tax 

receipts, JPY 7.79trn in corporate tax revenue and 

JPY 10.199trn from the consumption tax (this 

excludes JPY 2.569trn from the local consumption 

tax and transfers to local governments). Beyond 

these main taxes, the tobacco tax is projected to 

generate JPY 816.0bn and alcohol tax JPY 1.348trn. 

Consumption tax should be earmarked for social 

welfare/fiscal reform 

As noted above, the government has said that the 

consumption tax should be raised to 10% “by the 

middle of the 2010s.” While this timeframe is rather 

vague, the main opposition party, the LDP, basically 

holds the same view. Hiking this tax and earmarking 

the revenue for financing welfare/fiscal reform is 

preferable in our view as the consumption tax does 

not distort the efficient allocation of resources. 

(Income taxes penalise labour – a serious issue 

given Japan’s shrinking productive population.) 

Corporate taxes, such as on capital, essentially 

penalise capital accumulation and thus reduce 

investment– another serious issue as capital 

accumulation is slowing as society’s rapid ageing 

causes the savings rate to fall. When employment 

and investment opportunities are impeded, a falling 

trend growth rate results. 

Temporary hikes in income and/or corporate 

taxes would normally be best for reconstruction 

and HBV compensation 

Which taxes would be appropriate for financing 

reconstruction and HBV compensation? If the tax 

hike is for a limited time, income and corporate taxes 

are in theory more appropriate than the consumption 

tax. While the consumption tax has the least 

economic impact when the rate hike is permanent, a 

temporary hike can cause substantial fluctuations in 

consumer spending. Meanwhile, income and 

corporate tax hikes do not distort the allocation of 

resources if the duration of the tax hike is strictly 

limited. 

Income and corporate tax hikes would have to be 

in place a long time to finance reconstruction 

Chart 5: Public Debt and Primary Fiscal Balance 

(Central government + local governments, % of 

nominal GDP) 

primary fiscal balance 

4 

2 

0 

-2 

-4 

-6 

-8 

-10 

1981 

19922002 

20022007 

40 60 80 100 120 140 160 180 

long-term national debt, end of previous fiscal year 

Source: MOF, Cabinet Office, BNP Paribas 

2009 

2010 

From this point of view, one can applaud those 

ruling-party lawmakers that called early on for 

income and corporate taxes to be temporarily raised 

to finance reconstruction, with the consumption tax 

being reserved for social welfare/fiscal reform. But 

the problem is that these taxes would have to be 

raised more than the maximum 10pp deemed 

tolerable for the rate hikes to be temporary (i.e. less 

than five years) and still generate the requisite 

revenue for financing reconstruction and HBV 

compensation. 

Do those advocating income and corporate tax hikes 

really know how much revenue will be required for 

reconstruction? There is even talk about raising the 

taxes on alcohol and tobacco but the meagre 

revenue such hikes would generate would not be 

enough either. 

Theoretically, a one-shot hike of 10pp would boost 

income tax revenue by about JPY 1.35 trillion a year 

and corporate tax revenue by JPY 780 billion. With 

respect to corporate taxes, if the authorities put the 

effective corporate tax rate deduction planned for FY 

2011 on hold but still abolished various special 

deductions as scheduled, the effect would be roughly 

the same as the 10pp hike mentioned above. 

Tax hikes lasting more than five years are not 

temporary 

Given what we have said about the revenue 

generated by a one-shot 10pp tax hike, how long 

would it take to secure the JPY 16.1trn total needed 

for reconstruction (JPY 15trn) and HBV 

compensation (JPY 1.1bn)? An income tax hike 

alone would take 11.9 years and a combination of 

income and corporate tax hikes, 7.6 years. 

If the authorities sell assets and drain surpluses from 

special accounts to cut the reconstruction bill by JPY 

5trn, the total remaining bill of JPY 11.1trn would 

require 8.2 years to finance using income taxes 


Market Mover 

17 


alone or 5.2 years with a combination of income and 

corporate tax hikes. 

Corporate tax hikes are inappropriate 

Raising corporate tax is a big problem in itself. The 

high level of Japan’s corporate taxes compared to 

other nations is the very reason the government 

decided to cut the effective corporate tax rate in FY 

2011. 

The disaster has not changed anything. Hiking 

corporate taxes would likely encourage more 

companies to move offshore, something already 

being widely considered in view of the prospects for 

protracted power shortages. Raising corporate 

taxation should thus be avoided, in our view. 

However, to rule out corporate tax hikes and rely only 

on a fixed 10pp hike in income taxes would require 

8.2-11.9 years to finance reconstruction and HBV 

compensation. Such a long period would appear as a 

permanent tax hike. Even so, the government must 

not force future generations to pick up the bill. 

Will the Japanese public tolerate dual tax hikes? 

If reconstruction and HBV compensation were 

financed using income taxes alone or a combination 

of income and corporate taxes, it could prove 

impossible to implement needed tax hikes for social 

welfare/fiscal reform for the entire time these 

provisional tax hikes were in place. Would Japanese 

households stand for such dual tax hikes (income 

and consumption)? Would politicians risk re-election 

bids to enact such tax legislation? 

That DPJ backbenchers have succeeded in relaxing 

the timeframe for hiking the consumption tax reflects 

the fact that Lower House elections are due not later 

than 2013. If welfare/fiscal reform is put oh hold for 

the 8.2-11.9 years needed for income tax hikes to 

finance reconstruction and HBV compensation (or 

5.2-7.6 years with a combination of income and 

corporate tax hikes), Japan’s fiscal predicament 

could reach critical mass before reforms can begin. 

Each year of delay in beginning these reforms leads 

to another JPY 10 trillion shortfall that adds to the 

national debt. 

A suggestion for hiking the consumption tax 

We believe there is a way of tackling all of these 

problems at once. It involves progressively hiking the 

consumption tax to 10% between FY 2013 and FY 

2015. For example, the rate could be raised 3pp (for 

JPY 7.5 trillion in increased revenue) in FY 2013, 

followed by an additional 2pp in FY 2015 (JPY 5 

trillion in new revenue). The rate hike increments 

could, of course, be 2.5pp each, but the ultimate 

target is a hike of 5pp to secure JPY 12.5 trillion in 

new revenue. 

For 10 years, direct some consumption tax 

receipts to reconstruction, HBV compensation 

While we think that the consumption tax receipts 

would ideally be applied only to social welfare, some 

of the money could be channelled toward financing 

reconstruction and HBV compensation. For example, 

if just 0.5pp (roughly JPY 1.25trn) of the consumption 

tax rise is earmarked for financing these other two 

issues, the costs involved could be settled in roughly 

10 years (actually 8.9-12.9 years, depending on 

whether state assets are sold and special accounts 

tapped to reduce the bill). 

Given that the money needed for welfare/fiscal 

reform is far greater, to say nothing of the urgency of 

fiscal restructuring, it appears logical that the lion’s 

share of consumption tax revenue be directed to 

social welfare/fiscal reform. 

Meanwhile, during the period that consumption tax 

revenue is earmarked for reconstruction, we would 

recommend that the government hold off on 

expanding the scale of social welfare benefits, such 

as the current plan to provide financial support to 

low-income households and younger households 

with children. 

Ask voters if they would prefer dual tax hikes or a 

more comprehensive approach 

The reluctance of most lawmakers to back the use of 

consumption tax revenue to finance anything other 

than social welfare is unsurprising. It took more than 

a decade to win public support for tax hikes to 

stabilise social welfare; suddenly telling everyone 

that the consumption tax must now be raised to 

finance reconstruction and HBV compensation would 

risk losing the hard-won support for alreadyimplemented 

tax hikes. 

But the fact remains that the authorities must secure 

revenue for all three of these pressing issues. The 

government thus needs to take the problem to the 

public and ask whether voters would prefer dual tax 

hikes or a comprehensive approach involving the 

consumption tax. 

We expect the answer would not be dual tax hikes. 

The comprehensive approach has the added benefit 

of being the least harmful to the economy (this is 

something that is not well understood). As things 

stand, the authorities might be lucky to secure the 

revenue for reconstruction alone, and there is a 

significant chance that they fail to find funding to fully 

cover social welfare/fiscal reform, reconstruction and 

HBV compensation. 


Market Mover 

18 


Japan: Exports to China Remain Low 

• Thanks to the rapid restoration of supply 

chains, real exports surged 9.0% m/m in June 

after rebounding by 5.7% in May. 

• As a result, real exports have recouped their 

big contractions of March and April to stand 

generally on a par with the pre-disaster level of 

February. 

7500 

7000 

6500 

6000 

5500 

Chart 1: Real Exports (s.a., JPY bn) 

• US and EU-bound exports continue to boom 

with the easing of Japan’s supply constraints. In 

contrast, shipments to China, despite growing 

for the first time in four months, remain at a low 

level, reflecting China’s economic slowdown. 

• It is uncertain if overall exports can remain 

on an upward trajectory because the global 

economy, led by the EMs (China, India, Brazil), 

has shown a pronounced deceleration. 

• Real imports rose 1.2% m/m in June for the 

third straight increase, raising them to 2.9% 

above the pre-disaster level. 

• Imports remain strong on robust efforts to 

make up for domestic supply constraints, 

coupled with increased demand for mineral 

fuels, as the shutdown of nuclear reactors has 

increased dependence on thermal power. 

Trade balance remains in deficit for third straight 

month 

According to the MOF’s trade statistics, nominal 

imports inched up 0.5% m/m in June (2.3% in May), 

marking a third straight increase, but nominal exports 

picked up the pace with solid 5.4% growth (2.2% in 

May). As a result, the seasonally-adjusted trade 

account deficit shrank sharply from JPY 450.0bn in 

May to JPY 191.2bn in June. The trade account has 

now been in deficit for three straight months. The last 

time the account was in the red was August 2008- 

March 2009, when overseas demand collapsed in 

the wake of the Lehman shock (prior to that, the last 

deficit was in December 1981). Note that media 

reports about the trade account returning to surplus 

after two months of deficit are based on the original 

series data that are not seasonally adjusted. 

Real exports return to pre-disaster level 

Adjusted for exchange rate and price fluctuations, 

our calculations show real imports rose 1.2% m/m in 

June (3.2% in May), which is also a third straight 

increase. Exports also picked up the pace in real 

terms, expanding a robust 9.0% m/m after 

5000 

4500 

4000 

07 08 09 10 11 

Source: MOF, BoJ, BNP Paribas 

120 

110 

100 

90 

80 

70 

60 

Chart 2: Real Exports to US (2005 = 100) 

50 

05 06 07 08 09 10 11 


rebounding 5.7% in May. After plunging steeply in 

the wake of the Great East Japan Earthquake (– 

10.2% in March, –7.0% in April), real exports have 

rapidly recovered alongside the restoration of supply 

chains. As a result, real exports are generally on a 

par with their level before the disaster. Despite 

posting growth in both May and June, real exports 

contracted again on a quarterly basis in Q2, falling 

5.9% q/q (–0.4% q/q in Q1), but growth should 

resume from Q3 as exports fully recover. 

Slowdown in global economy casts doubt over 

continued export growth 

Looking ahead, domestic supply chain problems 

have been resolved but it is uncertain whether 

exports can continue an upward trajectory as the 

global economy, led by China, has shown a 

pronounced deceleration. Indicative of China’s 

slowing economy, the Chinese manufacturing PMI 

fell below the boom-bust line of 50 in July, continuing 

a steady downward trek that began in February. 

Ryutaro Kono / Azusa Kato 28 July 2011 

Market Mover 

19 


But the Chinese economy is not the only one that is 

weakening, as other big emerging nations, such as 

India and Brazil, are in the same boat. Against this 

backdrop of the G3’s super-low interest rate regimes, 

these emerging economies have opted to prevent 

local currency appreciation, with the result that 

monetary conditions became extremely 

accommodative, causing domestic demand to 

become red hot. This voracious demand has not only 

fuelled inflation but has triggered supply constraints, 

as demand has outstripped supply, and this is now 

causing these economies to slow. Making matters 

worse, monetary tightening was long held back out of 

the mistaken belief that price growth was just 

imported inflation (that element certainly exists but 

voracious EM demand, coupled with the spillover of 

G3 easing, is what caused the global commodity 

price boom in the first place). Now, emerging 

economies find that they must contend with rising 

inflation as well as slowing economic growth, making 

it very likely that they will have to continue monetary 

tightening to the detriment of growth, and Japanese 

exports. 

Export growth continued for most products 

Returning to June’s trade report, transport equipment 

(roughly 30% of total exports) was the sector that 

contributed the most to real export growth in June. 

Shipments of transport equipment rose a brisk 28.3% 

after robustly rebounding 31.5% in May. With 

automobile manufacturing virtually grinding to a halt 

when supply chains were ruptured by the disaster, 

exports by this key sector plummeted 20.0% in 

March and 27.5% in April. But thanks to the feverish 

restoration of supply chains, car production has 

rapidly recovered, allowing transport equipment 

exports to return close to their pre-disaster level 

quickly. Another key sector whose shipments have 

quickly returned to normal is ordinary machinery. 

After plunging 9.5% in March, ordinary machinery 

exports were the first to stabilise in April (0.2%), 

followed by solid gains of 4.5% in May and 7.2% in 

June. While the level is already 1.5% higher than 

before the disaster, the meagreness of this 1.5% 

margin suggests demand (especially from China) 

could be stalling. 

Meanwhile, exports of electrical machinery rose 8.0% 

(–0.6% in May), ending four straight months of 

declines that were due to severely reduced output 

capacity for semiconductors because the disaster 

knocked out numerous Tohoku factories. Although 

shipments of this key product seem finally to be 

turning around, a steady recovery from the current 

low level looks unlikely as the global IT/digital sector 

entered an adjustment phase in the spring, due to 

stagnant US consumer spending and the slowdown 

by China. 

Chart 3: Real Exports to China (2005 = 100) 

220 

200 

180 

160 

140 

120 

100 

80 

60 

05 06 07 08 09 10 11 


260 

240 

220 

200 

180 

160 

140 

120 

100 

80 

Chart 4: Real Exports to China of General 

Machinery (2005 = 100) 

60 

05 06 07 08 09 10 11 


On the downside, exports of chemical products still 

do not show any sign of recovering. After declining 

by 4.5% in March, shipments of chemical products 

revived with 2.7% growth in April only to plummet 

11.8% in May followed by a further 0.9% drop in 

June. With the level still well below the pre-disaster 

level, this sector may have finally recovered from 

domestic supply constraints but now faces the 

faltering of demand from China. 

US and EU-bound exports boom with easing of 

supply constraints 

A geographical breakdown of the June trade report 

(seasonally adjusted, real basis, our estimates) 

shows US-bound exports surging 13.1% m/m after 

rebounding with 12.5% growth in May. Leading the 

surge was transport equipment (36.6% share in 

2010), which expanded a brisk 31.3% after soaring 

46.2% in May. Even so, owing to the steep declines 

posted earlier (–25.9% in March, –39.0% in April), 

transport equipment exports are still 13.3% below the 

pre-disaster level. US-bound shipments also 

remained solid for ordinary machinery (9.4% in May, 

12.0% in June) and electrical machinery (3.5% in 

May, 5.9% in June). 


Market Mover 

20 


EU-bound shipments also remained firm, expanding 

a robust 10.0% after surging 10.1% in May, with the 

result that they are 0.4% above the pre-disaster level. 

While most product categories posted gains, the 

most pronounced was again transport equipment, 

which surged 27.7% after soaring 34.9% in May. 

While the economic recoveries in both the EU and 

US are faltering, the fact that the export numbers 

through June remain so robust can be attributed to 

the easing of Japan’s supply constraints. 

China-bound exports still at a low level 

Exports to Asia rose 8.1% m/m (–1.5% in May), 

ending three months of declines. Although Japanese 

factory activity revived from May with the restoration 

of supply chains, shipments to Asia (and China) did 

not pick up until June. Leading the recovery was 

transport equipment, whose shipments surged 39.9% 

(–2.5% in May). Asia-bound exports of electrical 

machinery also revived (7.6% growth following -2.3% 

in May) but adjustments in the global IT/digital sector 

make it unlikely that shipments of this product will 

continue to expand. 

Exports to China, Japan’s largest trading partner, 

also grew for the first time in four months, with a solid 

advance of 9.6% m/m (–6.3% in May). Even so, the 

level is still 15.3% below the average for January- 

February, reflecting China’s reduced economic 

momentum. Leading the rise in China-bound 

shipments was transport equipment, which soared 

30.5% (4.7% in May) and electrical machinery, which 

expanded a brisk 10.5% (–1.3% in May) for the first 

rise since the 11 March disaster. Meanwhile, ordinary 

machinery exports averted a decline in June but the 

modest 2.7% growth after the plunge of 14.4% in 

May suggests this sector, which was relatively 

unscathed by the disaster, remains weak owing to 

faltering Chinese demand (on this score, machine 

tool orders from China have been soft since 

February.). On the downside, shipments to China of 

chemical products declined for a fourth straight 

month (–3.7%, –10.2% in May), as Chinese demand 

is faltering just as Japanese chemical production is 

getting back to normal. 

Real imports expand for third straight month 

Finally, after increasing for three straight months to 

June, the volume of imports is 2.9% above the predisaster 

level. Imports’ continued strength, despite 

the sharp drop in the economy’s operating level after 

the disaster, reflects robust demand for mineral fuels 

(LNG, petroleum products), as the shutdown of 

numerous nuclear reactors has increased 

Chart 5: Real Exports to China of Electrical 

Machinery (2005 = 100) 

260 

240 

220 

200 

180 

160 

140 

120 

100 

80 

60 

05 06 07 08 09 10 11 


Chart 6: Real Exports to China of Chemicals 

(2005 = 100) 

200 

180 

160 

140 

120 

100 

80 

60 

05 06 07 08 09 10 11 


dependence on thermal power generation. With 

public disapproval making it increasingly hard to 

restart idle nuclear plants, dependence on thermal 

power is sure to increase, keeping imports of mineral 

fuels at very high levels. However, it is not just 

imports of fuel that are increasing, as shipments 

have increased for a wide array of products from 

electronics and chemicals to textiles, all of which 

reflects efforts to make up for domestic supply 

constraints. 

With imports expected to continue to grow more 

strongly than before, real GDP may not rise 

appreciably, even if production continues to expand 

(imports subtract from total GDP). On this score, we 

project external demand (net exports) subtracted 

0.9pp from the change in GDP in Q2 after subtracting 

0.2pp in Q1. 


Market Mover 

21 


Australia: Excessive Volatility 

• Australian rate expectations have been 

whipped around this year, recently switching to 

pricing in cuts. 

• The consumer lacks confidence, but other 

areas of the economy are holding up better. 

Underlying inflation pressures appear to be 

bubbling up. 

• Our forecast remains for a rate hike in Q4. 

The risk is that it is not delivered. But bar a 

significant worsening in global conditions, 

expectations for an RBA cut look premature. 

Taking a step back 

Australian rate expectations have been whipped 

around this year. At the time of writing, the futures 

market was pricing in some chance of a cut by the 

RBA from December onwards. However, at its most 

pessimistic (around 18 July) the market was pricing 

in two 25bp of cuts by around April 2012 and some 

probability of a third by mid-year. In late May it had 

been pricing in a hike by end-2011 and at the start of 

2011 it was looking for 50bp of hikes during the year. 

Our view on the RBA has been more stable. From 

January through to May we were forecasting no 

change in the cash rate during 2011. In May we 

changed our RBA forecast to include a 25bp in 

August (subsequently pushed back to October). The 

change largely reflected the more hawkish language 

of the RBA at the time. Specifically, it noted in its 

Quarterly Statement and the minutes to the May 

meeting that: 

“…members judged that if economic conditions 

continued to evolve as expected, higher interest 

rates were likely to be required at some point if 

inflation was to remain consistent with the mediumterm 

target.” 

Past behaviour suggested that having touted the idea 

of a rate hike, the RBA would act within a few months. 

However, since the RBA’s adoption of a bias to hike 

and since our forecast change in May, there have 

been a number of developments that significantly 

challenge our rate forecast, not least that the RBA 

back-tracked on its bias to hike in the July minutes. It 

noted that “the flow of recent information suggested 

both that there was more time to assess the likely 

strength of inflationary pressures in Australia and that 

it would be prudent to use that time”. Other factors 

affecting our forecast are discussed below. 

External concerns 

To some extent downside risks to the global 

economy have crystallised. Certainly, problems in 

Europe flared up in June and July. However, a more 

comprehensive approach to dealing with them, 

agreed at a eurozone summit on 21 July, has, in our 

view, improved the outlook. 

Just as the debt situation in the eurozone was being 

brought under greater control, the debate, or debacle, 

over raising the debt ceiling in the US came to the 

fore. This has helped undermine US consumer 

confidence at a time when the economy has already 

lost some momentum. Our central expectation 

remains that the ceiling will be raised at the eleventh 

hour, but there remains considerable uncertainty. It 

may be that the ceiling will only be upped by enough 

to pay the bills until early 2012. The issue would then 

come back onto the agenda ahead of a new round of 

elections. Nonetheless, providing the ceiling is raised, 

at least for a while the situation will be less fractious. 

Moreover, as the shocks from the Japanese disaster 

and oil price spike earlier in the year continue to fade, 

US growth should pick up to an albeit still-modest 

pace in the second half of the year. 

In Asia-Pacific, Chinese data have been mixed. 

While Q2 GDP was a little better than expected, 

indicators such as the manufacturing PMI have 

weakened further. Moreover, GDP was supported by 

a boost to net trade from stronger exports and 

weaker imports, which looks to be temporary. 

Domestic demand softened during the quarter. With 

CPI inflation jumping to 6.4% y/y in June, the 

authorities remain in a difficult position. Our central 

expectation is that they will selectively ease policy, in 

line with the aim to support growth outlined at the 

CCPCC Poliburo Summer Economic Meeting. 

However, high current inflation means the risk is that 

there is some delay or that the magnitude of easing 

is more limited than initially expected, at least in the 

near term. Overall, however, our forecast is that the 

economy begins to strengthen in Q4. 

The external situation, while precarious now, should 

improve in the balance of the year. The risks, 

however, are skewed to the downside. 

Dominic Bryant 28 July 2011 

Market Mover 

22 


Consumer caution 

Domestic data have been mixed, but on balance 

have tilted towards the disappointing side. Consumer 

confidence has been a particular area of weakness. 

It has dropped significantly below average levels and 

is now close to the lows seen in 2001 and during the 

GFC. The weakness in levels terms is driven by 

concerns over family finances. Sentiment, both 

looking back over the past 12 months and looking 

forward over the next 12 months, is exceptionally low 

(Chart 1). On a three-month moving average basis 

the forward-looking index is below the levels seen in 

the financial crisis, albeit still marginally above mid- 

2000 levels and still notably above early 1990 levels. 

Confidence in economic conditions over the next 12 

months and next five years, while down significantly 

on levels at the start of the year, is still above 

average. Similarly, despite significant pessimism 

over their own finances, on a three-month moving 

average basis, households appear to believe it is a 

better time than usual to buy a major household item. 

Similarly, confidence in the labour market, although 

down sharply in the last few months, is still around 

average levels. It is therefore difficult to fully 

understand why households are so pessimistic. 

One factor is the stance of policy. Interest payments 

on dwellings as a share of income are close to alltime 

highs. However, they have been stable since Q2 

2010 and are likely to have remained so in Q2 2011. 

If the RBA hikes rates again, it will only be fine tuning. 

The squeeze on incomes is therefore not likely to 

become significantly worse. 

Chart 1: Worried About Finances… 

Source: Reuters EcoWin Pro, BNP Paribas 

Chart 2: …But Willing to Buy? 


Chart 3: Solid Employment Expectations 

Stock market jitters and house prices flattening off 

may be weighing on households’ wealth expectations. 

Headline inflation at 3.6% y/y is also crimping real 

income growth. But none of the above factors in 

isolation would appear to explain Australian 

households’ pessimism. We struggle to see that 

current levels of pessimism over family finances are 

justified by fundamentals, such as unemployment, 

income growth and the policy stance. 

It may be that a run of negative shocks, such as the 

Queensland floods, Japanese tsunami, commodity 

price increases, the debt crisis in Europe and the 

latest wrangling in the US, have left households 

feeling vulnerable despite solid Australian 

fundamentals. If this is the case it means that as the 

impact of these negative shocks unwind, which is 

already happening in Queensland and Japan and we 

expect to happen Europe and the US, Australian 

consumer confidence will gradually recover. 

Business as usual 

Business confidence has softened but there is little 

evidence of the distress that households appear to 


be feeling at present. Business conditions are below 

average but far above 2000/01 and 2008/09 lows. 

Within this aggregate, forward orders looked sluggish 

in June, but are volatile month to month. For example, 

in August last year they fell sharply to a level notably 

below their current reading before recovering sharply. 

Employment intentions, which are more stable have 

held up in recent months and are consistent with 

solid employment growth (Chart 3). 


Market Mover 

23 


Importantly, judged against firms’ employment 

expectations, the recent increase in consumers’ 

concern over unemployment looks to be, in the main, 

a correction to previous excessive optimism (Chart 4). 

Don’t forget about inflation 

The Q2 inflation figure gave the market a timely 

reminder that expectations of a rate cut in Australia 

are highly premature. Measures of underlying 

inflation were strong. Both printed 0.9% q/q, or 

3.6% q/q annualised, in Q2. In Q1 the average of the 

weighted median and trimmed mean inflation was 

3.4% q/q annualised. Therefore, underlying 

annualised inflation over the last two quarters has 

been well above the RBA’s target (Chart 5). 

The approximately 3.5% q/q annualised pace of 

underlying inflation in the last two quarters means 

that relatively modest quarter-on-quarter increases in 

Q3 and Q4, for example around 2.25% annualised, 

will be enough to push the year-on-year underlying 

rate up to 2.9% by end-year. Given this is nudging 

the upper end of the RBA’s target range, a rate hike 

remains possible. 

While a strong AUD may weigh on inflation, there are 

also upside risks to inflation. For example, unit labour 

costs are rising quickly (Chart 6). The recent spike in 

labour cost growth should unwind, as it is due to the 

flood-induced drop in Q1 GDP. However, 

compensation per employee, which is not affected by 

the temporary drop in GDP, also highlights the 

potential for underlying inflation to rise from here. 

Chart 4: Consumer Correction 


Chart 5: Inflation Jump 


Chart 6: Unit Labour Cost Risk 

This is not to say Australia is on the verge of 

developing a significant inflation problem. But given 

the RBA’s mistake in the previous cycle – allowing 

inflation to pick up significantly above target – it may 

well favour a further precautionary tap on the brakes 

to ensure history does not repeat itself. 

Chance of a hike 

After the upside surprise to Q2 inflation, we retain our 

forecast of a rate hike in Q4 this year. The risk is 

clearly that, with policy already restrictive and 

consumer confidence soft, the RBA holds fire. 

Providing the situation in the US is resolved and the 

actions taken in the eurozone are successful in 

preventing a significant shake-out in financial 

markets with spillovers to the major economies, 

market pricing of rate cuts in Australia looks 

unnecessary. Moreover, the modus operandi of the 

RBA in the past has been to wait for clear evidence 

of the need to ease policy and then act aggressively. 


Since 1993 the RBA has cut rates on 17 occasions. 

Only five of those were 25bp moves. Bar the solitary 

move in December 1998, no cutting cycle has begun 

with a 25bp move. With underlying inflation 

pressures bubbling up, the Australian economy is 

clearly a long way from needing significant monetary 

loosening. The next move is more likely to be a hike. 


Market Mover 

24 


US/EUR Spread: Impact of a US Downgrade 

• The probability of a downgrade of the US’s 

sovereign credit rating has increased and is 

now very high. 

Chart 1: US/EUR Spreads 

• While the impact on US yields may be 

limited, a downgrade would lead to a widening 

of the US/EUR spread. 

• STRATEGY: Buy 10-30y USD/EUR box 

spreads. 

Risk of a US downgrade high 

As the chances of a large reduction of the US federal 

budget deficit are fading, an agreement to raise the 

debt ceiling may not prevent rating agencies from 

downgrading the US’s sovereign credit rating. Our 

US strategists see the probability of such a 

downgrade as very high and a downgrade as the 

most likely scenario in the coming weeks. This may 

lead to the downgrade of agencies, especially in the 

MBS sector. However, our US strategists also 

consider the potential for a rise in US Treasury yields 

as limited (less than 25bp in the 10y area). One of 

the key reasons for this is that there is almost no 

alternative for investors. Therefore the USD 17trn of 

debt does not look to be at massive selling risk (for 

more details on the domestic impact, see article “US: 

Impact of a Potential US Downgrade”. 

Double impact on US/EUR spreads 

While limited, the impact of a downgrade of US debt 

on Treasuries’ yield would be significant, especially 

on US/EUR spreads. A one-notch downgrade of the 

current rating would put US debt under a AA+ rating. 

Comparison to similar ratings to asses what could be 

the fair spread between US T-Notes and the EUR 

benchmark (currently at 32bp) is difficult. By 

definition, there is no other USD sovereign debt. In 

the dollar area, New Zealand is the only AA+ 

sovereign. The 10y New Zealand yield is close to 

5%, a level irrelevant for the 10y Note. In the EUR 

area, the only AA+ sovereign is Belgium and the 10y 

OLO/Bund stands around 160bp. Such a spread 

level for the 10y T-Note/Bund spread also looks 

unrealistic. In other sectors, we can make some 

comparisons. For instance, the 10y AA Corp 

US/EUR spread is slightly above 50bp, while the 10y 

US AA/EUR AAA Corp spread is above 100bp. 

All else being equal, a 20-25bp rise in the T-Note 

yield would push the 10y T-Note/Bund spread closer 

to 60bp, which is between the USD AA / EUR AA 

spread and the USD AA / EUR AAA spread in the 


Chart 2: US and EUR Long Ends 


corporate sector. However, a US downgrade could 

also have an impact on EUR yields. Indeed, as such 

a downgrade would add to the current risk-off trading 

mode, it would further fuel the bid for safety. This 

may drag 10y Bund yields lower in the coming 

weeks. The impact may be moderate, but a further 

5-10bp decline in yields cannot be ruled out in such 

conditions. In such an event, the 10y T-Note/Bund 

spread may be pushed 5-10bp wider as well, into the 

65-70bp area, i.e. double its current level. 

In addition, a downgrade is expected to lead to a 

steepening of the 10-30y segment of the US curve. 

The 10-30y EUR segment looks less exposed to 

such a move in the near term, especially if stock 

markets continue to weaken. The 10-30y USD/EUR 

box spread is therefore also likely to widen. 

Strategy: Buy the 10-30y USD/EUR box spread. 

Currently at 58bp, the spread may widen closer to 

65-70bp. 

Patrick Jacq 28 July 2011 

Market Mover, Non-Objective Research Section 

25 


US: Impact of a Potential US Downgrade 

• A one-notch downgrade would not cause 

forced selling of USTs. Still, there could be a repricing, 

with UST rates rising by 25bp or more in 

long maturities. 

• GSEs debt would also be subject to 

downgrade along with USTs. Agency securities 

are widely held by high credit quality investors, 

particularly foreign Central Banks (USD 734bn), 

and there are likely to be very few forced sellers. 

Over time, we expect investors will diversify 

where possible to other AAA-rated paper, 

resulting in wider agency debt spreads to USTs, 

with longer-duration, less-liquid paper coming 

under particular pressure. 

• Agency MBS is likely to suffer vs. USTs, at 

least initially, owing to a number of factors 

including higher haircuts and increased market 

volatility. 

• The unsecured Fed funds market is likely to 

escape the downgrade unscathed, but repo 

rates and margin requirements are headed 

higher, as the large providers of cash and credit 

demand slightly higher haircuts for downgraded 

collateral. But as far as we know, the Federal 

Reserve is not increasing their haircuts on 

Treasury and Agency securities, and that should 

provide an anchor to the market. 

• Ramifications for corporate credit are 

modest. A few financials will experience 

downgrades, but the implications are expected 

to be mixed for banks. 

• Ratings for Aaa munis directly linked to the 

government are likely to move in tandem with 

the US rating, leading to some selling for 

liquidity purposes, but forced selling is not 

expected. 

One of the most important lessons learned over the 

last few years has been the need to evaluate 

potential “knock-on” effects from the various 

unprecedented developments that have transpired. 

Fundamental linkages such as the decline in US 

consumer spending subsequent to housing’s 

collapse or the curtailment in lending activity as 

banks repaired their balance sheets were not hard to 

envision, when the right scenario assumptions were 

applied. However, the technical and X-asset class 

linkages were harder to predict and, ultimately, more 

damaging to security prices and investor risk 

appetites. Examples such as the roll-back of SIV’s 

onto bank balance sheets or the pace of money fund 

redemptions immediately subsequent to Lehman 

Brothers’ bankruptcy filing come to mind. Investors 

who have sufficiently contemplated both unanticipated 

events and the possible policy responses 

have been best equipped to avoid land mines and 

add risk at opportune times. 

We believe it is timely to review the potential knockon 

effects to a possible downgrade to the US 

Sovereign senior debt rating. We are reviewing one 

possible branch of the decision tree (the one we 

believe to be most likely) in order to thoroughly 

assess the transmission effects across the major 

fixed-income markets. This note does not evaluate 

the various potential outcomes subsequent to a 

hypothetical debt-service breach. 

Since Treasury securities serve as the primary 

valuation benchmark and hedging tool for many other 

market instruments, a potential downgrade has 

numerous first and second order implications for key 

parts of the capital markets. The very political nature 

of the ongoing discussion in Washington and the 

related media reporting has resulted in a good deal 

of hyperbole and misinformation tied to this topic 

lately. Therefore, separating partisan hype from likely 

market developments is crucial. 

Key Takeaways 

If the US sovereign rating were downgraded to AA+ 

by one or more of the major rating agencies, we 

believe there would be many small knock-on effects 

but no major ones. If, as we assume, the markets 

have largely discounted the potential for this to occur, 

we do not believe disorderly or panicked markets will 

ensue. In the near term, a number of municipal, 

corporate and structured finance credits will likely 

experience minor price adjustments as they suffer 

UST-linked downgrades. Some Government 

Securities bond funds may experience selling 

pressure as they lose their coveted AAA ratings. And 

the cost of financing and repo for a range of market 

participants will increase, adversely effecting both 

liquidity and profitability for those involved. 

We do not anticipate money market funds to face 

sizable redemptions or fund downgrades in the near 

term, in large part because the UST A-1+ is expected 

to be affirmed. We also do not expect material 

changes to repo lines or haircuts. The level of 

interest rates and the extreme level of liquidity are 

powerful mitigants to drastic changes in front-end 

behaviour. 

Bulent Baygun / Mary-Beth Fisher / Mark Howard 28 July 2011 


26 


Based on discussions with a broad range of money 

managers, insurance companies, central banks, and 

other institutional investors, we believe a migration to 

AA+ for UST will not force asset divestitures or 

purchase curtailments sufficient to disrupt orderly 

markets. This reflects the predominant wording in 

most investment mandates, the absence of ratings 

triggers, the functioning of most benchmarks and the 

requirements of the NAIC, among other 

considerations. 

Longer term, UST and related downgrades will seep 

into nearly every aspect of the financial markets, 

marginally raising the cost of capital and hurdle rates. 

It is also expected to impinge on bank profitability as 

Basel 2.5 guidelines are adopted. However, there is 

a small chance that one or more downgrades serve 

as a wake-up call and spur Washington into more 

concerted action and a possible re-attainment of the 

AAA rating down the road. 

Central Assumptions 

For the purposes of this report, we have made 

several important assumptions. First and foremost, 

we do not contemplate a missed payment or default 

of any kind on US government securities. Were this 

to occur, our scenario analysis would play out quite 

differently. In addition to a debt-ceiling deal, we are 

assuming that a modest budget agreement is 

reached by policy makers in Washington (roughly 

USD 2trn). Building on these assumptions, we 

conclude that Standard & Poor’s would likely lower 

the senior debt rating of the US by one or two 

notches but affirm the A-1+ short-term rating. 

However, based on discussions and our analysis, we 

assume that Moody’s and Fitch would not lower their 

sovereign ratings under this scenario (see Tables 1- 

3). 

For the purposes of this analysis, we assume that 

rather than leave the UST under review, they will 

affirm their respective AAA ratings, albeit with 

negative outlooks. We have also made the implicit 

assumption that all of this happens against the 

backdrop of a tentative, but stable, near-term market 

context in Europe now that a new financial construct 

has been introduced and the bank stress tests have 

been disseminated. Last and importantly, we are of 

the belief that despite (and partly due to) the market’s 

focus on developments in Europe, the migration of 

UST ratings to AA+ will not cause a major sustained 

downward price move in Treasury securities. As a 

consequence of the debt ceiling’s multi-month 

headlines and the rating agencies’ numerous reports 

on the US government’s eroding creditworthiness, 

we believe sufficient hedging and portfolio repositioning 

has already occurred so as to limit the 

violence of any subsequent price action. 

Table 1: Standard & Poor’s Ratings 

current projected 

US Long-term AAA AA+ 

US Short-term A-1+ A-1+ 

Outlook Negative Negative 

S&P has stated if the debt ceiling is raised in time to avoid 

a default, but without a credible deficit reduction plan of 

~$4 trn, then they might lower the US long-term sovereign 

rating from AAA to AA+ within 3 months; possibly as soon 

as early Aug. 

Within weeks of a US downgrade, S&P would also 

downgrade the following government-linked institutions: 


Fannie Mae AAA AA+ 

Freddie Mac AAA AA+ 

FHLBs AAA AA+ 

FFCB AAA AA+ 

US insurance groups AAA AA+ 

Military govt agencies AAA AA+ 

Source: Standard & Poor’s 

Table 2: Moody’s Ratings 


US Bond rating* Aaa Aaa 

US Short-term P-1 P-1 

*On review for possible downgrade 

Moody's has stated that if the debt ceiling is raised in time 

to prevent a default, the bond rating would likely be 

confirmed at Aaa. 

Source: Moody’s 

Table 3: Fitch Ratings 


US Sovereign AAA AAA 

US Long-term AAA AAA 

US Short-term F1+ F1+ 

Outlook Stable Stable 

Fitch has thus far maintained a stable outlook on the 

US. If the debt ceiling is not raised by August 2nd, 

Fitch will place the US sovereign rating on RWN 

(ratings watch negative). 

Source: Fitch 



27 


Treasury Market Considerations 

While there are some exceptions, an overwhelming 

majority of a broad spectrum of investors will be able 

to hold on to their UST holdings in the event of a 

downgrade, presumably to AA+. In other words, 

there is little reason to expect forced selling of USTs. 

This is true for a number of reasons: 

• Investment mandates typically specify the types 

of securities in which a portfolio can invest. In the 

case of US government securities (defined as 

securities backed by the full faith and credit of the 

US), very often there is no specific stipulation that 

they need to be AAA, so a downgrade does not 

automatically translate to ineligibility. 

• For most real money investors (central banks, 

money managers, insurance companies, etc.), the 

overall credit quality of their portfolio is the main 

consideration in terms of what they can and cannot 

hold. In the event of a downgrade, the average 

quality of the portfolio would suffer. Although it may 

at first seem counter-intuitive, this could conceivably 

prompt portfolio managers to sell their lower-quality 

assets, investing the proceeds in USTs to maintain 

the overall quality. 

• Indexed portfolios mainly need to mimic the 

moves in the composition of their respective 

benchmark – so as long as USTs remain in the 

benchmark, such portfolios do not need to liquidate 

their USTs. 

• In the event that a downgrade pushes UST 

securities outside the mandate of a portfolio, there 

will likely be a waiver issued as is often the case in 

similar situations, and then, a change in investment 

guidelines will be sought to maintain the holdings on 

an ongoing basis. 

For these reasons, it is widely expected that any selloff 

in USTs will likely be limited in magnitude. 

Essentially, if investors sell, they will do so not 

because they are forced to sell but because they 

want to express a view. 

Another factor that should help keep a lid on UST 

rates is that the Fed will likely maintain easy 

monetary policy to accommodate any ensuing fiscal 

tightening, encouraging investors to extend farther 

out on the curve. Furthermore, a preference for 

liquidity could bring flows into USTs, especially 

benchmark issues, most notably in intermediate (5- 

7yr) maturities. 

Most estimates of the rise in yields hover around 

25bp for long maturities – although S&P’s report “The 

US Debt Ceiling Standoff Could Reverberate Around 

the Globe – With or Without A Deal” puts the 

estimate in the 25-50bp range. 

Amount ($ billions) 

Chart 1: Foreign Official Holdings of USTs, 

Agency Debt and MBS 

3,500 

3,400 

3,300 

3,200 

3,100 

3,000 

2,900 

2,800 

2,700 

2,600 

May-09 

Jul-09 

Sep-09 

Nov-09 

Jan-10 

Mar-10 

May-10 

Among the reasons why there could be a market 

repricing (to the tune of 25bp or more) are the 

following: 

• USD could come under pressure, as investors 

call into question the status of the USD as the 

reserve currency (admittedly not as much as in the 

case of an actual default). In that case, investors 

would want to protect themselves against higher 

inflation, and this would be true especially if 

commodities, being denominated in USD, spiked in a 

mechanical reaction. 

• Inflation-linked securities (TIPS) may have a 

different treatment than USTs, in that they are not 

necessarily lumped in as Treasuries – sometimes 

with an explicit exclusion in the definition of what 

“Treasury Securities” mean. Therefore, TIPS may be 

more vulnerable to selling flows than nominal USTs. 

Combined with higher inflation expectations, this 

translates to higher nominal rates. 

• The cost of capital would increase – although 

most would expect a small change in the haircuts for 

USTs, if any. Still, to compensate for the loss of 

Jul-10 

Source: Federal Reserve Bank of New York 

Foreign Official Holdings of 

Treasuries, Agency Debt & MBS 

Table 4: Other Large AAA-Rated Sovereign 

Debt Markets 

Sep-10 

Public Debt 

Outstanding* 

Nov-10 

Jan-11 

Mar-11 

May-11 

Sovereign 

Rating 

Canada $1,304 AAA 

United Kingdom $1,796 AAA 

France $2,059 AAA 

Germany $2,288 AAA 

Total $7,447 

Japan $10,892 AA- 

*This total does not include foreign agency debt of the 

countries above. 

Source: The Economist 

Jul-11 



28 


carry, UST yields would have to rise as investors 

require a bigger enticement to hold USTs. Under 

Basel 2.5, which is supposed to kick in at the end of 

2011, banks are required to hold capital for 

Incremental Risk Charge (IRC) – this is basically a 

credit charge to account for the risk of a downgrade 

on the ratings of the securities banks hold in their 

portfolio. Even now, with USTs being rated AAA, the 

IRC charge is supposed to impose a significant cost 

on banks as they hold significant amounts of USTs. 

History Lessons 

The lack of any historical precedent for a downgrade 

of the US makes it particularly challenging to 

handicap a market reaction with great precision. 

However, similar episodes in a few developed 

countries do provide some guidance. If we look at 

other developed nations that have faced potential 

and actual downgrades, then the results suggest that 

rates did indeed rise at first. The magnitude of the 

initial moves in the 10y rate was +50bp (UK), +80bp 

(Canada), and +160bp (Japan). 

However, the long-term impact on debt prices 

appears to be positive (conceivably due to austerity 

measures being taken in the aftermath of the 

downgrades). Perhaps, it takes a market reaction to 

really bring opposing lawmakers together in 

agreement, and some have expressed this view 

regarding the current debate in the US. 

The most recent event to compare this with is the UK 

budget battle (for a more complete summary, see our 

note in “UK: English Lessons”, Market Mover, 21 

April 2011). In May 2009, S&P came out with a 

negative outlook and Gilt yields rose (also widening 

vs Bunds). Part of this was also due to higher 

inflation in the UK, but when it was announced later 

that there was a hung parliament at the general 

election (causing uncertainty that policymakers could 

agree on a budget), this caused the Gilt/Bund spread 

to widen sharply. This proved to be short-lived as a 

coalition agreement was signed and Gilts tightened. 

S&P later returned its outlook on UK debt from 

negative to stable. If we try to capture the initial 

negative reaction, what we notice is that 2y yields 

rose +40bp, 10y +50bp, and 30y +25bp. 

Ratings cuts to Japan have not prevented 10y yields 

reaching very low levels of 1-2%, although the 

domestic demand base for JGBs does differ from the 

more diverse/international demand base for USTs. 

The initial downgrade from AAA status came in 1998 

by Moody’s. This initial warning shot sent yields 

sharply higher, but even though there were several 

more downgrades from 1998-2002 from Moody’s and 

S&P, JGBs recovered during this period, although 

with the help of lower inflation. In terms of the initial 

downgrade, the final score was: 2y yields +55bp, and 

10y +160bp (there was no 30y bond market at the 

time in Japan). 

Canada’s long-term debt was first downgraded by 

Moody’s from AAA status in 1994, and yields peaked 

soon after that. Once again, the long-term trend in 

yields was lower in the years after that episode. In 

this case however, the market initially bear-flattened 

with 2y yields rising 115bp, 10y by 80bp and 30y by 

75bp. 

Impact on the GSEs 

As S&P has stated, government-sponsored entities 

are meaningfully linked to the US government’s 

credit standing. Therefore, in the event the US longterm 

rating is downgraded from AAA to AA+, the 

GSEs will have their ratings downgraded in-line. In 

particular, this applies to: 

• Fannie Mae 

• Freddie Mac 

• Federal Home Loan Banks 

• Federal Farm Credit Bureau 

These four GSEs have combined outstanding debt of 

USD 2.5trn, which would all drop from AAA to AA+. 

The mortgage-backed securities issued by Ginnie 

Mae, Fannie and Freddie are not actually rated 

separately by S&P, but they inherit their rating from 

the issuing agency. A one-notch downgrade of the 

US will result in the approximately USD 5.4trn of 

AAA-rated agency MBS dropping to AA+. 

Agency debt and MBS are widely held. Among the 

largest investors are foreign central banks (USD 

734bn and USD 2.7 trn of UST securities – see Chart 

1), domestic banks, insurance companies and 

pension funds, as well as state and local 

governments – all of which have requirements or a 

pronounced desire to hold AAA or high-credit quality 

assets. As stated earlier, the number of forced sellers 

of these products are very few. The sheer volume of 

holdings of foreign central banks and their need to 

remain USD invested will likely prevent them from 

initiating large selling programs. We do expect many 

investors will diversify where possible to other AAArated 

issuers, and there may be a slowdown in 

buying on the margins, particularly in agency MBS 

due to its longer duration. Investors could move into 

AAA rated foreign sovereign debt, but as shown in 

Table 4 the amount outstanding is dwarfed by UST 

and Agency debt outstanding. (Note that, in the event 

of issuer default or receivership, senior unsecured 

debt is pari passu to the agency MBS guarantees; 

so, there is no difference in the two claims from a 

credit perspective.) 



29 


Overall, we expect this activity will result in the 

following: 

• Wider spreads to Treasuries for agency debt. 

Spreads are not likely to break through the upper end 

of the range of the past year, except perhaps in very 

long-dated, off-the-run paper. 

• Widening of the agency MBS basis, with long 

cashflow CMOs under the most pressure. 

One noteworthy impact of the downgrade for the 

GSEs from AAA to AA+ is that it would activatea 

lowering of collateral thresholds embedded in their 

ISDA agreements with their derivatives 

counterparties. For example, if the net fair value of 

an entity’s OTC derivatives trades to a broker-dealer 

are in a USD 500 million loss position, then the entity 

posts cash or eligible collateral (typically Treasuries) 

above some threshold, say USD 100 million. So the 

entity posts USD 400 million of collateral to the 

broker-dealer. The ISDA spells out how much a 

ratings downgrade of the counterparty will lower that 

threshold. A multi-notch downgrade might lower the 

threshold to zero, while a single-notch downgrade 

might reduce it by half, to maybe USD 50 million in 

the example above. That means the counterparty 

now must post an additional USD 50 million in cash 

or collateral to secure the derivatives positions. 

Fannie, Freddie and the FHLBanks all have 

significant derivative portfolios that are marked to 

market daily, so they both pledge and accept 

collateral under master netting arrangements across 

a variety of counterparties. Although each will need 

to post more collateral if the threshold drops, the 

incremental increase is relatively small compared to 

both: 

a) The amount of collateral that they already 

post, and 

b) The daily swings in fair market value of those 

positions. 

To illustrate, Fannie Mae’s Q4 2010 annual report 

shows that they posted an aggregate USD 3.4bn in 

cash collateral as a result of their derivatives 

activities. We can conservatively assume that 

exposure is across 10-15 counterparties, each of 

which has current threshold of USD 100 million, that 

drops to USD 50 million in the event Fannie is 

downgraded from AAA to AA+. That would mean 

Fannie needs to post an additional 10 * USD 50mn = 

USD 500 mn or 15 * USD 50mn = $750 mn in 

collateral to secure their derivatives positions. That is 

clearly not a trivial number – on the high side, USD 

750/USD 3,400 = a 22% increase in collateral – but it 

is an amount they could easily pull from their lending 

in the interbank or repo markets, where they routinely 

park tens of billions of dollars in cash. 

Agency MBS 

Even before an actual downgrade, there has been 

some pressure on agency MBS (vs Treasuries) and 

lower liquidity, and this is likely to continue if the US 

were indeed downgraded, at least initially. There are 

several reasons for this: 

• Unlike USTs, which do not have an explicit credit 

rating requirement in most investment guidelines, 

Agency MBS falls in the category (“other AAA-rated 

securities”) where ratings do matter. 

• Many investors have affirmed that their 

guidelines are more stringent when it comes to 

Agency MBS vis à vis USTs. 

• A downgrade, and the attendant market 

uncertainty, should lead to higher market volatility – 

something that would also be captured in implied 

volatility. Being negatively convex, mortgages would 

suffer in a high volatility environment initially, 

widening to USTs. 

• The increased haircuts would be another hurdle 

to own Agency MBS, affecting them more severely 

than USTs. 

Looking past the initial market reaction, Agency MBS 

should find a bid – among portfolios that can hold 

them at the new rating level – since higher rates 

means lower prepayment risk, making them more 

attractive to spread buyers. 

Impact on Short-Term Financing Markets 

We can dispense with the easiest first: 

Fed Funds: No impact. 

It is a completely unsecured lending market. The 

GSEs are certainly among the biggest lenders in the 

Fed funds market right now, but as we stated above, 

a moderate cash drain as a result of higher collateral 

postings is unlikely to meaningfully raise the rate at 

which money that changes hands here. 

Repo / Margin: low-to-medium impact, higher rates. 

There are multiple factors that influence rates in the 

repo market, and the closely related margin 

requirements for posting collateral. Generally 

speaking, the weaker, more price volatile (longer 

duration) or more illiquid the collateral, the higher the 

haircut. 

If we assume the quality of the collateral is stable, 

then repo rates are driven by the dynamics of the 

supply of cash from the lenders (GSEs, money 

market funds, corporations) versus the demand for 

cash from the borrowers (broker-dealers, hedge 



30 


funds, central banks, SecLenders) that need to 

finance their collateral. When the Federal Reserve 

implements monetary policy in a “normal” 

environment, it does so by conducting temporary 

open market operations – which it hasn’t done since 

late 2008, except as part of an operational readiness 

program. These operations with the primary dealers 

are done exclusively through repo/reverse repo of 

Treasury securities, agency debt or agency MBS. 

The Fed publishes a collateral schedule with haircuts 

as part of its discount window lending, but it applies 

as well to open market operations. There is no 

expectation at this time that the Federal Reserve is 

going to increase its haircuts on Treasuries and GSE 

securities based on a downgrade of the US and 

GSEs from AAA to AA+. 

Despite the presumed stability of haircuts from the 

Fed, we expect others over time will begin to adjust 

their haircuts higher in both repo and margin. The 

Chicago Mercantile Exchange (CME) – which revises 

its haircuts frequently – this week increased its 

haircuts by 0.5% to 1.0% on Treasury, agency and 

some foreign sovereign collateral. Although these 

adjustments are routine and haircuts were below 

historical norms, we believe the potential downgrade 

did influence their decision somewhat, despite their 

denials. We expect other exchanges, broker-dealers 

and SecLenders to follow in the days and weeks to 

come if the potential downgrade becomes a reality. 

Corporate Credit Impacts 

A downgrade of UST to AA+ by Standard & Poor’s 

would have some consequence on financial credits 

but a de-minimus impact on corporates and utilities, 

in our view. Of course, the USD 244 billion of FDIC 

guaranteed TLGP debt issued by banks and insurers 

would face immediate downgrade. Since all of this is 

short duration and predominantly backed by sound 

credits, we do not believe these downgrades would 

cause but a ripple for the affected holders. In 

addition, six AAA-rated insurers would face likemagnitude 

adjustments to their credit standings due 

to sovereign ceiling criteria for financial strength as 

well as their significant UST holdings. However, 

because these insurers represent roughly USD 6bn 

of debt outstanding and because their standalone 

business profiles are so strong, one or two notch 

downgrades should have minor, if any, knock-on 

effects. 

Standard & Poor’s has indicated that a one or two 

notch UST senior debt downgrade will not have 

immediate implications for the creditworthiness of US 

banks. Unlike Moody’s, S&P does not infer enough 

sovereign support into current bank ratings to 

necessitate linked downgrades under the scenarios 

we have assumed. Of course, if higher interest rates 

and lower economic growth were to occur as a 

consequence of a weak budget compromise and 

S&P’s downgrade to AA range, bank earnings and 

asset quality trends would most likely weaken 

somewhat over time, all things equal. In addition, if 

international banks embrace new and stricter Basel 

guidelines later this year or next, UST ratings 

downgrades would be expected to require even 

greater capital charges for their significant Treasury 

holdings. 

One additional knock-on for banks from an S&P 

downgrade of the US relates to expected 

downgrades for the US clearinghouses and one 

CSD. The rating agency believes that a sovereign 

downgrade may increase securities volatility, reduce 

prices, increase margin calls and reduce the value of 

clearinghouse and CSD invested capital. While these 

concerns are understandable in the more extreme 

UST-default scenario, they are much less likely to be 

of concern if just one rating agency applies a one or 

two notch downgrade of the US. Under our base 

case of no default and just one of three rating 

agencies removing the UST’s AAA rating, we do not 

believe a potential clearinghouse/CSD downgrade 

will have a material immediate spill-over influence on 

broader markets or banks in particular. 

For AAA-rated non-financial corporates, S&P (and 

Moody’s) has stated that sovereign downgrades to 

AA will not lead to corporate ratings actions. This 

reflects the fact that the four remaining AAA-rated 

firms are sufficiently strong on a standalone basis 

and do not have disproportionate revenue or asset 

exposures to UST. To the extent that the sovereign 

downgrade creates a near term “risk-off” reaction in 

the capital markets, high yield corporates would be 

expected to experience a knock-on effect to 

valuations. However, since little of a fundamental 

nature will have changed for these companies, we 

would expect this price action to be temporary. 

Finally with regard to corporates, there is some 

concern that fund managers may be required or 

otherwise motivated to sell corporate bonds to even 

out portfolio risk parameters subsequent to a UST 

downgrade to AA+. Based on investor discussions 

and prospectus reviews, we do not believe this to be 

a cause for concern with the majority of domestic 

mutual fund and money managers, nor will it be of 

concern to active or passive investors looking to 

minimize benchmark tracking errors. The one place 

where risk budgets may require some modification is 

with insurance companies. For life companies, we 

believe the critical variable to monitor is the UST’s 

NAIC rating. All likely near-term outcomes short of a 

default would see the UST retain its “1” rating, 

removing the need to adjust credit holdings. For P&C 

companies, some risk adjustment might seem 

warranted, especially since liquidity is such a critical 



31 


portfolio attribute. However, given that UST debt 

remains the most liquid in the world, we would not 

expect to see major adjustments in credit allocations 

in response to UST downgrades, unless and until the 

expected future returns for credit deteriorated. 

Money Market and Bond Fund Implications 

Fortunately, the most liquidity/redemption sensitive 

fund products are not likely to be downgraded in the 

near term. Because subtle but important distinctions 

need to be made, one must differentiate between the 

creditworthiness of the underlying fund holdings from 

that of the fund entity. Once clarified, we believe it is 

instructive to look through to the end investors and 

their objectives and constraints. Based on this 

framework, we come to the following conclusions: 

• For money market funds, both liquidity 

considerations and fund credit ratings need to be 

evaluated. NAV stability drives individual as well as 

institutional behavior in money funds while fund 

ratings matter to a greater degree with institutional 

investors. 

• We do not expect UST money market funds 

to experience outsized volatility in the event of a 

sovereign downgrade because their investment 

mandates are driven by the SEC’s rule 2A-7. This 

edict requires “tier 1” or “tier 2” ratings on money 

fund holdings. In practice, the top tier is required for 

borrowers to have meaningful access to a broad 

range of money funds. Tier 1 is determined by the 

short-term debt ratings and would not be 

compromised unless 2 or more agencies lowered 

their senior debt ratings by 6 or more notches. Put 

another way, the current AAA would have to fall 

below A for the short term rating to drop to Tier 2. 

And even in this unlikely event, the funds would have 

some discretion over the timing of related portfolio 

dispositions. In the absence of forced divestiture of 

the underlying and in light of the absence of 

alternative, safe money market investments, we do 

not envision particular turbulence or redemption 

demands in these money market funds under our 

base case. However, in the unlikely event of a UST 

default event or another shock akin to the Lehman 

Brother bankruptcy, money market fund turbulence 

cannot be ruled out. 

• Unlike longer-term bond funds, US 

Government securities money market funds are 

unlikely to face ratings-induced downgrades which 

should allay concerns about large institutional 

redemptions. While these funds hold an estimated 

USD 1.3 trillion of US Government and related 

securities, their fund ratings are based on numerous 

factors, not just underlying collateral ratings. Portfolio 

stability, duration, liquidity and mark-to-market stress 

tests combined with the willingness and ability of the 

fund management company to support the fund are 

all considered when ratings are assigned. 

• For bond funds, where individuals are the 

primary holders, ratings may matter on the margin, 

but the nature of the product limits the scope for 

immediate liquidity demands. Bond fund NAV’s move 

in response to underlying fund holdings’ price 

changes, but there is no assumption of principal 

preservation. This greatly limits the need for fire 

sales of fund holdings in response to redemption 

requests. Therefore, if S&P downgrades the fund 

quality ratings on the 73 bond funds currently on 

CreditWatch, we do not foresee any spill-over effects 

to the broader fixed income marketplace. 

Munis 

In munis the main takeaway, similar to USTs, is that 

there would be little forced selling, for the following 

reasons: 

• For downgraded AAA credits, assuming just a 

single notch downgrade, muni portfolios can still 

typically hold them as AAs. 

• For lower-rated munis that would be 

downgraded, note that all these credits were recently 

optically upgraded by one to three notches when 

rating agencies re-mapped their muni ratings to the 

corporate scale. Some would just revert to or above 

their original rating. In other words, portfolios would 

not have to sell these securities since they already 

owned them at similar or better ratings in the past. 

However, some selling flows should still be expected 

even though muni credit quality would not change 

much. These would come in different waves and 

could have a varying degree of intensity. As a side 

note the outflow from munis could even benefit 

USTs. 

• Build America Bonds (BABs): Issued between 

February 17, 2009 and December 31, 2010, there 

are USD 181bn BaBs outstanding. Foreign holders 

may be particularly interested in unwinding their 

positions, not just because of the downgrade, but 

also because of the gains they can lock in due to 

appreciation since issuance. 

• Concurrently, high net-worth investors (mostly 

domestic) would sell another slice of their tax-exempt 

muni holdings as they did last November. Such 

action would not be an expression of a negative 

sentiment on US munis, but rather of a negative 

sentiment on the US itself. Some of that money could 

be recycled in USTs for liquidity purposes. 

• There could be some marginal selling from direct 

and indirect retail investors. While the muni market 

size is around USD 3.5 trillion, most of it is static, 



32 


eing in retail + insurance companies + commercial 

bank + foreign hands, so the actual "tradeable" 

market is, in fact, quite thin, and it does not take 

much to move the market. 

Moody’s published a report, “Implications of a US 

Rating Action for Aaa-Rated US Municipal Credits”, 

dated 13 July 2011, addressing some aspects of the 

downgrade issue. Here are the important points: 

• 7000+ directly linked Aaa credits (USD 130bn 

par amount), placed on review for possible 

downgrade, will move in lock-step with the US rating. 

These include muni bonds defeased with Treasury 

and/or Agency securities, and certain housing bonds 

either secured by mortgages which are insured or 

guaranteed by the US government or Fannie 

Mae/Freddie Mac, or receive payment streams from 

the US government. 

• Indirectly linked Aaa credits have no explicit 

guarantees or support from the US government. 

Action will be taken over the next several weeks. 

• Vulnerable credits: subject to review for possible 

downgrade or negative outlook (e.g. dependence on 

Medicaid matching funds). 

• Resilient credits: will NOT be placed under 

review for downgrade; could be rated one to two 

notches above US government (e.g. low reliance on 

direct or indirect transfers from the federal 

government or low dependence on capital markets 

for liquidity) 

Note that among all Aaa-rated entities, there are: 

• 15 Aaa states – five of which are already on 

negative watch: MD, NM, SC, TN, and VA 

• 440 local governments 

• 100 Housing Finance Authorities (HFAs) 

• 43 higher-ed and not-for-profit 

There is a silver lining on the muni front: states and 

local governments have been cleaning up their 

balance sheets aggressively since the crisis. A big 

part of this has been achieved by cutting expenses 

(e.g hiring/wage freezes, furloughs, layoffs, among 

other things) and the creation of new revenue 

sources. Furthermore, unlike the Federal 

government, municipalities are bound by law to have 

a balanced budget 

. 



33 


US: Missed Payments Shocking Front USTs 

• T-bills maturing in August have sold off in 

recent days from 0.05% to around 0.15%. In 

terms of the math, this implies that Treasury will 

miss payments for over a month! 

• Of course, other factors such as selling 

flows have pressured these T-bills. 

• It is still very difficult to believe that 

Treasury would allow payment to be missed. 

But it’s useful to know the mathematical impact 

on bond yields because it can help us gauge the 

market’s expectation of the length of default. 

The mathematical impact of delayed payments 

It turns out that credit markets have to deal with this 

all the time. Corporations or other governments 

sometimes miss payments; the market knows about 

it in advance; there is some guidance as to when 

payments will resume; and so, bond prices adjust 

and reprice. It’s a similar situation in this case, just on 

a slightly grander scale. 

If a coupon payment is missed, then we assume it 

will eventually be paid but with no compensation for 

the delay. Treasury officials have not clarified this yet 

and maintain that 2 August is the doomsday date. 

Various recent analyses have suggested 10 August 

instead, so we will assume this cut-off date for now. 

The closer a bond is to maturity, the more the yield 

will rise to adjust for a missed payment. Therefore, 

the biggest payment shocks are seen in T-bills 

maturing in August (see Table and Chart 2). 

Incidentally, when we move out to 1y maturities and 

longer, the impact is less than 0.1bp. 

Is this the maximum sell-off we expect in a 

default? Because this makes the T-bill reaction 

look very scary. 

If there is a heightened chance of default as we 

approach 10 August, then the shock due to missed 

payments is actually the minimum reaction we would 

expect. There will be other factors to contend with, 

too, and not just selling flows. There is uncertainty 

about financing these assets, in terms of the repo 

cost and also the margin requirement having to go up 

if there is a downgrade or default. However small 

these factors might be, everything will add up. 

Notice in the Table that we show where T-bills are 

currently trading, and they are implying more than a 

1-month delay in payments. This is assuming that the 

Chart 1: Here We Go – 1M/3M Bill Curve Inverts 

7 

6 

5 

4 

3 

2 

1 

0 

-1 

-2 

-3 

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 

Table: T-Bills Repricing Under 2W or 1M Delays 

T-Bill 

Initial Yield 

(on July 25th) 

New Yield 

(2W Delay) 

Change 

(bp) 

New Yield 

(1M Delay) 

Change 

(bp) 

Current 

Yield 

11-Aug 0.05% 0.07% 2.2 0.12% 7.0 0.15% 

18-Aug 0.05% 0.06% 1.4 0.09% 4.4 0.12% 

25-Aug 0.05% 0.06% 1.0 0.08% 3.4 0.10% 

1-Sep 0.05% 0.06% 0.7 0.07% 2.1 0.06% 

8-Sep 0.05% 0.06% 0.5 0.06% 1.0 0.06% 

15-Sep 0.05% 0.05% 0.4 0.06% 1.3 0.06% 

22-Sep 0.05% 0.05% 0.5 0.07% 1.6 0.05% 

29-Sep 0.05% 0.05% 0.5 0.07% 1.6 0.05% 

Chart 2: BP Shock to Bill Yield Curve (1M Delay) 

8 

7 

6 

5 

4 

3 

2 

1 

0 

Bill 11- 

Aug 

Bill 18- 

Aug 

Bill 25- 

Aug 

Bill 1- 

Sep 

All Charts and Table Source: BNP Paribas 

Bill 8- 

Sep 

Bill 15- 

Sep 

Bill 22- 

Sep 

Bill 29- 

Sep 

only impact is due to bond math and not the other 

factors above. In this case, the sell-off since July 

25th would clearly be an overreaction because it’s 

happened in only a few days. This should underscore 

how much uncertainty there is over how much stress 

the short end could face. 

At the end of the day, it’s not a huge dollar impact 

since the duration of these bonds is minimal, but it’s 

interesting, nevertheless, that the T-bill market has 

suddenly woken up and may wake up others, too. 

Suvrat Prakash 28 July 2011 


34 


MBS: Staying Underweight 

• We maintain our underweight allocation on 

MBS with every passing day without a 

resolution on the debt ceiling. 

• GN/FN swaps may continue to see support 

as investors may question an implicit 

guarantee, when an explicit guarantee itself is 

under question. Overseas entities are the 

principal investors in the US sovereign credit 

but not in GSE credit, and their support of 

GNMAs may not change all that much. 

• GNMA 60-day delinquencies increased 

from 1.20% to 1.23% in June; however, the 

absolute level is much lower than in past 

years. 

• FRE’s retained portfolio resumed declines 

in June after an increase in May due to roll 

activity. 

Remain Underweight MBS 

We moved to an underweight position on MBS early 

last week due to a possible US downgrade or 

selective default. With the continued impasse over 

the debt-ceiling, we maintain that stance. Since the 

Obama and Boehner USD 4 trillion plan fizzled, 

current coupon mortgages have widened by 13 ticks, 

while up-in-coupon has outperformed (Chart 1). 

As investors assess the impact on their portfolios or 

wait for a resolution on the debt ceiling, liquidity 

should remain poor. Asset sales on the margin to 

keep some cash on hand to deal with a potential 

selective default or downgrade should continue to put 

pressure on the basis. Funding for MBS took a turn 

for the worse on Wednesday and further impacted 

spreads. We have also seen long-duration CMOs 

sales from insurance companies, which make sense 

given the likelihood of the long end on the curve 

underperforming in the current climate. Dealer MBS 

inventories remain around the Lehman crisis levels. 

While we maintain an underweight allocation, MBS 

underperformance is not likely to be particularly 

outsized. As we’ve discussed in prior notes, 

insurance companies should not see a significant 

impact as the top NAIC ratings extends down to an 

A- (or equivalent) rating. Risk weights for banks for 

conventionals and GNMA’s should remain at 20% 

and 0% respectively, as the weights are not tied to 

ratings. The impact on money managers depends on 

the language in individual prospectuses, but mostly, 

they are not likely to be forced sellers. 

Chart 1: Mortgage Performance (vs Swaps in 

Ticks as of Wednesday, 27 July) 

CPN 1D Since Friday 1M 

3.5 -0-06 2 -0-16 4 -0-13 7 

4.0 -0-05 4 -0-13 0 -0-11 0 

4.5 -0-05 5 -0-10 3 -0-10 0 

5.0 -0-05 3 -0-07 7 -0-05 4 

5.5 -0-05 0 -0-04 2 -0-02 6 

6.0 -0-04 6 0-01 3 -0-01 2 

Source: Yield Book, BNP Paribas 

Chart 2: REIT Balance Sheets Normalised to 

USD 100bn 


$ bn (USD) 

Assets: 

Agency MBS $ 94.0 

Cash $ 0.7 

Treasuries, Agencies etc $ 1.3 

Other $ 4.0 

Total $ 100.0 

Liabilities: 

Repos $ 79.9 

Other Liabilities $ 7.7 

Equity $ 12.4 

Total $ 100.0 

Chart 3: Holders of Treasury Securities as of 

Q1 2011 (USD 9,621bn) 

Insurance & 

Pension 

Funds, 

$1,074 , 11% 

State & Local 

Govt. , $506 , 

5% 

Mutual Funds, 

$696 , 7% 

Rest, $1,230 

, 13% 

Banks*, $329 

, 3% 

Source: Federal Reserve 

Fed, $1,340 , 

14% 

*Banks, Saving Institutions and Credit Unions 

Foreign 

Holdings, 

$4,445 , 47% 

Increase in haircuts and funding may somewhat hurt 

REIT and hedge fund ROEs. But we do not see an 

immediate selling pressure from REITs which have 

been a dominant supporter of MBS recently. 

Anish Lohokare/Timi Ajibola 28 July 2011 


35 


Consider the balance sheet of some prominent 

REITs in Chart 2, combined and normalised to USD 

100bn. Assuming a typical haircut of 5%, the repo 

level of USD 80bn indicates that about USD 84bn in 

securities are encumbered. The total agency MBS 

size of USD 94bn indicates that USD 10bn of 

securities may be unencumbered. On top, if we add 

treasuries, agency debt, reverse repo agreements, 

etc, about 12% of assets may be available, should 

haircuts increase. This is a very generous buffer, in 

case haircuts increase of the order of 2% or so in a 

selective default scenario. 

Overseas investors have already diminished their 

purchases of conventionals since the credit crisis, but 

may reduce purchases further. GNMAs should be 

impacted to a lesser degree. Due to the overriding 

matter of sovereign credit for foreign investors, we 

think GNMAs are comparable to Treasuries and not 

conventionals in this context. It would be unlikely for 

these investors to materially weaken support for 

Treasuries (and GNMAs) given their sizeable 

holdings, but not so for GSE securities Note that 

foreign entities are the largest investors in the 

Treasury market (Chart 3) but are relatively modest 

investors in GSE securities (Chart 4). Their holdings 

of Treasuries vs Agency debt + MBS is a 4:1 ratio, 

which would skew further if we club GNMAs with US 

Treasuries and compare US vs GSE credit (due to 

data limitations GNMA and conventionals were 

clubbed together). 

As we’ve discussed previously, in an era where the 

willingness of the US to repay its own direct 

obligations has come under questions, investors 

could question the willingness to support GSEs, 

which should also be supportive of GN/FNs. Further, 

if the Treasury does not inject equity to make up 

GSEs loss in fair value below 0 in Q2 2011 within 60 

days of quarter end, GSEs would enter receivership. 

This “what if” scenario, while highly remote, should 

still help GN/FNs on the margin. 

High coupons had cheapened on the possibility of 

refi legislation, but their hedged carry has improved 

(Chart 5) as volatility declined. To that extent, up in 

coupon could do better. But valuations appear to be 

on the richer side for 5.5s and 6s. Also, in case of a 

default or a receivership, where investors would have 

access to collateral before further claims are made to 

GSEs, higher coupons would have higher credit 

losses. From a credit perspective, higher coupons 

are thus less attractive. We continue to maintain our 

neutral stance on the coupon stack. 

GNMA DLQ up, Lower than Previous Years 

The GNMA delinquency report for June showed an 

increase in 60-day delinquencies across all products 

from 1.20% to 1.23%. By issuer, we saw similar 

results. For instance, BofA 60-day delinquencies saw 

Chart 4: Holders of Agency and GSE securities 

as of Q1 2011 (USD 7,648.7bn) 

Insurance & 

Pension Funds, 

$970 , 13% 

US Govt.**, $583 

, 8% 

Rest, $925 , 

12% 

Mutual Funds, 

$1,174 , 15% 

Source: Federal Reserve 

*Banks, Saving Institutions and Credit Unions 

**Federal, State and Local Government 

Foreign Holdings, 

$1,173 , 15% 

Fed, $1,070 , 

14% 

Banks*, $1,754 , 

23% 

Chart 5: 1M Hedged Carry in Ticks 

Curve Hedged Curve & Vol 

CPN Roll Carry Hedged Carry 

3.5 9.9 0.9 0.1 

4.0 11.0 3.0 0.6 

4.5 11.3 4.7 1.2 

5.0 11.0 5.4 2.4 

5.5 8.4 3.4 2.2 

6.0 9.0 4.7 3.5 

Source: Yield Book, BNP Paribas 

Chart 6: Monthly 60-Day GNMA 

Delinquencies by Vintage (Fixed and ARMs) 

60 day Delinquences 

2.3 

2.1 

1.9 

1.7 

1.5 

1.3 

1.1 

0.9 

0.7 

0.5 


2011 2010 2009 

2008 2007 2006 

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 

an increase from 1.14% to 1.17%, Chase increased 

from 1.58% to 1.60%, Citi increased from 1.38% to 

1.46%, GMAC increased from 1.53% to 1.61%, and 

Wells increased from 0.88% to 0.91%, but TBW 

declined from 4.08% to 4.07%. In addition, 30-day 

delinquencies also increased from 3.43% to 3.47%. 

Although delinquencies picked up again, the overall 

level of delinquencies continues to be low when 



36 


compared with the same period over the previous 

three years. For instance, versus 1.23% in June 

2011, 60-day delinquencies in June during previous 

years were 1.49% in 2010, 1.89% in 2009 and 1.46% 

in 2008. (Chart 6) 

Overall GNMA 90+ day delinquencies increased from 

1.20% to 1.27%, and CBRs increased from 2.69% to 

3.26%. The increase in 90+ day delinquencies was 

led by BofA whose 90+ day delinquencies increased 

from 1.14% to 1.41%. While BofA CBRs increased 

from 0.23% to 0.73%, the increase was substantially 

less than we expected. We believe that there is 

further room for BofA CBRs to increase next month, 

especially given the elevated 90+ day delinquency 

level, the second highest level over the past year. 

Overall, GNMA fixed-rate voluntary speeds (CRR) 

increased by 11% to 6.14; in comparison, FHLMC 

voluntary speeds increased by 20% to 12.47 and 

FNMA voluntary speeds increased by 21% to 12.49. 

FRE Summary: Portfolio Decline Resumes 

FRE’s retained portfolio was down USD 4.6bn to 

USD 685.03bn in June, with the declines spread 

across agency MBS, non-agency and whole loan 

holdings. Total debt outstanding declined by USD 

3.6bn to USD 695.22bn, and delinquencies declined 

by 3bp to 3.50%. The duration gap was 0, while the 

sensitivity of the portfolio to a 50bp shift in the level 

of rates, a measure of negative convexity, increased 

from USD 397mn to USD 469m. 



37 


EUR: OIS/BOR Spreads Still Wider 

• The price of liquidity is pushing higher in 

USD and in EUR. This ascent may gather pace 

given rising concerns (US downgrade, EUR 

peripherals…). 

Chart 1: Limited Scope for Higher Eonias 

• While tensions on eonias have a limit given 

the full allotment at ECB tenders, euribors are 

more subject to pressure. 

• STRATEGY: Pay OIS/BOR spreads. 

Stress on liquidity has not eased 

Demand at this week’s ECB operations provided 

evidence that the pressure on liquidity remains high 

and that the risk-off mode is a key driving force. 

Demand for the MRO (1-week liquidity) came out at 

EUR 164.2bn (EUR 197.1bn expiring) and demand 

at the 3mth LTRO reached EUR 85.0bn (EUR 63.4bn 

expiring). As a result, liquidity provided to the 

eurosystem dropped EUR 11.3bn. 

At this stage of the reserve maintenance period, we 

should expect to see the amount of liquidity provided 

declining slightly as banks are well ahead of their 

reserve requirements. However, the drop in demand 

was less than in normal times. This points to some 

tensions. Moreover, the decrease in 1-week demand 

and the increase of demand for 3mth liquidity shows 

that term liquidity supplied in the market is drying up. 

While eonias are unlikely to rise sharply in the 

coming days and weeks, given the large frontloading, 

euribors remain subject to upward pressure. This is 

keeping OIS/BOR spreads paid. 

After the results of the stress tests on banks were 

published, one might have thought that stress on 

banks would have receded somewhat. But, as 

concerns about Greece and other peripherals persist, 

and given the elevated exposure of banks to 

sovereign risk, the risk premium on financials has not 

eased at all. The close correlation between financial 

CDS and OIS/BOR spreads leads us to see further 

risk of widening. 

In addition, USD liquidity seems likely to richen in the 

current context (uncertainty about an agreement to 

raise the debt ceiling, high risk of a downgrade of US 

debt). A downgrade of US debt would certainly fuel 

demand for liquidity. Dollar OIS/BOR spreads are 

therefore exposed to the risk of severe widening 

pressures in the near term. This can only add to the 

global pressure on liquidity. 


Chart 2: OIS/BOR Spreads Still Exposed to 

Widening 


Tensions could mount further in the near term 

Given the current environment, the scope for eonia to 

decline is clear but limited. At the very least, recent 

tensions will ease somewhat. But OIS/BOR spreads 

may rewiden further. The rise of financial CDS keeps 

widening pressures on OIS/BOR spreads. 

The situation in the US may add to current stress. 

The impact of a downgrade on US debt yields seems 

likely to be limited. But as it will intensify the search 

for cash, with no possibility of the Fed delivering a 

more accommodating liquidity policy, the risk is 

clearly on the upside for USD Libor spreads. 

Strategy: Continue to pay OIS/BOR spreads at 

current levels. 

Patrick Jacq 28 July 2011 


38 


EMU Debt Monitor: CDS Analysis 

Chart 1: AAA 5y CDS Basis: A Very 

Short-Lived Narrowing 

Chart 2: Wider Olo/OAT Spread and Tighter 

Belgium/France 5y CDS Differential 

115 

5Y CDS basis 

cash expensive vs CDS 

140 

120 

100 

5Y CDS and cash spreads 

90 

80 

60 

65 

40 

cash cheap vs CDS 

40 

Jan-11 Feb-11 Mar-11 Mar-11 Apr-11 May-11 Jun-11 Jun-11 Jul-11 

AUS FIN FRA NETH 

20 

0 

Jan-11 Feb-11 Mar-11 Mar-11 Apr-11 May-11 Jun-11 Jun-11 Jul-11 

BEL/FRA BEL/FRA cash FRA/NETH FRA/NETH cash 

The decline in AAA CDS from Monday 18 July’s extreme levels was short-lived and stopped on Friday. On the basis side, the 

swap spread widening – due to a renewed flight to quality and buying of protection – led to a sharp rewidening of AAA basis 

(Chart 1). AAA CDS – especially for Germany and France – not only reflect the sovereign risk but also local banks’ exposure 

to peripherals. The release of the second stress test results this month showed a reduction in non-core holdings but has not 

led so far to a protracted compression of AAA CDS basis. For instance, while the Germany and Belgium CDS basis 

differential used to move very closely, they have diverged since the second week of July. Chart 2 also highlights the diverging 

path between wider Olo/OAT spreads and the tightening of Belgium/France CDS (more than 20bp over the past week, 

z-scores for cash and CDS in the second table below are also quite telling). Such a decoupling – due to excessively cheap 

France CDS – is unsustainable and we believe will be corrected by tighter Germany and France CDS basis. 

All Charts Source: BNP Paribas 

CDS Table & Stats 

5y FIN NETH FRA AUS BEL ITA SPA POR IRE GRE 

CDS 45 48 112 86 175 272 320 1007 935 1650 

CDS Weekly change -1 0 2 1 -24 -31 -30 -271 -323 -900 

cash -34 -37 -20 -12 97 224 261 1226 1008 1343 

Basis 79 84 131 98 77 48 60 -219 -73 307 

Basis Box vs Gy -44.1 -38.5 8.3 -25.1 -45.5 -74.4 -63.1 -341.7 -195.3 184.1 

Average -31.1 -26.3 2.5 -14.5 0.4 -19.2 -10.7 -166.2 -203.9 37.6 

Max -23.8 -14.3 13.8 4.7 20.4 5.5 15.8 3.7 -1.2 885.6 

Min -46.4 -46.2 -10.3 -40.8 -45.5 -78.0 -64.9 -408.3 -417.4 -227.1 

Z score** 2.89 1.42 -1.19 1.11 3.62 3.08 2.90 1.49 -0.09 -0.47 

Change to 31/12/2010 CDS Cash 

2y 5y 10y Current Min/Max z-score Current z-score 

FIN 12 14 18 AUS/BEL -89 -124/-64 -0.5 -109 -2.7 

NETH -8 -7 -2 BEL/FRA 63 52/95 -1.1 117 2.8 

FRA -10 9 17 FRA/NETH 64 29/69 2.9 17 1.1 

AUS -10 -11 -3 FRA/FIN 67 36/71 3.1 14 0.4 

BEL -55 -35 -30 ITA/BEL 97 2/115 2.8 126 2.6 

ITA 51 36 17 AUS/FRA -26 -32/-2 -2.5 8 0.8 

SPA -25 -27 -39 SPA/IT 48 30/118 -1.8 37 -2.2 

POR 768 509 386 POR/SPA 687 166/927 1.6 965 1.5 

IRE 544 327 203 IRE/PO R -72 -136/181 -1.5 -219 -2.7 

GRE 1039 633 625 GRE/IRE 715 227/1633 0.0 336 -1.5 


** z-score measures the deviation from six-month rolling average CDS/cash basis of the country versus Germany, expressed in numbers of standard deviations. A 

number above 1.50 means the cash is trading historically cheap compared with its average basis level. 

Eric Oynoyan / Ioannis Sokos 28 July 2011 


39 


EMU Debt Monitor: Key RV Charts 

Chart 3: German 2y/5y/10y Fly: Observed vs. Fitted 

Chart 4: 2y/10y Bono Still Too Steep 

30 

20 

10 

Hedged Eur u11 OE CTD Fly 

5y too cheap 

50 

40 

30 

20 

10 

Phase 1: Spread widening 

Bono 2013 expensive 

Phase 2: Spread widening 

0 

0 

-10 

US QE 

-20 

Exotic desks hedging 

5y expensive 

-30 

May-07 Sep-08 Feb-10 Jun-11 

After a quick normalisation when the 5y Obl corrected half of 

its overvaluation in late June, renewed pressures on 

peripherals led to a return close to levels seen in June 2008. 

There is no sign of a reversal but the normalisation to come 

at some stage would imply a 17-18bp cheapening of the fly. 

-10 

-20 

-30 

Bono 2013 cheap 

-40 

Jan-10 Mar-10 May-10 Aug-10 Oct-10 Dec-10 Mar-11 May-11 Jul-11 

Bono/BTP 2013/2020 box 

After a quick flattening in July, the Bono 2y/10y dramatically 

resteepened over the past week. As Chart 4 illustrates, the 

box vs. BTP is still far too high, i.e. the Bono curve is too 

steep. Bono Oct 13/Apr 21 flatteners around 40bp above 

BTPs remain a very cheap option in the current context. 

Chart 5: Bund July 13/Jan 16 ASW: Marked 2y Cheapening Chart 6: 10y/30y Bund: Observed vs. Fitted: 30y Too Cheap 

DBR 3.75 4/7/13 S0302 ASW-DBR 3.5 4/1/16 05 ASW 

25 

0 

20 

10y/30y Bund too steep 

-5 

2y ASW cheapening vs 5y 

15 

10 

-10 

5 

0 

-15 

-5 

-20 

-10 

-15 

-25 

-20 

-30 

Oct-10 Dec-10 Jan-11 Feb-11 Apr-11 May-11 Jul-11 

DBR 3.75 4/7/13 S0302 ASW-DBR 3.5 4/1/16 05 ASW 

In contrast to the German 2y/5y/10y cash fly, the swap is 

trading on its fair value. That unusual decoupling is explained 

by the huge cheapening of German 2y ASW vs. 5y (Chart 5). 

A normalisation should imply a wider 2y/5y ASW box. 

Chart 7: Distribution of Bund 42 ASW Conditional to 

Bund Jan 21 ASW: 30y ASW Too Tight 

-25 

Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 

Jan 20/July 40 Bund regressed vs. Euribor 

While the 10y/30y swap segment, and to a lesser extent the 

OAT spread, flattened over the past month, the Bund 

segment decoupled and remains close to its highs. The latter 

is clearly higher than its fair value and back to 2010’s 

extremes. 

Chart 8: Olo Curve: 2y Olo Cheapening Further 

40 

30 

20 

10 

0 

Historical Average + 2.0 st dev 

OLO 2013 too 

cheap 

2013 Olo 

richening 

-10 

-20 

-30 

-40 

Historical Average - 2.0 st dev 

OLO 2013 expensive 

-50 

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 

While the Bund 10y ASW has widened by 10bp since early 

July, the 30y tightened, pushing the 10y/30y ASW box to 

extreme levels. The conditional distribution approach also 

underscores the cheapness of 30y Bund with the current 

level being on the far-right of its distribution, making the 30y 

Bund ASW a buy. 

All charts’ source: BNP Paribas 

Olo Sep 13/Oct 13//Sep 20/Apr 20 

We have stressed several times the expensive levels 

reached by the 2y Olo vs. BTAN in spreads and within the 

2y/10y Olo/OAT box. The 2y Olo has normalised within the 

box and is even trading a bit cheaply. Olo Sep 13/Mar 17 

spread is getting close to our 100/105bp target raised in Q2. 



40 


EMU Debt Monitor: Redemptions 

EGB Monthly Redemptions 

Bonds Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2011 

ITA 0.0 18.7 30.5 0.0 14.6 12.2 0.0 20.2 46.0 0.0 15.5 0.0 157.6 

FRA 17.8 0.0 0.0 18.4 0.0 0.0 29.3 0.0 13.8 15.7 0.0 0.0 95.0 

GER 23.3 0.0 15.0 19.0 0.0 15.0 24.0 0.0 16.0 17.0 0.0 18.0 147.3 

SPA 0.0 0.0 0.0 15.5 0.0 0.0 15.5 0.0 0.0 14.1 0.0 0.0 45.1 

GRE 0.0 0.0 8.7 1.0 7.0 0.0 0.0 6.8 0.0 0.0 0.0 5.8 29.4 

BEL 0.0 0.0 11.3 0.0 0.0 3.4 0.0 0.0 12.7 0.0 0.0 0.5 27.9 

NET 13.9 0.0 0.0 0.0 0.0 0.0 14.1 0.0 0.0 0.0 0.0 0.0 27.9 

AUS 8.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.1 8.4 

POR 0.0 0.0 0.0 4.5 0.0 5.0 0.0 0.0 0.0 0.0 0.0 0.0 9.5 

IRE 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 4.5 0.0 4.5 

FIN 0.0 5.7 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 5.7 

Total 63 24 66 58 22 35 83 27 89 47 20 24 558 

EGB Monthly Redemptions 

T-Bill Monthly Redemptions 

T-Bills Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2011 

ITA 17.4 17.3 17.3 17.3 14.6 19.3 16.3 16.2 15.7 15.7 14.9 13.0 194.8 

FRA 33.3 35.9 38.3 31.9 32.1 32.7 30.9 28.7 43.0 28.8 16.1 18.8 370.4 

GER 11.0 11.0 11.0 11.0 11.0 11.0 9.0 9.0 9.0 10.0 10.0 9.0 122.0 

SPA 8.7 7.9 10.2 7.3 7.9 6.3 7.3 11.9 7.3 10.0 5.4 7.7 97.9 

GRE 4.2 0.4 1.4 3.2 1.0 4.4 2.5 3.8 3.6 2.0 2.0 28.5 

BEL 5.5 6.2 6.4 6.7 7.4 6.8 5.4 5.4 5.0 6.4 3.8 3.2 68.1 

NET 9.7 8.3 17.4 7.0 6.9 10.9 7.7 6.2 10.6 10.2 3.8 7.6 106.2 

AUS 0.1 2.2 0.9 3.4 0.5 1.9 2.4 2.0 1.5 0.7 0.3 0.0 15.8 

POR 3.4 3.5 3.8 0.0 4.0 3.1 3.5 3.3 1.7 0.4 26.7 

IRE 2.1 1.2 1.6 1.3 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 6.2 

FIN 3.5 2.3 2.6 1.5 2.2 0.7 0.0 0.6 1.3 0.1 0.0 0.0 14.8 

Total 98.9 96.2 110.9 90.6 83.6 89.6 87.4 85.3 100.8 88.7 57.9 61.6 1051.5 

T-Bill Monthly Redemptions 

100 

90 

80 

70 

60 

50 

40 

30 

20 

10 

0 

Monthly EGBs Redemptions 


120 

100 

80 

60 

40 

20 

0 

Monthly T-Bills Redemptions 


This Month’s EGB Redemptions 

Country Bond Maturity Issued Outstanding EURs (bn) CRNCY 

ITALY BTPS 5 1/4 08/01/11 01/08/2011 01/03/2001 20.20 20.20 EUR 

GREECE GGB 3.9 08/20/11 20/08/2011 24/05/2006 6.61 6.61 EUR 

This Month’s T-Bill Redemptions 

Country T-Bill Maturity CRNCY EURs 

AUSTRIA Various small T-Bills 

2.0 

BELGIUM BGTB 0 08/18/11 18/08/2011 EUR 5.4 

FINLAND RFTB 0 08/09/11 09/08/2011 EUR 0.6 

FRANCE BTF 0 08/04/11 04/08/2011 EUR 8.3 

FRANCE BTF 0 08/11/11 11/08/2011 EUR 6.1 

FRANCE BTF 0 08/18/11 18/08/2011 EUR 6.9 

FRANCE BTF 0 08/25/11 25/08/2011 EUR 7.4 

GERMANY BUBILL 0 08/24/11 24/08/2011 EUR 4.0 

GERMANY BUBILL 0 08/10/11 10/08/2011 EUR 5.0 

GREECE GTB 0 08/19/11 19/08/2011 EUR 2.0 

GREECE GTB 0 08/12/11 12/08/2011 EUR 0.5 

ITALY BOTS 0 08/15/11 15/08/2011 EUR 7.2 

ITALY BOTS 0 08/31/11 31/08/2011 EUR 9.0 

NETHERLANDS DTB 0 08/31/11 31/08/2011 EUR 6.2 

PORTUGAL PORTB 0 08/19/11 19/08/2011 EUR 3.1 

SPAIN SGLT 0 08/19/11 

Total 

19/08/2011 EUR 11.9 

85.3 

All charts’ source: BNP Paribas 



41 


UK: Trading BoE on Hold for Longer 

• We list a selection of interest rate strategies 

across assets in the sterling market against the 

backdrop of weak growth and stable monetary 

policy. 

• STRATEGY: Sell Z2Z3 Libor spread at 65bp. 

Buy Gilt 2.75% 2015 versus SONIA at 21bp. Sell 

the 1y1y straddle at 78bp implied volatility. 

Chart 1: Evolution of 6/10 Generic Libor Spread 

1.7 

1.5 

1.3 

1.1 

0.9 

0.7 

0.5 

0.3 

1) Front end 

The strip did not react to the preliminary Q2 GDP 

growth figures as they were roughly in line with 

consensus estimates. Meanwhile, front March 

contracts are comfortably trading above the 9900 

area. Curve-wise, red/green Libor spreads continue 

to tighten with Z2Z3 having narrowed by 26bp since 

early July. The spread is currently hovering around 

65bp and we expect it to narrow further; investors 

should set the first target at 59bp. The positive 

rolldown is worth some 7bp to the next IMM date. 

2) Gilt curve 

The benchmark curve has steepened significantly in 

the year to date. The bull-steepening move which 

has developed over the period is mainly the result of 

a repricing of monetary policy: the market has 

gradually reviewed expectations of rate hikes on the 

back of the dovish rhetoric of the majority of the MPC 

members, high inflation notwithstanding. Given the 

weak economic outlook, we expect the shape of the 

curve to remain stable in the medium term. In turn, 

an attractive (roll-down) strategy is to buy Gilt 2.75% 

2015 versus SONIA. Indeed, the bond is cheap, 

trading at SONIA +21bp and enjoys 8bp of roll-down 

to Gilt 5% 2014 in asset swap space (Chart 2). 

3) Volatility 

Chart 3 shows the evolution of the 1y and 2y swap: 

the 1y swap is remarkably less volatile than the 2y 

swap. Since the beginning of 2010, the 1y swap has 

traded between 0.78% and 1.24%. Again, given our 

expectations that the BoE will remain on hold for a 

long time, we expect volatility at the front end to 

remain subdued. Accordingly, we like monetising 

negative gamma positions via selling the 1y1y 

straddle, which is currently worth 59 cents; indeed 

the point looks expensive versus realised volatility. 

The terminal BE rates are 0.55% and 1.81% which 

are comfortably outside the 2010-to-date range. 

0.1 

-0.1 

-0.3 

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 


10 

8 

6 

4 

2 

0 

-2 

-4 

-6 

Chart 2: SONIA ASW Curve 

UKT 4 22/01/60 

UKT 4.25 7/12/55 

UKT 4.25 7/12/49 

UKT 4.25 7/12/46 

UKT 4.5 7/12/42 

UKT 4.25 7/12/40 

UKT 4.25 7/9/39 

UKT 4.75 7/12/38 

UKT 4.25 7/3/36 

UKT 4.5 7/9/34 

UKT 4.25 7/6/32 

UKT 4.75 7/12/30 

UKT 4.25 7/12/27 

UKT 5 7/3/25 

UKT 4 7/3/22 

UKT 3.75 7/9/21 

UKT 3.75 7/9/20 

UKT 4.75 7/3/20 

UKT 3.75 7/9/19 

UKT 4.5 7/3/19 

UKT 5 7/3/18 

UKT 4 7/9/16 

UKT 2 22/1/16 

UKT 4.75 7/9/15 

UKT 2.75 22/1/15 

UKT 5 7/9/14 

UKT 2.25 7/3/14 

UKT 4.5 7/3/13 

UKT 5.25 7/6/12 

UKT 5 7/3/12 

UKT 3.25 7/12/11 


2.1 

1.9 

1.7 

1.5 

1.3 

1.1 

0.9 

0.7 

1y ASW rolldown (bp, LHS) 

SONIA ASW curve (bp) 

Chart 3: Evolution of 1y Swap and 2y Swap 

0.5 

Jan-10 Jul-10 Jan-11 Jul-11 


GBP 1y swap 

GBP 2y swap 

60 

50 

40 

30 

20 

10 

0 

-10 

-20 

Matteo Regesta 28 July 2011 


42 


JGBs: Negative Factors to Increase 

• August is likely to see PM Kan announce 

his resignation and the DPJ elect a new leader. 

Debate about the magnitude of, and the 

resources for, the third supplementary budget 

would take place immediately thereafter. 

• Negative market factors, including not only 

the worsening of government finances and 

rising JGB issuance, but also inflation 

pressures are set to increase through the 

autumn. 

• While the JGB market should remain firm, 

in the recent high price range for some time, 

steepening pressure will gradually increase. 

Chart 1: 30-year – 10-year Yield Curve Changes 

in Japan, the US and Germany 

1.8 

1.6 

1.4 

1.2 

1 

0.8 

0.6 

(%) 

Jackson Hole 

speech 

(27-Aug) 

Anti-govmt 

demonstration 

in Libya (17-Feb) 

Germany 

0.4 

10/4 10/7 10/10 11/1 11/4 11/7 

US 

Japan 


Economic conditions are improving in Japan 

Although various problems grip nations everywhere, 

Japanese economic activity, which plunged following 

the March earthquake, is steadily recovering. For 

instance, June’s trade balance recorded a surplus of 

JPY 70.7bn (non-seasonally adjusted), its first in 

three months. The trade deficit that had persisted 

since April has been reversed by growing exports as 

the supply chain recovers. Notably, exports of 

transport equipment increased 28.3% m/m, a backto-back 

strong monthly gain, boosting total exports. 

Japan has scored another major victory by achieving 

the ‘Step 1’ in resolving the Fukushima nuclear plant 

accident. The nuclear reactors there are approaching 

stability, now that the coolant systems are working, 

and this will reduce the risk premium for the 

Japanese economy. The ‘Step 2’ targets include the 

purification of contaminated water and the cold 

shutdown of the reactors. While a plethora of 

problems remain, including soil decontamination and 

the stability of the purification system, the risk has 

peaked. 

2011 has seen an unbroken series of crises, 

including the US and the eurozone debt problems 

and March’s natural disaster in Japan. The policy 

response has been difficult because no perfect 

solutions exist, and forecasting has been further 

complicated because responses are linked to political 

situations. Even so, countries are likely to narrowly 

move past these crises in the coming months. 

Negative factors will increase through autumn 

An examination of yield curves in Japan, the US and 

Germany reveals that flattening between the short 

and the medium sectors (a reflection of the economic 

soft patch) has paused simultaneously. On the other 

hand, the curves have steepened between the long 

and the super-long sectors notably in Europe and the 

US. Investors are concerned about the course of 

deficit reduction talks in the US, while the receding of 

the flight to quality in the eurozone has induced a 

steepening in the back end of the German curve. 

These yield curve changes show a shift in market 

focus from monetary easing to fiscal easing. 

Even if a deficit reduction agreement is reached, we 

expect the US curve to continue to steepen for the 

following reasons: 1) S&P might still downgrade US 

debt, depending on the agreed deficit cuts, and 

Moody’s might consider downgrading, depending on 

subsequent progress in fiscal reform; 2) opportunities 

to reduce the deficit will drop ahead of the 2012 

presidential election; 3) finally, once the debt ceiling 

is raised, Treasury issuance will increase. 

The second supplementary budget has been passed 

in Japan; reports about the third supplementary 

budget are already appearing. Because the political 

situation remains confused, enactment of this third 

supplementary budget will be delayed but its size is 

likely to swell. Common sense suggests that August 

will probably see PM Kan announce his resignation 

and the DPJ elect a new leader. Debate about the 

magnitude of, and the resources for, the third 

supplementary budget would take place immediately 

thereafter. 

We expect negative market factors, including not 

only the worsening of government finances and rising 

JGB issuance, but also inflation pressures, to 

increase through the autumn. While the JGB market 

should remain firm, in the recent high price range for 

some time, steepening pressure will gradually rise. 

Koji Shimamoto 28 July 2011 


43 


Global Inflation Watch 

EMU Flash HICP seen stable at 2.7% 

The flash estimate for the eurozone July HICP, due 

on Friday 27, is expected to show inflation remained 

stable for the third month running at 2.7% y/y. Risks 

are tilted slightly to the upside following higher-thanexpected 

figures in Germany. 

German preliminary CPI release showed a 0.4% 

m/m rise (HICP 0.5%), 0.1pp higher than the 

consensus forecast. These monthly changes pushed 

the inflation rates up by 0.1pp and 0.2pp to 2.4% and 

2.6% for the CPI and the HICP, respectively. German 

inflation is back to the level reached in September 

2008. The main factor underlying the surprising rise 

appears to have been core inflation. Seasonal sales 

discounts were not as aggressive as last year and air 

transport prices soared more than usual. Looking to 

non-core items, weak food prices compensated the 

increase in heating oil and gasoline. We believe that 

the upward pressures on core are a specific factor in 

Germany and we maintain our forecast for the 

eurozone HICP inflation at 2.7% but risks are tilted to 

the upside. 

A point to note is the greater convergence of national 

developments to the EMU average, with eurozone 

countries that traditionally had below average 

inflation, such as Germany but also Austria or 

Finland, experiencing some upward pressure. With 

growth in these economies running faster and 

peripherals undergoing a significant fiscal 

adjustment, these trends are likely to continue over 

the next few months. 

In Japan, we estimate that June core CPI inflation 

eased 0.2pp to 0.4% y/y, reflecting slower price 

growth for energy. In April, the index returned to 

growth for the first time in 28 months with a rise of 

0.6% y/y. That rate of increase – the fastest since 

November 2008 – was maintained in May. But the 

price growth leader, energy, has steadily lost 

momentum, going from 7.3% growth in April to 5.7% 

in May; this reduced momentum should continue in 

June, resulting in the index’s slower rate of growth. 

Meanwhile, index rebasing (2005 to 2010), to take 

effect from the 26 August release of the national CPI 

data for July, will lower the core CPI by 0.7-0.8pp 

according to our estimates. The rebasing (2000 to 

2005) five years ago lowered the index by 0.5pp. 

Consequently, under the new index, the core CPI 

rate should hover around zero, while the US-style 

core-core CPI rate (0.1% y/y in May) will probably 

turn negative again. 

Chart 1: Eurozone vs. Germany (HICP, % y/y) 

4.0 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 

-0.5 

-1.0 

Eurozone 

Germany 

06 07 08 09 10 11 


5 

4 

3 

2 

1 

0 

France 

Austria 

Chart 2: HICP (% y/y) 

Germany 

Eurozone 

Finland 

-1 

Jan Jul Jan Jul Jan Jul Jan Jul Jan 

07 08 09 10 11 

Source: Reuters EcoWin Pr 

6 

5 

4 

3 

2 

1 

0 

-1 

-2 

-3 

Eurozone 

Spain 

Chart 3: HICP (% y/y) 

Portugal 

Greece 

Ireland 

-4 

Jan Jul Jan Jul Jan Jul Jan Jul Jan 

07 08 09 10 11 


Luigi Speranza/Gizem Kara/Dominique Barbet 28 July 2011 

Market Mover 

44 


Table 1: BNP Paribas' Inflation Forecasts 

Eurozone 

France 

US 

Headline HICP Ex-tobacco HICP 

Headline CPI 

Ex-tobacco CPI 

CPI Urban SA CPI Urban NSA 

Index % m/m % y/y Index % m/m % y/y Index % m/m % y/y index % m/m % y/y Index % m/m % y/y Index % m/m % y/y 

2010 109.8 - 1.6 109.5 - 1.5 121.1 - 1.5 119.8 - 1.5 218.1 - 1.6 218.1 - 1.6 

2011 (1) 112.9 - 2.8 112.6 - 2.8 123.7 - 2.1 122.3 - 2.1 224.8 - 3.1 224.8 - 3.1 

2012 (1) 115.6 - 2.3 115.1 - 2.3 126.0 - 1.8 124.4 - 1.8 229.0 - 1.9 229.0 - 1.9 

Q1 2010 108.6 - 1.1 108.3 - 1.0 120.3 - 1.3 119.0 - 1.2 217.5 - 2.4 217.0 - 2.4 

Q2 2010 110.1 - 1.6 109.8 - 1.5 121.3 - 1.6 120.0 - 1.5 217.3 - 1.8 218.1 - 1.8 

Q3 2010 109.9 - 1.7 109.6 - 1.7 121.2 - 1.5 119.8 - 1.5 218.0 - 1.2 218.3 - 1.2 

Q4 2010 110.8 - 2.0 110.5 - 2.0 121.7 - 1.6 120.2 - 1.6 219.5 - 1.2 218.9 - 1.3 

Q1 2011 111.3 - 2.5 110.9 - 2.4 122.5 - 1.8 121.0 - 1.7 222.3 - 2.2 221.7 - 2.1 

Q2 2011 113.1 - 2.8 112.7 - 2.7 123.9 - 2.1 122.4 - 2.0 224.5 - 3.3 225.5 - 3.4 

Q3 2011 (1) 113.1 - 2.9 112.8 - 2.9 124.0 - 2.3 122.6 - 2.3 225.8 - 3.6 226.0 - 3.6 

Q4 2011 (1) 114.2 - 3.1 113.8 - 3.0 124.5 - 2.3 123.0 - 2.3 226.7 - 3.3 226.1 - 3.3 

Jul 10 109.6 -0.4 1.7 109.30 -0.4 1.7 121.0 -0.3 1.7 119.68 -0.3 1.6 217.6 0.3 1.3 218.01 0.0 1.2 

Aug 10 109.9 0.2 1.6 109.52 0.2 1.5 121.3 0.2 1.4 119.97 0.2 1.3 218.1 0.2 1.2 218.31 0.1 1.1 

Sep 10 110.2 0.3 1.9 109.86 0.3 1.8 121.2 -0.1 1.6 119.88 -0.1 1.5 218.4 0.2 1.1 218.44 0.1 1.1 

Oct 10 110.5 0.3 1.9 110.19 0.3 1.9 121.4 0.1 1.6 120.03 0.1 1.5 219.0 0.2 1.2 218.71 0.1 1.2 

Nov 10 110.6 0.1 1.9 110.28 0.1 1.8 121.5 0.1 1.6 120.09 0.0 1.5 219.2 0.1 1.1 218.80 0.0 1.1 

Dec 10 111.3 0.6 2.2 110.93 0.6 2.1 122.1 0.5 1.8 120.61 0.4 1.7 220.2 0.4 1.4 219.18 0.2 1.5 

Jan 11 110.5 -0.7 2.3 110.11 -0.7 2.2 121.8 -0.2 1.8 120.32 -0.2 1.7 221.1 0.4 1.7 220.22 0.5 1.6 

Feb 11 111.0 0.4 2.4 110.58 0.4 2.4 122.4 0.5 1.7 120.90 0.5 1.6 222.3 0.5 2.2 221.31 0.5 2.1 

Mar 11 112.5 1.4 2.7 112.11 1.4 2.6 123.4 0.8 2.0 121.90 0.8 1.9 223.5 0.5 2.7 223.47 1.0 2.7 

Apr 11 113.1 0.6 2.8 112.75 0.6 2.8 123.8 0.3 2.1 122.32 0.3 2.0 224.4 0.4 3.1 224.91 0.6 3.2 

May 11 113.1 0.0 2.7 112.74 0.0 2.7 123.9 0.1 2.0 122.40 0.1 2.0 224.8 0.2 3.4 225.96 0.5 3.6 

Jun 11 (1) 113.1 0.0 2.7 112.75 0.0 2.7 124.0 0.1 2.1 122.49 0.1 2.1 224.3 -0.2 3.4 225.72 -0.1 3.6 

Jul 11 (1) 112.6 -0.5 2.7 112.21 -0.5 2.7 123.7 -0.2 2.2 122.24 -0.2 2.1 225.4 0.5 3.6 225.76 0.0 3.6 

Aug 11 (1) 113.1 0.5 3.0 112.76 0.5 3.0 124.2 0.4 2.4 122.72 0.4 2.3 225.8 0.2 3.5 226.02 0.1 3.5 

Sep 11 (1) 113.7 0.5 3.1 113.30 0.5 3.1 124.2 0.0 2.5 122.76 0.0 2.4 226.3 0.2 3.6 226.28 0.1 3.6 

Oct 11 (1) 114.0 0.3 3.2 113.68 0.3 3.2 124.4 0.1 2.5 122.91 0.1 2.4 226.5 0.1 3.5 226.27 0.0 3.5 

Nov 11 (1) 114.1 0.1 3.2 113.76 0.1 3.2 124.5 0.1 2.4 122.97 0.0 2.4 226.5 0.0 3.3 226.07 -0.1 3.3 

Dec 11 (1) 114.5 0.3 2.9 114.07 0.3 2.8 124.7 0.2 2.2 123.18 0.2 2.1 227.0 0.2 3.1 225.96 0.0 3.1 

Updated 

Next 

Release 

Jul 14 

Jul HICP Flash (Jul 29) 

Jul 14 

Jul CPI (Aug 12) 

Jul 15 


Source: BNP Paribas, (1) Forecasts 

4.0 

3.0 

2.0 

1.0 

0.0 

-1.0 

0.2 

0.0 

-0.2 

-0.4 

-0.6 

-0.8 

Chart 4: German Inflation (% y/y) 

HICP (% y/y) 

CPI (% y/y) 

CPI (% y/y) - HICP (% y/y) 

04 05 06 07 08 09 10 11 

Chart 5: US Core CPI (pp) 


The domestic and harmonised measures of German inflation do 

not differ much, except when special factors occur, as in 2005- 

2006. However, the harmonised inflation is usually a little more 

volatile, so it is not surprising to see it above domestic inflation. 


Core goods inflation accelerated in June on past commodity price 

surges. Shelter inflation also soared, due to the delayed impact of 

the past rise in energy prices. However, core services remained 

subdued, helped by the on-going wage moderation. 


Market Mover 

45 



Japan 

UK 

Sweden 

Core CPI SA 

Core CPI NSA 

Headline CPI 

RPI 

CPI 

CPIF 

Index % m/m % y/y Index % m/m % y/y Index % m/m % y/y Index % m/m % y/y Index % m/m % y/y Index % m/m % y/y 

2010 99.3 - -1.0 99.3 - -1.0 114.5 - 3.3 223.6 - 4.6 302.5 - 1.2 194.6 - 2.0 

2011 (1) 99.9 - 0.6 99.9 - 0.6 119.5 - 4.4 235.4 - 5.3 311.7 - 3.1 197.6 - 1.6 

2012 (1) 100.6 - 0.7 100.6 - 0.8 122.7 - 2.5 244.8 - 4.0 318.2 - 2.1 200.4 - 1.4 

Q1 2010 99.8 - -1.2 99.3 - -1.2 112.9 - 3.2 219.3 - 4.0 301.2 - 0.7 193.4 - 2.3 

Q2 2010 99.3 - -1.2 99.3 - -1.2 114.4 - 3.4 223.5 - 5.1 302.8 - 0.9 194.3 - 1.9 

Q3 2010 98.8 - -1.1 99.1 - -1.0 114.7 - 3.1 224.5 - 4.7 302.9 - 1.1 194.2 - 1.7 

Q4 2010 99.3 - -0.5 99.4 - -0.5 115.9 - 3.4 227.0 - 4.7 307.0 - 1.9 196.4 - 2.0 

Q1 2011 99.6 - -0.2 99.1 - -0.2 117.6 - 4.1 230.9 - 5.3 308.1 - 2.6 196.1 - 1.4 

Q2 2011 (1) 99.8 - 0.5 99.8 - 0.5 119.4 - 4.4 234.9 - 5.1 311.6 - 3.3 197.5 - 1.7 

Q3 2011 (1) 99.8 - 1.0 100.1 - 1.0 119.9 - 4.5 236.4 - 5.3 312.1 - 3.4 197.6 - 1.7 

Q4 2011 (1) 100.3 - 1.0 100.4 - 1.0 121.1 - 4.5 239.5 - 5.5 315.1 - 3.0 199.3 - 1.5 

Jul 10 98.8 -0.4 -1.2 99.0 -0.3 -1.1 114.3 -0.3 3.1 223.6 -0.2 4.8 302.0 -0.3 1.1 193.7 -0.3 1.7 

Aug 10 98.8 0.0 -1.0 99.1 0.1 -1.0 114.9 0.5 3.1 224.5 0.4 4.7 302.1 0.0 0.9 193.7 0.0 1.5 

Sep 10 98.7 -0.1 -1.1 99.1 0.0 -1.1 114.9 0.0 3.0 225.3 0.4 4.6 304.6 0.8 1.4 195.1 0.7 1.8 

Oct 10 99.1 0.4 -0.6 99.5 0.4 -0.6 115.2 0.3 3.1 225.8 0.2 4.5 305.6 0.3 1.5 195.7 0.3 1.8 

Nov 10 99.3 0.2 -0.5 99.4 -0.1 -0.5 115.6 0.3 3.2 226.8 0.4 4.7 306.6 0.3 1.8 196.2 0.2 1.9 

Dec 10 99.5 0.2 -0.3 99.4 0.0 -0.4 116.8 1.0 3.7 228.4 0.7 4.8 308.7 0.7 2.3 197.3 0.6 2.3 

Jan 11 99.5 0.0 -0.2 99.0 -0.4 -0.2 116.9 0.1 4.0 229.0 0.3 5.1 306.2 -0.5 2.5 195.2 -1.1 1.4 

Feb 11 99.5 0.0 -0.3 98.9 -0.1 -0.3 117.8 0.8 4.3 231.3 1.0 5.5 308.0 0.6 2.5 196.2 0.5 1.3 

Mar 11 99.7 0.2 -0.1 99.4 0.5 -0.1 118.1 0.3 4.1 232.5 0.5 5.3 310.1 0.7 2.9 196.9 0.4 1.5 

Apr 11 99.9 0.2 0.6 99.8 0.4 0.6 119.3 1.0 4.5 234.4 0.8 5.2 311.4 0.4 3.3 197.6 0.4 1.8 

May 11 99.9 0.0 0.6 99.9 0.1 0.6 119.5 0.2 4.5 235.2 0.3 5.2 312.0 0.2 3.3 197.8 0.1 1.7 

Jun 11 (1) 99.6 -0.3 0.4 99.7 -0.2 0.4 119.4 -0.1 4.2 235.2 0.0 5.0 311.3 -0.2 3.1 197.2 -0.3 1.5 

Jul 11 (1) 99.7 0.1 0.9 99.9 0.2 0.9 119.1 -0.2 4.2 234.6 -0.2 4.9 311.1 -0.1 3.3 197.0 -0.1 1.7 

Aug 11 (1) 99.8 0.1 1.0 100.1 0.2 1.0 120.0 0.7 4.4 236.3 0.7 5.3 311.3 0.1 3.4 197.2 0.1 1.8 

Sep 11 (1) 99.9 0.1 1.2 100.3 0.2 1.2 120.6 0.5 4.9 238.2 0.8 5.7 313.9 0.8 3.4 198.6 0.7 1.7 

Oct 11 (1) 100.1 0.2 1.0 100.5 0.2 1.0 120.8 0.2 4.8 238.7 0.2 5.7 314.8 0.3 3.4 199.1 0.3 1.7 

Nov 11 (1) 100.3 0.2 1.0 100.4 -0.1 1.0 120.9 0.1 4.6 239.4 0.3 5.5 315.1 0.1 3.1 199.3 0.1 1.6 

Dec 11 (1) 100.4 0.1 0.9 100.3 -0.1 0.9 121.7 0.6 4.2 240.4 0.4 5.3 315.4 0.1 2.5 199.4 0.1 1.1 

Updated 

Next 

Release 

Jul 01 

Jun CPI (Jul 29) 

Jul 14 


Jul 12 



Chart 6: Japanese CPI (% y/y) 

Chart 7: UK CPI (% y/y) 


Japanese inflation was stable in positive territory in May. However, 

we expect the new rebased index to show a different picture with 

much lower inflation rates. Japanese deflation is not over. 


Inflation surprised to the downside in June, on slower core inflation. 

We still expect the headline inflation rate to go higher before the 

year is out given the large hikes in utility prices which are in the 

pipeline. 


Market Mover 

46 



Canada Norway Australia 

CPI Core CPI Headline CPI Core 

CPI 

Core 

Index % q/q % y/y Index % q/q % y/y Index % q/q % y/y Index % q/q % y/y Index % q/q % y/y Index % q/q % y/y 

2010 116.5 1.8 115.6 1.7 128.8 2.4 120.1 1.4 172.6 2.8 - 2.6 

2011 (1) 119.8 2.8 117.6 1.7 130.6 1.4 121.4 1.1 178.6 3.5 - 2.7 

2012 (1) 122.7 2.4 120.0 2.1 133.0 1.8 123.5 1.8 183.7 2.8 - 2.7 

Q3 2010 116.9 2.2 1.4 116.9 0.3 1.7 128.2 -0.7 1.9 119.9 -0.3 1.2 173.3 0.7 2.8 - - 2.4 

Q4 2010 117.5 2.3 1.8 117.5 2.0 1.7 129.4 0.9 2.2 120.5 0.5 1.0 174.0 0.4 2.7 - - 2.2 

Q1 2011 119.4 3.3 2.0 119.4 0.7 1.6 130.2 0.6 1.4 120.3 -0.2 0.8 176.6 1.5 3.3 - - 2.3 

Q2 2011 119.8 5.6 2.5 119.8 3.4 1.5 130.9 0.6 1.4 121.5 1.0 1.0 178.0 0.8 3.6 - - 2.7 

Q3 2011 (1) 120.1 -0.4 2.7 120.1 1.4 1.6 129.9 -0.8 1.4 121.2 -0.3 1.0 179.3 0.7 3.6 - - 2.8 

Q4 2011 (1) 120.9 2.6 2.8 120.9 3.4 1.7 131.4 1.1 1.5 122.4 1.0 1.6 180.6 0.7 3.7 - - 2.9 

Q1 2012 (1) 122.2 3.3 2.9 122.2 2.0 2.1 131.8 0.3 1.2 122.5 0.1 1.8 182.0 0.8 3.0 - - 2.7 

Q2 2012 (1) 122.9 4.0 2.6 122.9 1.3 2.2 133.0 1.0 1.6 123.7 1.0 1.8 182.9 0.5 2.6 - - 2.5 

Updated 

Next 

Release 

Jul 28 


Jul 12 


Jul 27 

Q3 CPI (Oct 26) 


Chart 8: Canadian Total versus Core CPI 

4.0 

BoC Mid-Point Inflation Target 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

BoC CPI Core (% y/y) 

0.0 

-0.5 

CPI Total (% y/y) 

-1.0 

04 05 06 07 08 09 10 11 


In Canada, inflation surprised on the downside in June. More 

importantly, the move was driven by core inflation. Core inflation will 

increase due to the past rise in the headline CPI, but the starting 

point is reassuringly low. 

7.0 

6.0 

5.0 

4.0 

3.0 

2.0 

1.0 

0.0 

(% y/y) 

Chart 9: Australian CPI (% y/y) 

Headline CPI 

Underlying CPI 

-1.0 

Q193 Q195 Q197 Q199 Q101 Q103 Q105 Q107 Q109 Q111 Q113 


Food prices should drive headline inflation sharply higher in 2011. 

Underlying inflation should drift higher, but remain within the target 

range. Risks to inflation are to the upside, particularly in the near 

term. 

CPI Data Calendar for the Coming Week 

Day GMT Economy Indicator Previous BNPP F’cast Consensus 

Thu 28/07 23:30 Japan CPI National y/y : Jun 0.3% 0.2% 0.2% 

23:30 Core CPI National y/y : Jun 0.6% 0.4% 0.5% 

23:30 CPI Tokyo y/y : Jul -0.2% 0.1% 0.0% 

23:30 Core CPI Tokyo y/y : Jul 0.1% 0.2% 0.2% 

Fri 29/07 07:00 Spain HICP Flash y/y : Jul 3.0% 2.9% 2.9% 

09:00 Eurozone HICP (Flash) y/y : Jul 2.7% 2.7% 2.7% 

Thu 04/07 07:30 Neths CPI m/m : Jul -0.5% -0.1% n/a 

07:30 CPI y/y : Jul 2.3% 2.4% n/a 

Fri 05/08 07:15 Switzerland CPI m/m : Jul -0.2% -0.6% 

07:15 CPI y/y : Jul 0.6% 0.7% 

07:15 CPI Ex-Petroleum y/y : Jul n/a 

Release dates and forecasts as at c.o.b. prior to the date of publication: See Daily Economic Spotlight for any revision 



Market Mover 

47 


Inflation: Unequal In Face Of Debt 

• GLOBAL: Mixed. 

• EUR: BEs are not so immune to debt issue. 

• USD: 10y BEs look rich. Sell 5y5y (versus 

EUR/UK?). 

• GBP: Fall in BEs. Is it August already? 

Chart 1: TIPS/OATEI20 BE Spd vs. 10y UST 

40 

TIIJUL20 / OATEI20 Breakeven 

TIIJUL20 Nominal Rhs 

30 

20 

10 

380 

340 

300 

Global/mixed environment 

Strong food commodities, an upward surprise on 

German preliminary CPI data and index extensions 

are supportive of the inflation market. The 

consolidation in equities and energy commodities are 

not. With regard to the sovereign crisis – the impact 

depends. After having been resilient during most of 

the EGB crisis, inflation breakevens have finally 

fallen out of favour in Europe over the past few days, 

with cash underperforming swap, while TIPS seem to 

be benefiting from the debt ceiling saga, with cash 

outperforming swap. In Europe, beyond summer 

volatility, the Greek deal should be seen as 

supportive for peripherals and at least BTPei 

breakevens. In the US, our colleagues think that a 

downgrade of US debt could trigger up to 25bp of 

nominal sell off. That said, and as Chart 1 shows, the 

10y TIPS/OATei breakeven spread is already back to 

its high and looks wide versus the USD 10y nominal 

yield. Looking at 5y5y breakevens, we are close to 

highs on the US BE forward (Chart 2). As far as the 

US/EUR inflation swap spread is concerned, the 

current level of 90bp compares with a long-term 

average of 50bp and a high of 100bp. If agreement is 

reached in Washington over the weekend, US 

breakevens should underperform from next week. In 

any case, we do not expect the Fed to implement 

QE3 if (or because) there is no fiscal agreement 

found and the macro picture is still not very 

encouraging. In that context, we expect the recent 

range to hold and we would be a seller of the 

US/EUR 5y5y breakeven spread above 90bp. We 

would also be a seller of the US/GBP 5y5y BE 

spread below 20bp. The 10y area is depressed in the 

UK but, with the probability of QE2 having risen, we 

see value in the 5y5y UK breakeven. 

0 

-10 

-20 

Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 


4.5 

4.2 

3.9 

3.6 

3.3 

3 

2.7 

2.4 

2.1 

Chart 2: 5y5y Inflation Swap: 

GBP and EUR cheap vs. US 

1.8 

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 


10 

0 

-10 

-20 

-30 

Chart 3: OAT(e)I / Swap BE Spreads 

OATEI20 / E9.0 Breakeven 

OATI19 / F8.0 Breakeven Rhs 

GBP 

USD 

EUR 

260 

220 

10 

0 

-10 

-20 

-30 

EUR: not so resilient 

Italy issued EUR 0.942bn of BTPei-21 at a real yield 

of 4.07%, and with a bid/cover of 1.7. BTPei real 

yields rose around 15bp before the auction. But the 

paper came out with a 1.5bp premium and 

outperformed within the BTPei curve afterwards. RVwise, 

and as we said in our pre-auction desknote, we 

-40 

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 May-11 Aug-11 Nov-11 


-40 

Hervé Cros 28 July 2011 


48 


still like the BTPei-21 versus the BTPei-17, if not the 

BTPei-23. On Thursday, the BTP auction was also 

decent but this did not prevent BTPs from 

underperforming afterwards. The market remains 

very volatile but BTPei breakevens still represent 

long-term buys in our view. 

Cash breakevens have underperformed again versus 

swap (Chart 3), which makes sense given the 

pressure on EGBs. However, at least for OATi, the 

cash/swap breakeven spread is back to the low of its 

range. Real yields are low but this may trigger some 

ASW activity again. 

GBP: The UK DMO sold GBP 4bn of UTKI-34 at 

4.5bp over the UKTI32. As expected, indexers 

bought most of the issue. That said, as in the 

eurozone, it was a bad week for UK breakevens, 

which bear steepened (with 20y+ breakevens falling 

by more than 12bp) in the week of the 1.5y index 

extension. As seen with the performance of the 

UKTI16 over recent months, the market tends to 

price in large index events well in advance. In that 

respect, the UKTI17 should underperform the 

UKTI16 further. Looking at the long end of UK 

inflation, we update the chart we showed a few 

weeks ago (Chart 4). There was indeed too much 

premium embedded at the long end of the UK curve 

and we expect more underperformance of the 

10y20y BE versus 5y5y in August. Historically, UK 

breakevens fall in August. They started to do so a bit 

earlier than usual this year. 

JPY: JGBis have stayed under some pressure after 

the BoJ buy-back operation on 25 July highlighted 

reasonable selling interest ahead of the CPI 

reweighting. As a reminder, since early 2007, the 

MoF has bought back around JPY 5.9trn of JGBi 

(58% of the outstanding) while BoJ’s the Riban 

operations have reached JPY 858bn (8% of the 

indexed debt). Chart 5 shows the history of the 

operations. With prices back above par and 

breakevens close to 0%, the operations have been 

reduced in 2011 to JPY 50bn per month for the MoF 

and JPY 40bn every other month for the BoJ. The 

schedule for Q3 is unchanged from Q2. Today, the 

JGBi market is worth around JPY 34trn. There is a 

negative relationship (R² at 40%) between market 

prices and percentages of JGBi bought back. If 

anything, the JGBi Jun-18 should be favoured by the 

MoF and BoJ. As we argued in our Inflation Monitor 

last week, JGBi breakevens could fall by another 10 

to 20bp before the end of the month. 

Chart 4: GBP 10y20y (Rich) vs. (Cheap) 5y5y 

0.3 

0.2 

0.1 

0 

% % 

5/10y BE 

lhs 

-0.1 

Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 


10/30y BE 

10Y20Y-5Y5Y 

Chart 5: JGBi Operations and JGBis 

Outstanding vs. Prices 


Chart 6: JGBis Outstanding and ‘Buy-Backs’ 

300 

250 

200 

150 

100 

50 

0 

0 

Jan-2007 Jun-2008 Jun-2009 Jun-2010 Jun-2011 


MOF Buy Back + BOJ Rinban 

JGBI Outstanding, RHS 

12000 

10000 

8000 

6000 

4000 

2000 

0.7 

0.6 

0.5 

0.4 

0.3 

0.2 

0.1 

0 



49 


USDi: Sell 5y5y Forward Inflation 

• Forward expectations are flying high, 

especially via inflation swaps. 5y5y in swap is 

near the highs and also too high vs 5y5y cash. 

• July maturities look cheap vs Jan maturities 

in 10y sector, and we favour ‘20 maturities over 

‘19 which are slightly rich in the ASW. 

• We recap our views on potential impact of 

debt ceiling negotiations. 

• STRATEGY: Sell 5y5y fwd on CPI; stay in 

10s30s BE flattener into month end. 

Chart 1: 5y5y Fwd Inflation Too High in CPI 

3.30 5y5y Fwd CPI Swap 

% 

5y CPI Swap (RHS) 

% 

3.20 

2.60 

3.10 

3.00 

2.35 

2.90 

2.80 

2.10 

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 


TIPS had a good run since a strong 10y TIPS auction 

last week. 10y breakevens outperformed both tails 

with 5s10s30s BE fly trading around 7bp higher since 

the auction-day closing levels. 10s30s BE flattener 

that we recommended as a post-auction trade is 

roughly 2.5bp flatter, having given back several bp in 

recent correction/profit-taking. We still think there is 

potential for further flattening over the next several 

days, although we would recommend taking it off the 

books by the second trading session of next month 

since month-end related flows should be done by 

then. 

5y5y CPI 

bp 

330 

310 

290 

270 

Chart 2: …also vs 5y5y BE in cash 

y = 0.7008x + 121.57 

R 2 = 0.6893 

250 

190 210 230 250 270 290 

5y5y cash BE 

bp 

5y5y forward inflation expectations are running high 

once again, especially considering the macro 

outlook. 5y5y fwd inflation is near multi-year highs 

(Chart 1), and we recommend selling 5y5y fwd on 

CPI. Furthermore, 5y5y fwd in CPI swaps is also 

10bp too high vs equivalent in cash breakevens 

(Chart 2). Meanwhile, we remain bullish on nearer 

forwards in cash, such as 2y1y BE, which is still 

around 2.04% currently. 2y2y BE is now higher and 

near 2.2% level. Although it is still a reasonable level 

historically, we now prefer 2.5y1y BE (via 

Jan14/Jan15) which is at 2.10%. We also have 

recently recommended taking profit on 3y1y BE 

which is still at 2.35% (up approximately 20bp from 

recent levels). 

Finally, we note that July maturity TIPS look cheap 

vs January maturities in 10y sector (Chart 3). For this 

RV analysis, we build real curve using Jan maturities 

and find fair value of Apr and Jul maturities by 

applying seasonals. We prefer 2020 maturities which 

are also slightly cheaper in the ASW relative to 2019 

maturities (using ASW z-scores). 



Chart 3: Rich/Cheap vs Jan TIPS 

What Deficit Reduction Plan and Downgrade 

Could Mean for Rates and Inflation (repost from 

Inflation Monitor; see “Pondering the (Once) 

Unthinkable” article in previous Market Mover for a 

more comprehensive rates market discussion). 

Sergey Bondarchuk / IRS NY Team 28 July 2011 


50 


No matter how you look at it, we may be heading 

toward one of two outcomes – each perhaps 

unthinkable not too long ago: either Republicans and 

Democrats reach an agreement on a deficit 

reduction/stabilisation plan, or else the country faces 

a downgrade (or worse yet, a default). The two 

denouements have polar opposite implications for 

the markets, causing everyone to suffer from 

whiplash every time a new headline comes out, only 

to be negated shortly thereafter. 

Scenario #1: 

The deficit reduction package ripples its way down to 

the markets through multiple channels. First and 

foremost is a drop in GDP in the next few years. 

Starting with a USD 14 trillion GDP, a swing of USD 

140bn in the fiscal picture represents 1% of the 

economy. Now, there is much debate on the actual 

economic impact of changes on the fiscal front, 

depending on the source of fiscal tightening/easing, 

This is the age-old debate, still raging, on whether 

government spending or taxation has a bigger 

multiplier effect as it translates to economic activity. If 

we assume a 1-for-1 relationship for the sake of 

argument, then for every USD 140bn in fiscal 

tightening for FY 2012 (the upcoming year), we are 

looking at a drop of 1% in GDP. According to our 

macro fair value model for 30y rates, a 1% change in 

GDP translates to a 10bp change in 30y rates. 

This may not sound like much, but keep in mind that 

there are also knock-on effects, such as lower 

inflation as a result of a slower economy – there 

tends to be a 12-18 month lag between GDP and 

core inflation (Chart 4). Furthermore, another part of 

the proposal is to change inflation indexation to the 

chain-weighted CPI, which is 28bp lower than the 

non-chain weighted y/y CPI on average since 2001 

and 32bp lower for core CPI (Chart 5). This could 

produce a psychological impact since the main 

measure of inflation could read as much as 75bp 

lower (widest spread between chain-weighted and 

non-chain-weighted core CPI) than the already-tame 

core CPI print of 1.6% y/y, stoking deflationary 

concerns and weighing on self-reinforcing inflation 

expectations (as a side note, we don’t expect new 

TIPS to be indexed to chain-weighted CPI, at least 

initially, although it is probable in the longer run as 

non-chained CPI will eventually be perceived as a 

less relevant/accurate measure of inflation). 

One caveat: A proposed 15 cent gasoline tax could 

produce a one-time 30bp upward shock on y/y 

headline CPI, offsetting breakeven tightening (at 

least in the front end) and flattening breakeven curve. 

The impact on long-term inflation is a bit murkier. A 

higher rate of potential growth could put upward 

pressure on inflation, but at the same time, the USD 

5 

3 

1 

-1 

-3 

-5 

Chart 4: Core Inflation Tends to Follow GDP 

GDP y/y 

1994 1996 1998 2000 2002 2004 2006 2008 2010 


75 

bp 

50 

25 

0 

-25 

CPI Core y/y (Lagged 5 Quarters) 

Chart 5: Chain-Weighted CPI Spreads 

01 02 03 04 05 06 07 08 09 10 11 


would likely cement its status as the reserve 

currency. In other words, it would stay strong, 

curbing export-driven inflation pressures. Therefore, 

it is difficult to see long-term inflation expectations 

get out of hand in this scenario. 

Scenario #2: Downgrade, Default, and All the Bad 

Stuff 

Admittedly, we don’t have much to go on in this 

scenario in terms of historical precedent – certainly 

not in the US. So, we must use some judgement and 

also point to similar episodes in other developed 

countries. A default can easily be averted, since the 

US has the ability to make good on its obligations as 

long as the debt ceiling is raised. As a result, while 

we cannot totally dismiss the default scenario, we 

find it highly unlikely. What would happen to the 

markets in the event of a default? It is safe to say 

that the USD would come under pressure. 

Furthermore, rates would rise significantly in the back 

end, as investors would want to protect themselves 

against higher inflation in the long term as the USD 

stands to lose its reserve currency status. Once its 

safe-haven status disappears, US debt would carry a 

stigma for a long time. Being denominated in USD, 

commodities would spike, and TIPS breakevens 

would rise materially. Additionally, a downgrade is 

3 

2.5 

2 

1.5 

1 

0.5 

CPI - Chain-Weighted CPI 

Core CPI - Core Chain-Weighted CPI 



51 


likely to lead to higher debt-servicing costs down the 

road. 

Market implications in the event of a downgrade are 

likely to be similar: higher rates, steeper curve, 

tightening swap spreads (or in the case of the 30y, 

becoming more negative), much higher implied 

volatility, and wider TIPS breakevens especially in 

short maturities. If we look at other developed 

nations that have faced actual downgrades, then the 

results suggest that the eventual impact on debt is 

likely to be positive (perhaps due to austerity 

measures being taken). However, there is also a 

common theme here: there was initially a downtrade. 

Perhaps, it takes a market reaction to really bring 

opposing lawmakers together in agreement, and 

some have expressed this view regarding the current 

debate in the US. 



52 


Table 1: BNP Paribas Carry Analysis 

Benchmark Carry 

Pricing Date 

28-Jul-11 

Term 1 

Term 2 

3m 

6m 

12m 

Repo Rate 

0.42% 0.42% 0.34% 0.34% 0.56% 

Sett. Date 

29-Jul-11 01-Sep-11 01-Oct-11 

31-Oct-11 

30-Jan-12 

30-Jul-12 

Yield BE Real BE Real BE Real BE Real BE Real BE 

Short-end 

OATei Jul-12 -0.58% 1.90% -15.3 -16.4 -94.0 -92.8 -61.7 -58.0 -26.9 -6.9 

OATI Jul-13 -0.09% 1.60% -2.1 -3.6 -19.8 -21.3 -5.5 -7.0 -22.1 -23.1 -10.5 -10.5 

TIPS Jul-12 -1.38% 1.58% -22.5 -23.8 -38.1 -40.4 -45.1 -48.0 -146.9 -152.0 

UKTi Aug-13 -2.55% 3.23% -24.0 -24.6 -1.5 -2.7 27.3 25.6 40.6 37.4 85.6 85.8 

5y 

BUNDEI Apr-16 0.21% 1.79% -1.6 -3.1 -14.7 -17.1 -5.9 -9.4 6.7 0.1 16.7 5.4 

BTANI Jul-16 0.36% 2.07% 0.0 -2.4 -5.9 -10.1 0.4 -5.7 -2.2 -14.4 8.9 8.9 

TIPS Apr-16 -0.60% 1.89% -2.7 -5.5 -3.6 -8.9 -2.6 -10.4 -6.6 -22.3 9.4 -24.0 

UKTi Nov-17 -0.77% 3.03% -1.5 -4.3 -6.9 -12.2 2.7 -5.1 19.6 3.6 51.3 18.4 

JGBI-4 June-15 0.63% -0.35% -3.9 -4.4 2.7 1.8 9.2 8.0 25.6 23.2 42.2 37.1 

10y 

OATEI Jul-22 1.13% 2.17% 0.0 -2.1 -4.9 -8.8 -0.2 -6.2 7.5 -4.3 16.4 -6.7 

OATI Jul-19 0.70% 2.32% 0.3 -1.9 -3.1 -7.2 1.4 -4.9 1.0 -11.5 10.4 10.4 

TIPS Jan-21 0.55% 2.35% -0.2 -3.4 0.4 -5.7 2.0 -6.9 3.6 -14.4 18.8 -18.1 

UKTi Nov-22 0.19% 3.06% 0.0 -2.9 -2.4 -7.9 4.0 -4.1 16.1 -0.1 38.4 5.4 

JGBI-16 June-18 1.02% -0.42% -1.7 -2.5 2.7 1.2 6.8 4.9 15.8 11.8 28.6 20.1 

30y 

OATei Jul-40 1.41% 2.58% 0.1 -1.2 -2.0 -4.5 0.2 -3.6 3.9 -3.7 8.3 -6.4 

OATI Jul-29 1.26% 2.58% 0.5 -1.3 -1.0 -4.4 1.7 -3.4 2.6 -7.7 9.4 9.4 

TIPS Feb-41 1.62% 2.64% 0.4 -2.0 1.0 -3.5 2.0 -4.5 3.8 -9.1 12.0 -14.0 

UKTI Mar-40 0.55% 3.54% 0.1 -1.8 -0.7 -4.4 1.9 -3.5 6.9 -3.8 15.7 -5.5 

Short-end 

Term 1 -> Term 2 Term 2 -> 3m 

3m -> 6m 

6m -> 12m 

OATei Jul-12 -78.7 -76.4 30.5 32.9 34.8 51.1 26.9 6.9 

OATI Jul-13 -17.8 -17.7 13.1 12.9 -16.7 -16.1 11.7 12.6 

TIPS Jul-12 -15.7 -16.6 -7.8 -8.8 -101.8 -104.0 146.9 152.0 

UKTi Aug-13 22.5 21.9 28.7 28.2 13.3 11.9 45.0 48.3 

5y 

BUNDEI Apr-16 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 

BTANI Jul-16 -13.0 -14.0 8.2 7.2 12.6 9.5 10.0 5.3 

TIPS Apr-16 -5.9 -7.7 5.8 3.9 -2.6 -8.6 11.1 23.3 

UKTi Nov-17 -1.0 -3.4 0.9 -1.7 -4.0 -11.9 16.0 -1.7 

JGBI-4 June-15 6.6 6.2 6.8 6.4 16.4 15.2 16.6 13.8 

10y 

OATEI Jul-22 -4.9 -6.7 4.4 2.5 7.7 1.9 8.9 -2.4 

OATI Jul-19 -3.4 -5.3 4.1 2.1 -0.4 -6.6 9.4 21.9 

TIPS Jan-21 0.6 -2.3 1.7 -1.4 1.5 -7.5 15.2 -3.7 

UKTi Nov-22 -2.4 -5.0 6.3 3.5 12.1 3.9 22.3 5.5 

JGBI-16 June-18 4.4 3.7 4.4 3.8 9.0 6.9 12.8 8.3 

30y 

OATei Jul-40 -2.1 -3.3 2.0 0.8 3.7 -0.1 4.4 -2.7 

OATI Jul-29 -1.5 -3.1 2.5 0.8 0.8 -4.3 6.8 17.1 

TIPS Feb-41 0.6 -1.4 1.1 -1.2 1.8 -4.6 8.1 -4.9 

UKTI Mar-40 -0.8 -2.5 2.6 0.7 4.9 -0.3 8.8 -1.7 




53 


Trade Reviews 

Options, Money Market and Bond Trades – Tactical & Strategic Trades 

This page summarises our main tactical (T) and strategic (S) trades. The former focus on short-term horizons (a few weeks), 

allowing one to play any near-term corrections within a defined trend, while the latter rely on a medium-term assumed trend. 

For each trade we provide the expected target and the recommended stop loss. 

New Strategies 

USD 5s10s Spread Flattener Long 5Y Spread Short 10Y Spread 

We like this position due to the following: (i) auction stats indicating a favourable 

bias going into next week; (ii) belief that Europe could deteriorate further, helping 5y 

spreads to outperform; (iii) belief that US downgrade fears could rise, weighing on 

10y and 30y spreads. 

Current* Targets Stop Entry 

-17.25 

(T) 

-25.0 -16.0 -19.25 

(21-Jul) 

Carry 

/ mth 

Risk** 

P/L 

(ccy/Bp) 

15k/01 USD -30k 

-2bp 

Current Strategies 

Yield Curves 

USD 2s10s Box Spread Buy 6m-fwd 2s10s Sell 1y-fwd 2s10s 

Flattening implied from 6m- to 1y-fwd is too little compared to history, and position 

has little negative roll. Will tend to work in a sell-off and risk-reward looks better than 

for other bearish trades. 

9.5 

(S) 

30.0 0.0 10.0 

(19-Jul) 

15k/01 USD -7.5k 

-0.5bp 

Money Markets 

Eurodollar 1-2-3 Fly Sell ED U1Z1H2 

It makes no macro sense for the fly to be positive given that hikes are more likely to 

come later rather than sooner. Strong selling flows in Z1 (for Libor protection) have 

pushed the fly to attractive levels. 

Eurodollar blues/golds fly Sell ED M5Z5M6 

Z5 looks quite cheap on the curve vs. surrounding contracts (same goes for 4y1y 

swaps). On a fly, these points look almost at all-time cheap levels, and an added 

feature of the trade is its lack of directionality. 

6.0 

(T) 

9 

(T) 

-3.0 11.0 6.0 

(13-Jul) 

-3.0 16.0 9.5 

(19-Jul) 

20k/01 USD 0k 

0bp 

30k/01 USD +15k 

0.5bp 

Options 

USD 7s10s15s Conditional Bear-Tightener Buy 1Y7Y Payer Sell 1Y10Y Payer -20k 

Buy 1Y15Y Payer 

(S) 

7s10s15s (either spot or 1y-fwd) has rarely gone above the current level of 11bp in 

its entire history, but using payers one can sell the fly at 17bp (due to vol advantage) 

if the trade is in the money at expiry. 

Euribor Call Spread Buy Euribor Z1 9825/50 CS 

11.5 

Upside risk with good risk/reward. ECB priced at 2% year-end, could see significant (S) 

retracement in between. 

*Tactical (T) and strategic (S) trades. **Risk: vega, gamma for options, or ΔDV01 for futures, bonds and swaps. 

300k -150k 0k 

(14-Jun) 

25.0 0.0 3.25 

(12-Apr) 

1k/01 USD 

-20k 

. 12.5k/01 EUR 

+100k 

+8c 

Interest Rate Strategy 28 July 2011 


54 


So What if the US Loses its AAA Status? 

• Under a scenario of a US ratings downgrade 

with no default, USD may not come to any 

(sustained) great harm 

• Assuming default is avoided and the debt 

ceiling raised, focus may quickly turn to the 

scale of 2012 fiscal drag 

• Fiscal headwinds keeping growth subdued 

in 2012 plays to extension of USD downside risk 

through 2011. 

Chart 1: Japan Downgrade implications for FX 

and JGBs 

US debt downgrade shouldn’t harm USD 

Despite the absence as yet of any agreement on US 

deficit reduction, we continue to assume that the 

default scenario will be avoided. Even if this is so, 

the chances of Standard & Poor’s electing to strip the 

US sovereign of its AAA status remains high since 

the agency (in contrast to Fitch and Moody’s) has 

made plain that in the absence of a credible 10-yr 

deficit reduction agreement totalling something close 

to USD 4trn, a downgrade is likely. As the clock ticks 

down towards an August “drop-dead” date (albeit 

perhaps a bit beyond 2 August) so the chances of a 

deal that gets the debt ceiling lifted without satisfying 

S&P in terms of scale and substance, increases. 

Under “downgrade not default” and especially if a 

downgrade is confined to a single agency (S&P), it is 

not clear that major flows out of US Treasuries will 

necessarily result. While the knee-jerk reaction will 

almost certainly be USD negative, there will likely 

need to be evidence of large-scale physical selling of 

Treasuries in favour of non-dollar denominated AAA 

securities for there to be a sustained negative dollar 

impact. Our analysis and investigations suggests that 

across the broad spectrum of bond portfolio 

managers (money market funds, bond mutual funds, 

money managers, insurance companies, official 

institutions and central banks), few if any will be 

compelled to sell (for example many are mandated 

only to hold “Tier 1” assets not necessarily “AAA” 

assets – Tier 1 encompassing paper rated as much 

as 6-notches below AAA). Though we have seen 

evidence of money market funds starting to hoard 

liquidity as a precaution against redemption demand, 

we believe this provisioning is linked more to 

insurance against a debt default rather than 

downgrade scenario. 

In the case of the larger foreign holders of Treasuries 

(China, Japan, OPEC nations, other Asian monetary 

authorities), any large-scale sell-down of Treasury 

Source: Reuters EcoWin 

Source: BNP Paribas. Neither JGB yields not JPY came 

to any sustained harm after Japan was first stripped on its 

AAA rating by one agency (Moody’s) in late 1998. Limited 

foreign ownership of JGBs makes comparisons with the 

US Treasury market and the dollar specious, but the 

observation is nevertheless worth noting. 

Chart 2: US Projected Deficit Reduction under 

“Gang of 6” Proposals 

0 

-100 

-200 

-300 

-400 

-500 

-600 

-700 

-800 

-900 

Total Projected Deficit Reduction 

Total Ex Tax Reform 

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 

Source: BNP Paribas: Deficit reduction/implied fiscal 

tightening in 2012 shown here are in addition to whatever 

tightening is slated to occur anyway. Much depends on 

the extent to which tax breaks and benefit extensions 

currently in place are rolled forward into 29012, but we 

currently assume that we will get an implied fiscal 

tightening of some 1.8% of GDP independent of what falls 

out of the current deficit/debt ceiling process. 

debt may be viewed by these holders as a case of 

“cutting off your nose to spite your face” – prone to 

weakening the value of existing asset holdings both 

directly, and indirectly via weaker USD valuations. At 

a time when investors – central banks and otherwise 

– remain hesitant to add to euro-denominated debt 

holdings until greater clarity is provided on the 

substance of the new EU agreement on Greek 

funding and expanded EFSF remit, it is not clear 

funds will flow from US Treasuries to AAA-rated 

eurozone debt on any significant scale. Meanwhile, 

Ray Attrill 28 July 2011 


55 


UK (AAA) debt is already under the ratings spotlight 

while non-US and European AAA-rated sovereign 

credit markets (Australia, Canada, Sweden and 

Norway) are simply too small to accommodate 

inflows on the scale that would make an appreciable 

difference to total US Treasury holdings. 

Comparisons with Japan’s 1998 experience of losing 

their AAA status, initially from just from one ratings 

agency (Moody’s) are not that relevant give the 

limited foreign ownership of the JGB market, though 

it is worth noting that neither JGB yields nor the JPY 

came to any sustained harm (see Chart 1) 

Also important to keep in mind are the circumstances 

under which S&P issues a downgrade. This will be 

because of the absence of an agreement to medium 

term deficit reduction on a sufficient scale to 

convince the agency that US debt is being put on a 

sustainable footing. However as far as 2012 is 

concerned, it is highly probable that this will be the 

first time for many years that fiscal policy is acting as 

a headwind rather than tailwind on the economy. As 

such, any growth acceleration in 2012 versus what 

we expect will be something close to 2% in 2011 may 

be modest at best and conceivably non-existent. 

As and when we get through the current debt ceiling 

debacle and assuming default is avoided but not an 

S&P downgrade, then markets are likely to quickly 

refocus on the implications of fiscal policy for the 

2012 growth outlook. To the extent this will play to 

the view that the Fed will be “easier for longer”, then 

even in the absence of moves to price in QE3, the 

more likely it is that dollar remains on a weakening 

trend though the remainder of 2011. 

Ray Attrill 28 July 2011 


56 


Little Justification For BoJ Intervention 

• Strength of JPY driven more by concerns 

over US debt-ceiling deadlock than internal 

factors 

• Odds of BoJ intervention are low unless 

USDJPY moves become disorderly 

160 

150 

140 

130 

120 

110 

Chart 1: JPY REER v. JPY REER LT Avg. 

JPY REER Long Term Avg 

Focus on the US debt ceiling has kept safe-haven 

currencies like the JPY and CHF very well bid 

against the USD. USDCHF has reached an all-time 

low while USDJPY is well below 80, the once 

perceived line in the sand for Japanese officials. As 

USDJPY continues to trade below 80.00, speculation 

of intervention from the BoJ is rising. But in our view, 

the likelihood of intervention is very slim, barring any 

disorderly moves in USDJPY. While the motive for 

intervention is there for Japan as it continues to 

recover from the devastating earthquakes earlier this 

year, the reasoning is rather weak. 

For one, the intervention in March was the result of 

internal factors, chiefly the Japan earthquake. With 

JPY flows flooding back home, JPY made significant 

gains against the majors: USDJPY fell from a high of 

79.75 to 76.25 while EURJPY dropped to 106.61 

from 111.27 on 17 March. The G7 countries acted in 

solidarity via a coordinated intervention to mitigate 

the strength of the currency and help allay one of 

Japan’s key concerns. This time around, JPY 

strength has been mostly against the USD on the 

back of the stalemate on the US debt ceiling. With 

the US deep in its fiscal mess and the eurozone 

mending its own fiscal issues, a coordinated 

intervention would be a hard sell. In addition, FX 

intervention would likely prove to be unsuccessful as 

it would have to be accompanied by complementary 

BoJ policy (further monetary easing). The last 

intervention had a very limited impact on the JPY 

because while the BoJ initially expanded its balance 

sheet (to new record highs), it shrank it back down 

once the new fiscal year began in April. This 

undermined efforts to weaken the JPY. With the BoJ 

showing little inclination to embark on fresh balancesheet 

expansion (let alone JGB monetisation), 

unilateral intervention could quickly turn into an 

expensive policy mistake. 

Second, while the JPY may look expensive in 

comparison to USD in nominal terms, the picture is 

quite different in real terms and against an average 

of its trading partners. The JPY remains 

“undervalued” versus its trading partners on a REER 

100 

90 

80 

JPY REER 

70 

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 


95.0 

92.5 

90.0 

87.5 

85.0 

82.5 

80.0 

Chart 2: USDJPY v. 10yr Yield Differential 

77.5 

Nov Jan 

09 


USD/JPY 

10y UST v. JGB (RHS) 

Mar May Jul Sep Nov Jan 

10 

Mar May Jul 

11 

2.6 

2.5 

2.4 

2.3 

2.2 

2.1 

2.0 

1.9 

1.8 

1.7 

1.6 

1.5 

1.4 

basis, being well below its long term average. Since 

the start of 2011, the currencies of some of Japan’s 

key trading partners including EUR, KRW, and SGD 

have outperformed the JPY. Although the MYR has 

underperformed the JPY in recent months, it has 

since made a comeback. The USD has been the only 

big and consistent underperformer against JPY 

(China, Japan’s largest trading partner, has also 

underperformed but to a much lesser extent given 

the 5% drop in USDCNY in the past year.) In 

general, Japan maintains its competitiveness against 

its key trading partners on a REER basis and on a 

NEER basis against both Europe and some of its key 

Asian export competitors. The key positive spin on 

the strength of the currency against the USD is that 

raw materials and other commodities priced in USD 

have become markedly cheaper at a time when 

Japan begins its reconstruction efforts, something 

that Japanese officials have acknowledged as 

beneficial. 

Mary Nicola 28 July 2011 


57 


Based on the JPY REER, the BoJ should not be too 

alarmed by the moves in USDJPY unless it begins to 

freefall. USDJPY will remain hostage to the progress 

(or lack thereof) on the US debt negotiation. Our 

base-case scenario is that the US comes to a twostage 

deal at the 11th hour which may not please 

S&P resulting in a downgrade. The knee-jerk 

reaction will likely be a sell-off in the back end of the 

UST curve but potentially a rally in the front end of 

the curve as the markets start pricing in further US 

economic weakness from the implied 2012 fiscal 

drag. Thus, the net impact on USDJPY may be 

limited given USDJPY is more highly correlated with 

yield spreads at the front end of the respective 

curves than at the longer end. 



58 


AUD: The Future is Rosy 

• The robustness of AUD despite the 

diminishing of its yield advantage suggests the 

real drivers lie elsewhere. 

5.5 

5.0 

Chart 1: AU-US 2y Yield Spread 

1.10 

1.05 

• The key drivers appear to be robust 

sovereign demand, its role as a proxy for Asian 

FX appreciation and the terms of trade 

improvement. 

• STRATEGY: We believe that AUDUSD will 

appreciate further towards 1.15. 

4.5 

4.0 

3.5 

3.0 

2.5 

2.0 

1.5 

AU - US 2y Spread 

AUDUSD (RHS) 

1.00 

0.95 

0.90 

0.85 

0.80 

0.75 

0.70 

1.0 

0.65 

The outperformance of AUDUSD relative to expected 

interest rate differentials is not likely to be the 

catalyst for a sustained pullback on AUD. There has 

been much market discussion on the breakdown of 

this traditional relationship (Chart 1). We suggest 

that interest rate markets are not pricing in 

sufficient tightening from the RBA. Our 

economists are calling for a 25bp hike in Q4 

assuming that global downside risks do not 

crystallise. Further tightening is also likely in 2012 if 

the same conditions hold in contrast to almost flat 

market expectations. This week’s upside surprise to 

Q2’s CPI revealed an acceleration in underlying 

inflation to 2.7% y/y and it is likely to nudge higher 

over the balance of the year. In contrast, recent weak 

data in the US suggest little potential for a near-term 

increase in market expectations for Fed tightening. 

Accordingly, we believe there are prospects for the 

benchmark 2-year yield spread to move in favour of 

AUD over coming weeks. Still, the robustness of 

AUD, despite the diminishing of its yield 

advantage, suggests the real drivers lie 

elsewhere. 

The strong trend higher in Australia’s terms of 

trade appears consistent with the appreciation of 

AUD (Chart 2). The commodities boom continues to 

support the rise in prices of exports relative to 

imports while ongoing strong demand from 

Australia’s major trading partners, including China, 

should see this trend persist. This data series is only 

released quarterly but more recent CRB data is 

consistent with the terms of trade remaining at 

elevated levels. It is interesting to note that the 

moderation in China’s growth indicators since the 

second half of 2010, especially the PMI, has not 

produced a pullback in AUD. Such a divergence 

suggests that the improvement in Australia’s terms of 

trade is more broadly based that merely being a 

reflection of Chinese growth prospects. 

0.5 

Jul 

Nov 

08 

Mar Jul Nov 

09 


130 

120 

110 

100 

90 

80 

70 

Mar Jul Nov 

10 

Mar 

11 

Chart 2: AUD TWI vs. Terms of Trade 

Term s of trade, Index, 2008-2009=100 

60 

01 02 03 04 05 06 07 08 09 10 11 


1.15 

1.10 

1.05 

1.00 

0.95 

0.90 

0.85 

0.80 

0.75 

0.70 

0.65 

0.60 

0.55 

Jul 

AUD TW I (RHS) 

Chart 3: AUDUSD vs. CNY 12m NDFS 

Nov 

08 


AUDUSD 

USDCNY 12m NDF (RHS inverted) 

Mar Jul Nov 

09 

Mar Jul Nov 

10 

Mar 

11 

AUD may have become an FX proxy for general 

Asian currency appreciation. AUDUSD appears 

very closely linked to USDCNY 12-months NDFs and 

does not appear to have outpaced CNY appreciation 

(Chart 3). This link seems reasonable given 

Australia’s geographic location and its exposure to 

emerging Asian economies. Specifically, as official 

Jul 

Jul 

0.60 

80 

75 

70 

65 

60 

55 

50 

45 

6.2 

6.3 

6.4 

6.5 

6.6 

6.7 

6.8 

6.9 

7.0 

7.1 

7.2 

7.3 

7.4 

Steven Saywell 28 July 2011 


59 


intervention remains a significant risk from many of 

the region’s central banks there has been very little 

verbal opposition from Australian officials. The RBA 

has been capitalising on recent AUD strength to build 

official reserve assets but the rise has been 

moderate in recent months standing at AUD 41.1bn 

as at the end of June. 

In our opinion, the strongest rationale behind AUD 

appreciation remains demand form sovereign funds 

and central banks. In a world where both EUR and 

USD have faced debt market issues, alternatives 

such as AUD, CAD, GBP, JPY and SEK continue 

to benefit. Data on specific AUD demand is scarce. 

The official IMF COFER data for Q1 (IMF COFER Q1 

Update – EUR Conundrum) reveals the largest rise 

by category among countries that do report reserve 

breakdown by currency was among the non-specific 

“other” group of currencies at 12.6% q/q. This 

category relates to non-USD, EUR, JPY, CHF and 

GBP G10 holdings. We assume this group pertains 

mainly to AUD and CAD but a breakdown is 

unavailable and also excludes holdings from the 

largest foreign exchange reserve holder China. 

Separately, monthly data from the RBA report a 

sharp increase in total foreign ownership of 

Commonwealth Securities (Chart 4). The total has 

surged from AUD 57.8bn at the end of 2008 to 

AUD 191.3bn as at June 2011. This data series 

probably underreports total foreign held securities as 

purchases through local subsidiaries in Australia are 

likely excluded from the foreign total. Accordingly, the 

trend of rising holdings of AUD assets by foreign 

reserve managers appears clear. 

Chart 4: Foreign Ownership of Commonwealth 

AUS Government Securities. (AUD mn) 

200000 

180000 

160000 

140000 

120000 

100000 

80000 

60000 

40000 

Jun-94 Jun-98 Jun-02 Jun-06 Jun-10 

Source: RBA 

In summary, we do not believe the divergence 

between AUDUSD and relative near-term interest 

rate expectations will be a catalyst for a sustained 

AUD pullback. Indeed, the robustness of AUD 

despite the pullback in its yield advantage 

suggests the real drivers lie elsewhere. In 

contrast, the ongoing rise in Australia’s terms of trade 

supports the currency’s appreciation while the likely 

role of AUD as a proxy for Asian appreciation 

presents strong prospects for further appreciation. 

Finally, reserve manager demand is rising and 

should continue to remain strong. Strategically, we 

believe that AUDUSD will continue to appreciate 

beyond new multi-decade highs above 1.10 towards 

1.15. 

Steven Saywell 28 July 2011 


60 


Factors Behind The Soaring Bird Set to Hold 

• Increasing demand from China for dairy 

products to keep NZD on strong footing 

Chart 1: NZDUSD vs. NZ Terms of Trade 

• RBNZ to remove emergency rate cuts from 

March 2011; mispricing between rate hike from 

RBA vs. RBNZ to work in favour of AUD 

• STRATEGY: Buy AUDNZD on dips, targeting 

1.30 

NZDUSD continues to soar to new highs despite the 

recent rise in volatility in G10 FX markets, conjuring 

up questions as to whether such moves are 

overextended and whether this move is in fact 

warranted. 

First and foremost, New Zealand is experiencing a 

significant positive terms-of-trade shock as trade with 

China and emerging Asia has soared in recent years 

along with food prices – including those for dairy 

products, which account for about 22% of exports. 

Second, reconstruction is underway as New Zealand 

rebuilds after the Christchurch earthquakes. Third, 

NZD is gaining ground in this low-rate environment 

not only because of absolute rate differentials but 

also because markets are pricing in further rate hikes 

from the RBNZ as the economy rebounds. 

As a soft commodity exporter, New Zealand is 

benefiting from the surge in food prices. Earlier this 

year, the IMF noted that the world would have to get 

used to higher food prices given the rise in demand 

for food commensurate with global income growth 

and other structural factors. The IMF argues that this 

phenomenon is not going away anytime soon, a 

sentiment with which we broadly agree. 

But more specific to NZD is the surge in exports to 

China and emerging Asia. Following the 2008 milk 

scandals in China when some 300,000 children fell ill 

from drinking melamine-contaminated milk, a general 

distrust of Chinese-produced dairy products led to an 

increase in imports. New Zealand benefited greatly 

from this, and it is now China’s second largest 

trading partner (after Australia). The demand for 

dairy products has risen not only for this reason but 

also because of a rising middle class in China and 

emerging Asia. Demand for dairy produce in China 

among high-income households is twice as strong as 

among low-income ones. We also find that the price 

elasticity of export demand for dairy products is very 

low; this means that higher dairy prices arising from 

both the ongoing appreciation of the NZD and the 


Chart 2: AUDNZD v. Relative Rate Expectations 


rising trend in (NZD-constant) prices is not impacting 

negatively on overall demand. As such, the positive 

terms-of-trade shock seen in New Zealand will likely 

persist. 

The devastating earthquakes in Christchurch, New 

Zealand’s second largest city, in September 2010 

and February 2011 require enormous reconstruction, 

with an estimated building cost of USD 20bn. 

Rebuilding efforts now look to be starting to have a 

positive impact on the economy via a surge in 

construction investment, after Q1 (earthquake 

affected) GDP data surprised significantly to the 

upside with a gain of 0.8%. 

NZD is also benefiting in this low-rate environment as 

one of the higher yielding currencies in the G10 

space. Even at the post-earthquake emergency level 

of 2.5%, money market rates remain favourable with 

respect to most other G10 currencies. And, we 

should soon see RBNZ reverse its emergency rate 

cut. While the RBNZ left rates unchanged in July, 

they were optimistic on the economic recovery and 

noted that they see little need to maintain the 

emergency rate setting from back in March. This 



61 


statement was followed by concerns over the 

strength of NZD and that if its strength persists, then 

“it is likely to reduce the need for further OCR 

increases in the short term”. The key phrase here is 

“further OCR increases”, which is interpreted to 

mean they would soon get rid of the emergency 50bp 

cut from back in March but with limited tightening 

thereafter assuming NZD remains so strong. After 

the meeting, a Reuters poll showed that the 

consensus now expects the RBNZ to raise rates by 

50bp at the next meeting on 15 September. After 

that, consensus is looking for rates to rise to 3.25% 

by March 2012 and then 3.5% by June 2012. The 

market is now pricing in about 111bp of rate rises 

over the next 12 months, a view with which we are in 

broad agreement. 

While the market is fully pricing in the removal of the 

RBNZ emergency cut and looking for more rate hikes 

from the RBNZ further down the road, we think the 

market is significantly under-pricing tightening risks 

from the RBA. Currently, the market is looking for 

about 19bp in cuts over the next 12 months, but a 

15% chance of a rate hike at the upcoming meeting. 

In our view, the uncomfortably high Q2 CPI outcome 

will, at the very least, see the RBA shifting its rhetoric 

at the upcoming (2 August) meeting. We expect a 

hike from the RBA to come in Q4. Thus, in the short 

term, this disconnect in rate pricing will work in favour 

of AUD v. NZD. AUDNZD could rally back up to 1.30 

on a hawkish RBA. 



62 


Economic Calendar: 29 Jul - 5 Aug 

GMT Local Previous Forecast Consensus 

Fri 29/07 23:01 00:01 UK GfK Consumer Survey : Jul -25 -26 -26 

(28/07) 

08:30 10:30 Mortgage Approvals : Jun 45.9k 46.0k 46.0k 

08:30 10:30 Net Consumer Credit : Jun GBP0.2bn GBP0.2bn GBP0.3bn 

23:30 08:30 Japan CPI National y/y : Jun 0.3% 0.2% 0.2% 

23:30 08:30 Core CPI National y/y : Jun 0.6% 0.4% 0.5% 

23:30 08:30 CPI Tokyo y/y : Jul -0.2% 0.1% 0.0% 

23:30 08:30 Core CPI Tokyo y/y : Jul 0.1% 0.2% 0.2% 

23:30 08:30 Household Consumption y/y : Jun -1.9% -4.3% -2.3% 

23:30 08:30 Unemployment Rate (sa) : Jun 4.5% 4.6% 4.6% 

23:50 08:50 Industrial Production (Prel, sa) m/m : Jun 6.2% 4.5% 4.5% 

(28/07) 

05:00 14:00 Housing Starts y/y : Jun 6.4% 7.8% 4.6% 

06:45 08:45 France Retail Sales m/m : Jun -0.8% 1.0% n/a 

06:45 08:45 Retail Sales y/y : Jun -1.8% 0.9% n/a 

06:45 08:45 PPI m/m : Jun -0.5% 0.3% -0.1% 

06:45 08:45 PPI y/y : Jun 6.1% 6.2% 5.9% 

07:00 09:00 Spain HICP Flash y/y : Jul 3.0% 2.9% 2.9% 

07:00 09:00 Unemployment Rate : Q2 21.3% 21.0% 20.9% 

07:00 09:00 Norway Unemployment Rate (nsa) : Jul 2.5% 2.7% n/a 

07:30 09:30 Sweden GDP (Prel, sa) q/q : Q2 0.8% 0.6% 0.6% 

07:30 09:30 GDP (Prel, sa) y/y : Q2 6.5% 5.0% 5.0% 

07:30 09:30 Eurozone Eurocoin : Jul 0.52 0.37 n/a 

09:00 11:00 HICP (Flash) y/y : Jul 2.7% 2.7% 2.7% 

09:00 11:00 Italy CPI (NIC, Prel) m/m : Jul 0.1% 0.2% 0.2% 

09:00 11:00 CPI (NIC, Prel) y/y : Jul 2.7% 2.6% 2.6% 

09:00 11:00 HICP (Prel) m/m : Jul 0.1% -1.3% -1.0% 

09:00 11:00 HICP (Prel) y/y : Jul 3.0% 2.6% 2.9% 

12:30 08:30 US GDP (Adv, saar) q/q : Q2 1.9% 1.0% 1.8% 

12:30 08:30 GDP Deflator (Adv, saar) q/q : Q2 2.0% 1.5% 2.0% 

12:30 08:30 Employment Cost Index q/q : Q2 0.6% 0.5% 0.5% 

12:30 08:30 Employment Cost Index y/y : Q2 2.0% 2.0% n/a 

13:45 09:45 Chicago PMI : Jul 61.1 58.0 60.0 

13:55 09:55 Michigan Sentiment (Final) : Jul 71.5 65.0 64.0 

19:15 15:15 Fed’s Bullard & Lockhart Speak on Monetary Policy in Wyoming 

12:30 08:30 Canada GDP m/m : May 

13:00 15:00 Belgium GDP (Flash) q/q : Q2 1.1% 0.5% 0.3% 

13:00 15:00 GDP (Flash) y/y : Q2 3.0% 2.4% n/a 

Mon 01/08 07:30 09:30 Switzerland PMI Manufacturing : Jul 53.4 52.0 52.8 

08:00 10:00 Eurozone PMI Manufacturing (Final) : Jul 50.4 (p) 50.4 50.4 

09:00 11:00 Unemployment Rate : Jun 9.9% 9.9% 9.9% 

08:30 09:30 UK CIPS Manufacturing : Jul 51.3 50.0 51.0 

Canada Public Holiday 

14:00 10:00 US Construction Spending m/m : Jun -0.6% -0.3% -0.1% 

14:00 10:00 ISM Manufacturing : Jul 55.3 54.5 55.2 

Tue 02/08 01:30 11:30 Australia House Price Index q/q : Q2 -1.7% -1.0% n/a 

04:30 14:30 RBA Rate Announcement 

09:00 11:00 Eurozone PPI m/m : Jun -0.2% 0.1% 0.1% 

09:00 11:00 PPI y/y : Jun 6.2% 6.0% 6.0% 

12:30 08:30 US Personal Income m/m : Jun 0.3% 0.1% 0.2% 

12:30 08:30 Personal Spending m/m : Jun 0.0% 0.0% 0.2% 

Market Economics 28 July 2011 

Market Mover 

63 


Economic Calendar: 29 Jul - 5 Aug (cont) 

GMT Local Previous Forecast Consensus 

Wed 03/08 01:30 11:30 Australia Trade Balance : Jun AUD2333mn AUD2000mn n/a 

01:30 11:30 Retail Sales m/m : Jun -0.6% 1.0% n/a 

01:30 11:30 Retail Sales y/y : Jun 2.2% 2.9% n/a 

08:00 10:00 Eurozone PMI Services (Final) : Jul 51.4 (p) 51.4 51.4 

08:00 10:00 PMI Composite (Final) : Jul 50.8 (p) 50.8 n/a 

10:00 12:00 Retail Sales (sa) m/m : Jun -1.0% 0.5% 0.5% 

10:00 12:00 Retail Sales (ca) y/y : Jun -1.8% -1.3% -0.9% 

08:30 09:30 UK CIPS Services : Jul 53.9 53.1 53.5 

11:30 07:30 US Challenger Layoffs : Jul 

12:15 08:15 ADP Labour Change : Jul 157k 100k 105k 

14:00 10:00 Factory Orders m/m : Jun 0.8% -1.0% -0.5% 

14:00 10:00 ISM Non-Manufacturing : Jul 53.3 52.5 54.0 

14:30 10:30 EIA Oil Inventories 

Thu 04/08 07:30 09:30 Neths CPI m/m : Jul -0.5% -0.1% n/a 

07:30 09:30 CPI y/y : Jul 2.3% 2.4% n/a 

08:00 10:00 Norway Unemployment Rate (sa) : May 3.4% 3.4% n/a 

10:00 12:00 Germany Factory Orders m/m : Jun 1.8% -2.5% -0.2% 

10:00 12:00 Factory Orders y/y : Jun 12.2% 5.1% 6.8% 

11:00 12:00 UK BoE Rate Announcement 

11:45 13:45 Eurozone ECB Rate Announcement 

12:30 14:30 ECB Press Conference 

12:30 08:30 US Initial Claims 398k 415k n/a 

Fri 05/08 Japan BoJ Rate Announcement 

Australia RBA Policy Statement 

06:45 08:45 France Trade Balance : Jun EUR-7.4bn EUR-6.9bn EUR-6.1bn 

07:00 09:00 Spain Industrial Production (wda) y/y : Jun -0.4% n/a 

07:15 09:15 Switzerland CPI m/m : Jul -0.2% -0.6% -0.6% 

07:15 09:15 CPI y/y : Jul 0.6% 0.7% 0.7% 

07:30 09:30 Neths Industrial Production m/m : Jun 0.3% -1.5% n/a 

07:30 09:30 Industrial Production y/y : Jun 2.6% 1.1% n/a 

08:00 10:00 Italy Industrial Production m/m : Jun -0.6% -0.2% n/a 

08:00 10:00 Industrial Production (wda) y/y : Jun 1.8% 1.2% n/a 

09:00 11:00 GDP (Prel) q/q : Q2 0.1% 0.2% n/a 

09:00 11:00 GDP (Prel) y/y : Q2 1.0% 0.7% n/a 

08:00 10:00 Norway Manufacturing Prod (sa) m/m : Jun 2.4% 1.0% n/a 

08:00 10:00 Manufacturing Prod (nsa) y/y : Jun 5.6% 2.0% n/a 

08:30 09:30 UK Input PPI (nsa) m/m : Jul 0.4% 0.6% 0.6% 

08:30 09:30 Output PPI (nsa) y/y : Jul 5.7% 5.8% 5.8% 

08:30 09:30 Output PPI (Ex-FDT, sa) y/y : Jul 3.2% 3.2% 3.2% 

10:00 12:00 Germany Industrial Production m/m : Jun 1.2% -0.5% 0.1% 

10:00 12:00 Industrial Production y/y : Jun 7.6% 7.8% 8.1% 

11:00 07:00 Canada Unemployment Rate : Jul 7.4% 7.5% 7.5% 

11:00 07:00 Payroll Jobs y/y : Jul 28.4k 13.0k 20.0k 

12:30 08:30 US Non-Farm Payrolls (Chg) : Jul 18k 50k 100k 

12:30 08:30 Unemployment Rate : Jul 9.2% 9.3% 9.2% 

12:30 08:30 Average Hourly Earnings m/m : Jul 0.0% 0.1% 0.2% 

19:00 15:00 Consumer Credit : Jun USD5.1bn USD5.0bn USD5.1bn 

During 1-5 UK Halifax House Prices m/m : Jul 1.2% 0.0% 0.0% 

Week Halifax House Prices y/y : Jul -3.5% -2.8% -2.8% 

Release dates and forecasts as at c.o.b. prior to the date of publication: See Daily Economic Spotlight for any revision 



Market Mover 

64 


Key Data Preview 

3 

2 

1 

0 

-1 

-2 

-3 

Chart 1: Japanese CPI (% y/y) 

CPI excluding energy and 

food, but not alcohol 

Core CPI 

02 03 04 05 06 07 08 09 10 11 

Source: MIC, BNP Paribas 

% y/y Jun (f) May Apr Mar 

Core CPI 0.4 0.6 0.6 -0.1 

CPI 0.2 0.3 0.3 0.0 

BNP Paribas Forecast: Positive But Slower 

Japan: CPI (National, June) 

Release Date: Friday 29 July 

We estimate that core CPI inflation in June will stay positive 

but ease 0.2pp to 0.4% y/y, reflecting slower price growth 

for energy. In April, the index returned to growth for the first 

time in 28 months with a rise of 0.6% y/y. That rate of 

increase – the fastest since November 2008 – was 

maintained in May. But the price growth leader, energy, has 

steadily lost momentum, going from 7.3% growth in April to 

5.7% in May; this reduced momentum should continue in 

June, resulting in the index’s slower rate of growth. 

Meanwhile, index rebasing (2005 to 2010), to take effect 

from the 26 August release of the national CPI data for July, 

will lower the core CPI by 0.7-0.8pp (according to our 

estimates). The rebasing (2000 to 2005) five years ago 

lowered the index by 0.5pp. Consequently, under the new 

index, the core CPI should hover around zero, while the 

US-style core-core CPI (0.1% y/y in May) will probably turn 

negative again. 

Key Point: 

The national core index in June should stay positive 

but post slightly slower growth, reflecting the 

reduced price growth of energy. 

Chart 2: Japanese Unemployment Rate (% s.a.) 

6.0 

5.5 

5.0 

4.5 

4.0 

3.5 

00 01 02 03 04 05 06 07 08 09 10 11 

Source: MIC, BNP Paribas 

% s.a. Jun (f) May Apr Mar 

Unemployment Rate 4.6 4.5 4.7 4.6 

Key Point: 

Employment is starting to pick up, with the 

automobile industry planning on hiring more 

contract workers. Even so, we expect the 

unemployment rate in June to rise slightly. 

BNP Paribas Forecast: Slight Rise 

Japan: Unemployment Rate (June) 


In May, the jobless rate eased 0.2pp to 4.5%, as the 

jobless total declined with the continued swelling of the 

ranks of those categorised as not in the work force. Though 

job growth in May was still anaemic, we expect 

employment to gradually start to recover, as manufacturing 

activity is expected to return to pre-disaster levels by the 

autumn thanks to the rapid restoration of supply chains. 

The automobile industry, which was especially hard hit by 

the disaster, plans on hiring more contract workers as 

leading carmakers gear up for production increases from 

the autumn. Despite steady improvements on the job front, 

we expect the unemployment rate in June to deteriorate 

slightly to 4.6% due to an increase in the labour force 

participation rate. 

Note that the areas hit hardest by the Great East Japan 

Earthquake are still excluded from the data as surveying 

remains difficult. 


Market Mover 

65 



Chart 3: Japanese Production and Exports 

120 

115 

110 

105 

100 

95 

90 

85 

80 

75 

70 

65 

(2005=100, seasonally adjusted) 

00 01 02 03 04 05 06 07 08 09 10 11 

Source: METI, BNP Paribas 

Production 

Exports (RHS) 

150 

140 

130 

120 

110 

100 

90 

80 

70 

60 

50 

Jun (f) May Apr Mar 

IP % m/m 4.5 6.2 1.6 -15.5 

Key Point: 

Although production is expected to continue 

expanding robustly in June, the slowing global 

economy and power shortages at home cast clouds 

over future factory activity. 

BNP Paribas Forecast: Recovering For Now 

Japan: Industrial Production (June) 


We expect production in June to expand by a solid 4.5% 

m/m, continuing May’s robust growth of 6.2%. While such 

an outturn would confirm that production activities are 

reviving thanks to the restoration of supply chains, the 

outlook is not without clouds. For one thing, power 

shortages are set to restrain the recovery of production 

over the summer. Indeed, with the growing political 

controversy around restarting idle nuclear reactors, power 

shortages have now become an issue for the entire nation, 

not just for the region of Japan that was directly affected by 

the earthquake. 

There are risks on the demand side too, as the global 

economy has been slowing. The US and Europe continue 

to struggle with their balance-sheet problems, while the 

combination of rising inflation pressure and slowing growth 

is posing challenges for policymakers in many emerging 

economies. Thus, the downside risk to external demand 

looks high. Given this background, the main focus of 

attention in the June report is the production plan survey 

for the summer months. 

Chart 4: French Retail Sales vs. Confidence 

5 

4 

3 

2 

1 

0 

-1 

-2 

-3 

Retail Sales (% y/y, volume) 

Household Confid. (RHS) 

Commission Survey 

05 06 07 08 09 10 11 


Constant Prices Jun (f) May Apr Jun 10 

SA-WDA 

Retail Sales % m/m 1.0 -0.8 -1.4 -1.8 

Retail Sales % y/y 0.9 -1.8 0.0 -0.7 

Key Point: 

The sharp fall seen in May reflects distortions; we 

forecast a strong rebound as soon as June. 

5 

0 

-5 

-10 

-15 

-20 

-25 

-30 

-35 

-40 

BNP Paribas Forecast: Strong Rebound 

France: Retail Sales (June) 


The recent collapse in retail sales was not consistent with 

the level of household confidence. Higher inflation weighed 

on households' purchasing power and caused a decline in 

retail sales. Moreover, the fall may have been amplified by 

the fact that there were fewer days off in May than normal. 

We expect a rebound in retail sales in June. Energy 

consumption was strong in May, and we see very little 

room for improvement in June despite the long weekend 

early in the month. Car sales were weak, but that is a 

legacy of past strength and we see modest potential for a 

rebound. Conversely, food sales were weak in May and we 

expect them to recover in June. More importantly, sales of 

other manufactured goods should be strong in June. They 

start from an abnormally weak level in May (possibly 

because of technical distortions), and seasonal sales 

started early this year (on 22 June). This should support 

retail sales for the month. 

Altogether, we forecast retail sales down 2.1% q/q in Q2 (if 

they are unchanged in June, they will be down 2.4% q/q). 

This implies a massive slowdown in GDP growth and a 

major change in its breakdown. 


Market Mover 

66 




Chart 5: Swedish Real GDP 

sa Q2 11 (f) Q1 11 Q4 10 Q3 10 

GDP % q/q 0.6 0.8 1.6 1.9 

GDP % y/y 5.0 6.5 7.6 6.6 

Key Point: 

Swedish GDP growth is to ease further slightly in 

Q2, with the quarter-on-quarter rate forecast to print 

0.6%, down from Q1’s 0.8%. 

BNP Paribas Forecast: Further Moderation 

Sweden: GDP (Q2) 


After very strong quarter-on-quarter readings in 2010, 

Swedish GDP growth has started to lose some momentum. 

Growth, at 0.8% q/q in Q1, was half of that in Q4 last year. 

We expect GDP growth to have eased further in Q2. 

On the consumer side, real retail sales, on average, have 

been weak so far in Q2, with strong April figures offset by a 

weak May outcome. Despite remaining above its long-term 

average, consumer confidence also continues to trend 

lower. Overall, these point to broadly flat private 

consumption in Q1. 

The trend in industrial production remains relatively robust. 

However, tight financial and monetary conditions and the 

downward trend in surveys, such as the manufacturing 

PMI, point to some moderation in investment growth over 

the quarter. 

In terms of net exports, after a 0.2pp deduction from overall 

quarterly growth in Q1, we expect a 0.1pp contribution in 

Q2. 

Overall, we project GDP growth in quarter-on-quarter terms 

to come in at 0.6% in Q2 – the lowest quarter-on-quarter 

reading since Q4 2009. This should take the year-on-year 

rate down from 6.5% to 5.0%. 

Chart 6: US Consumers Still Feeling the Pain 


Q2 (a) Q1 Q4 Q3 

GDP % q/q AR 1.0 1.9 3.1 2.6 

GDP Deflator % q/q AR 1.5 2.0 0.4 2.1 

Key Point: 

GDP is expected to slow to 1.0% q/q saar in Q1 from 

an already lacklustre 1.9% on the back of a stalling 

out in consumer spending growth. 

BNP Paribas Forecast: A Weak Showing 

US: GDP (Q2a 2011) 


GDP is forecast to grow only 1.0% q/q saar in Q2, after a 

lacklustre 1.9% performance in Q1. Driving the slowing is 

an expected stalling out in consumer spending growth, 

which is expected to be unchanged after a solid 2.2% gain 

in Q1. Households buckled under the weight of soaring 

food and energy prices that sapped their purchasing 

power, while Japan-related supply chain disruptions dented 

auto sales. Construction is expected to remain subdued but 

to show some improvement Similarly, government 

spending will continue to contract but at a more modest 

pace. Equipment and software investment is expected to 

slow to a still solid 7.0% pace after an 8.8% gain. Trade 

should be a modest positive as imports decline with 

consumer spending leading to a narrowing in the trade 

deficit. At the same time, inventory investment should 

weigh on growth as supply chain disruptions lead to a 

slower pace of restocking. Overall the report would 

represent another subpar performance highlighting the 

difficulties that continue to plague the current expansion. 

The GDP deflator is expected to rise 1.5%, which would 

lead nominal GDP growth to slow to 2.5% from 4.0%. 


Market Mover 

67 



Chart 7: UK CIPS Manufacturing vs. Industrial 

Production 


Jul (f) Jun May Apr 

CIPS Manufacturing 50.0 51.3 52.0 54.4 

Key Point: 

We expect a further weakening in the PMI, with the 

index likely to sink to the boom/bust line of 50.0. 

BNP Paribas Forecast: Volatile 

UK: CIPS Manufacturing (July) 

Release Date: Monday 1 August 

Our manufacturing PMI forecast is based on two main 

factors – the dynamic in the manufacturing sector and 

developments abroad, particularly in the eurozone. 

Domestic data have been on a weakening trend. In 

January and February, the CIPS manufacturing index was 

over 60. There was a sharp weakening of 5 points in March 

followed by falls of 1.7, 2.5 and 0.8 points in April, May and 

June, respectively. That is, in the last three months, falls in 

the index have averaged about 1.7 points a month. 

The eurozone is the UK’s largest export market and the 

two economies’ cycles are closely intertwined (see chart). 

Eurozone PMIs were very weak in July, with the aggregate 

manufacturing PMI falling by 2.3 points after a 2.3 point fall 

in May. This will have affected UK manufacturing. 

However, as the fall in the PMIs was partly due to the 

eurozone crisis, the impact on the UK may be less than the 

impact on the mainland. Our equations suggest that the UK 

CIPS will show a fall smaller than in the eurozone in July 

but chunkier than in June. 

We expect the index to return to 50, with a chance it starts 

to show manufacturing beginning to contract. 

Chart 8: US PMI Manufacturing Surveys 



Headline Index 54.5 55.3 53.5 60.4 

Prices Paid 64.0 68.0 76.5 85.5 

Key Point: 

We expect the ISM manufacturing index to fall to 54.5 

in July affected by temporary and more lasting 

factors such as slowing in the global economy. 

BNP Paribas Forecast: Losing Ground 

US: ISM (July) 

Release Date: Monday 1 August 

The latest FOMC minutes highlighted that “although the 

effects of the Japanese disaster on U.S. motor vehicle 

production accounted for much of the deceleration in 

industrial production since March, the most recent readings 

from various regional manufacturing surveys suggested a 

slowing in the pace of manufacturing activity more 

broadly”. In other words, the slow down could be a result of 

both temporary and more long-lasting factors such as 

slowing in the global economy in general and less growth 

in China in particular. 

On an ISM-adjusted basis, the Philly Fed index rose from 

47.2 to 52.1 in July—a move out of contractionary territory; 

however, the Empire State index fell to 49.3 from 49.7 and 

Richmond Fed index also fell into contractionary mode. We 

interpret the movements in the regional indices as 

suggestive of a fall in the ISM manufacturing index to 54.5 

in July, remaining in expansionary territory as still-strong 

activity in the high-tech sector offsets the weakness in the 

East Coast regions. 


Market Mover 

68 



Chart 9: US Confidence vs. Consumption 


% m/m Jun (f) May Apr Mar 

Personal Income 0.1 0.3 0.3 0.4 

Consumption 0.0 0.0 0.3 0.6 

Core PCE Prices 0.3 0.3 0.2 0.2 

BNP Paribas Forecast: Nominal Decline 

US: Personal Income and Spending (June) 

Release Date: Tuesday 2 August 

Personal consumption is forecast to be flat for the second 

month in a row as consumers show the wear and tear of 

rapid inflation in H1. A decline in auto sales is expected to 

offset tepid gains in retail spending and a modest increase 

in services. On a real basis, consumer spending will also 

be flat after a modest decline supporting our forecast that 

we will see no growth in real consumption in Q2. 

Meanwhile, personal income is forecast to rise 0.1%. Both 

aggregate hours worked and average hourly earnings 

posted small declines in June suggesting a loss in wage 

and salary income. We expect this to be offset by asset 

and transfer income gains. 

The core PCE price index is expected to rise 0.3% in June. 

This would lead the annual pace of core inflation to jump to 

1.5% from 1.2%. The rapid rise in core prices over the past 

six months has been enough to prevent the Fed from 

considering further stimulus even as the unemployment 

rate rises. 

Key Point: 

We look for a weak report with tepid gains in income, 

flat spending and a jump in core inflation. 


Chart 10: UK CIPS Services 


CIPS Services 53.1 53.9 53.8 54.3 

Key Point: 

Domestic demand remains weak and export orders 

are likely to have slipped with the global slowdown 

and eurozone turmoil. But our FMCI suggests the 

decline will be moderate. 

BNP Paribas Forecast: Slight Decline 

UK: CIPS Services (July) 

Release Date: Wednesday 3 August 

According to the ONS, growth in GDP adjusted for 

distortions due to unusual holiday patterns in April was 

0.7% in Q2. We’ve not laughed so much in ages and 

certainly there has been no sign of services picking up 

since April – the CIPS services has actually declined. 

June’s CIPS numbers may have reflected some delayed 

business and so the lack of a fall is misleading. Future 

business expectations were at an eight-month low. 

All the signs are that domestic demand remained weak in 

Q2. Retailers had to bring sales forward due to weak 

demand and many businesses seem to be struggling to 

keep afloat. Consumer- and government-facing businesses 

are doing worse that those serving other businesses. 

The trend in services tends to follow the trends in 

manufacturing in the UK and the eurozone, which are 

weakening, although to a lesser extent (see chart). The 

turmoil in the eurozone over recent months should be 

harming export orders for UK services. 

The CIPS services index has been pretty flat in the last two 

or three months. Our financial and monetary conditions 

index (FMCI) suggests that any decline will be relatively 

mild. 

Overall, we expect the CIPS services index to decline in 

July, by three quarters of a point. 


Market Mover 

69 



Chart 11: US NM ISM Employment & Claims 


BNP Paribas Forecast: Another Decline 

US: ISM Non Manufacturing (July) 

Release Date: Wednesday 3 August 

We look for the non-manufacturing ISM to fall slightly 

further in July after it declined more than a point in June. 

The decline in the index should reflect weakness in such 

economic sectors as retail, construction, and government. 

Indeed, retail sales momentum slowed down with core 

retail sales rising by a mere 0.1% m/m in June mostly on 

the back of higher prices rather than growth in real sales. 

Housing remains weak, and state and local governments 

layoffs are expected to accelerate. Accordingly, we think 

the index is set for a modest decline to 52.5. We look for 

the prices paid index to fall to 68.0 from 69.6 reflecting the 

recent broad-based decline in commodity prices. 


NM Composite 52.5 53.3 54.6 52.8 

Prices Paid 59.0 60.9 69.6 70.1 

Key Point: 

We look for the non-manufacturing ISM to fall slightly 

further in July reaching 52.5 on broad-based slowing. 

30 

20 

10 

0 

-10 

-20 

-30 

-40 

Chart 12: German Orders and PMI 

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 


PMI Manufacturing: 

Orders (RHS) 

Manufacturing Orders (% y/y Smoothed) 

Jun (f) May Apr Mar 

Orders % m/m -2.5 1.8 2.9 -2.7 

Orders % y/y 5.1 12.2 10.6 10.2 

Output % m/m -0.5 1.2 -0.8 1.2 

Output % y/y 7.8 7.6 9.4 11.4 

Key Point: 

The pace of growth in the manufacturing sector is 

already slowing and will weaken further. 

75 

65 

55 

45 

35 

25 

15 

BNP Paribas Forecast: Catching Down 

Germany: Orders and Output (June) 

Release Date: Thursday 4 and Friday 5 August 

Manufacturing orders rose strongly in both April and May, 

implying a strong rise for Q2 as a whole (around 2% q/q), 

even though we expect orders to fall sharply in June. 

Our forecast of a decline in June relates, in part, to the 

slide in leading indicators, such as the manufacturing PMI, 

which have deteriorated markedly over recent months. The 

new orders sub-index of the PMI, for example, has been 

below the 50 expansion level since June. 

The composition of May’s orders data also points to a June 

correction. Domestic orders surged by 11% m/m in June, 

the largest rise in the series’ history, lifted by a 20% m/m 

increase in orders for capital goods. 

Industrial output is also on track to record a quarter-onquarter 

increase, though the pace of growth is likely to be 

around half that in the previous two quarters (2.5% q/q on 

average). This is supportive of our long-standing forecast 

of a pronounced slowdown in Q2 GDP growth after a surge 

in Q1. 

The output index of the manufacturing PMI has also been 

losing ground recently and ‘catch down’ for the ‘hard’ data 

is likely in the period ahead. We forecast a fall in output in 

June which will lead to a weak carry over for Q3. 

The softening of the survey data suggests that the y/y rate 

of growth in orders will fall markedly in the period ahead, 

exacerbated in June by unfavourable base effects. 


Market Mover 

70 



Chart 13: US Claims, ADP, Private Payrolls 



Payroll Jobs k 50 18 25 217 

Private Payrolls k 100 57 73 241 

Unemployment Rate % 9.3 9.2 9.1 9.0 

Key Point: 

Public sector layoffs and tepid private hiring are 

expected to produce just 50k in nonfarm payrolls and 

another uptick in the unemployment rate to 9.3% 

BNP Paribas Forecast: Still Weak 

US: Labour Report (July) 

Release Date: Friday 5 August 

Nonfarm payrolls are expected to post another weak 

reading in July with a gain of 50k after just 18k in jobs were 

added in June. We expect private sector hiring to improve 

to 100k after a 57k increase a month earlier as some of the 

extreme weakness in private education and health care 

fades. Meanwhile, the large number of teacher layoffs at 

the end of the school year and an ongoing slowdown in 

federal government spending are expected to combine to 

shave 50k jobs from total nonfarm payrolls. Another tepid 

gain in jobs is expected to lead the unemployment rate to 

rise to 9.3%, the fourth straight month of backtracking. 

Average hourly earnings are expected to rise 0.1% after a 

flat reading as wage and salary growth remains subdued in 

the face of elevated unemployment. The report would be 

consistent a broad swath of indicators that show the 

economy lost significant momentum in Q2. Since 

employment tends to follow activity, and in light of elevated 

global and political uncertainties, we think firms will remain 

cautious early in Q3. 

Chart 14: Canadian Employment (thousands) 

150 

100 

50 

0 

-50 

-100 

-150 

Monthly Change 

Full-Time 

Part-Time 

Jan 07 Jan 08 Jan 09 Jan 10 Jan 11 



Unemployment Rate % 7.5 7.4 7.4 7.6 

Payroll Jobs k 13.0 28.4 22.3 58.3 

BNP Paribas Forecast: Modest Gains 

Canada: Labour Report (July) 

Release Date: Friday 5 August 

Canadian employment is forecast to improve by 13k in July 

following a below-average 28.4k increase in the previous 

month. The pace of employment growth has averaged an 

impressive 32.0k per month for the previous six months. In 

June, the goods sector gained 3.3k jobs (after losing 11.3k 

in April and another 14.9k in May), leaving the services 

sector with average gains of 44k jobs for the previous three 

months. We expect to see some pull-back in service sector 

jobs from the April-May-June persistence as the weak 

domestic demand in Q2 begins to show up in the 

employment reports. We forecast the unemployment rate 

to tick up to 7.5% as a result of a small increase in the 

labour force participation rate as more students than usual 

enter the workforce. 

Key Point: 

Some pullback as the employment report is likely to 

begin reflecting the weaker consumption in Q2. 

Market Economics 28 October 2010 

Market Mover 

71 


Economic Calendar: 8 Aug – 2 Sep 

8 Aug 9 Aug 10 Aug 11 Aug 12 Aug 

Japan: Current Account 

Jun 

France: BoF Survey Jul 


Market Mover 

Australia: NAB Business 

Survey Jul 

Japan: M2 Jun 

UK: BRC Retail Sales 

Monitor Jul, RICS House 

Price Balance Jul, 

Industrial Production Jun, 

Trade Balance Jun 

Germany: Trade Bal Jun 

France: Budget Balance 

Jun 

US: Productivity and Costs 

Q2, NFIB Small Business 

Optimism Jul, FOMC Rate 

Announcement 

Japan: BoJ Monetary 

Policy Meeting Minutes, 

CGPI Jul, Tertiary Jun 

Australia: Westpac 

Consumer Confidence 

Aug 

UK: BoE Inflation Report 

Germany: CPI Jul 

France: Current Account 

Jun, IP Jun 

Norway: CPI Jul, PPI Jul, 

Norges Bank Rate 

Announcement 

US: Wholesale Trade Jul, 

Treasury Statement 

Australia: Labour Jul 

Japan: Machinery Orders 

Jun 

Eurozone: ECB Monthly 

Bulletin 

Sweden: CPI Jul, Labour 

nsa Jul 

US: Trade Balance Jun 

During Week: Germany WPI Jul 


Japan: GDP (Prel) Q2 

Holiday: France, Italy, 

Spain, Belgium 

UK: Rightmove House 

Prices Aug 

Sweden: Industrial 

Production Jun 

US: Empire State Survey 

Aug, TICS Data Jun, 

NAHB Housing Market 

Aug 

Australia: RBA MPC 

Minutes 

Eurozone: GDP (Flash) 

Q2, Trade Balance Jun, 

UK: DCLG House Prices 

Jun, CPI Jul 

Germany: GDP (Prel) Q2 

Spain: GDP (Flash) Q2 

Neths: GDP Q2, Retail 

Sales Jun 

US: New Home Starts 

Jul, Import Prices Jul, 

Industrial Production Jul 

Eurozone: HICP Jul, 

Current Account Jun 

UK: BoE MPC Minutes, 

Labour Jul 

US: PPI Jul 

Japan: Trade Balance 

Jul 

Germany: Employment 

Q2 

UK: Retail Sales Jul 

Neths: Consumer 

Confidence Aug, Labour 

Aug 

US: CPI Jul, Philly Fed 

Aug, Existing Home Sales 

Jul, Leading Indicators Jul 


Eurozone: PMIs (Flash) 

Aug 

Germany: ZEW Survey 

Aug 

Norway: GDP Q2 

US: New Home Sales Jul 

Eurozone: Industrial 

Orders Jun 

Germany: Ifo Survey Aug 

Belgium: Business 

Confidence Aug 

Norway: Labour Jun 

US: Durable Goods 

Orders Jul, FHFA HPI Jun 

France: Job Seekers Jul 

Spain: PPI Aug 

Sweden: Consumer 

Confidence Aug, Labour 

Jul, PPI Jul 

Neths: Producer 


During Week: Germany Import Price Index Jul, Retail Sales Jul, UK Nationwide House Prices Aug 

29 Aug 30 Aug 31 Aug 1 Sep 2 Sep 

UK: Holiday 

Germany: CPI (Prel) Aug 

Italy: ISAE Consumer 


Spain: Retail Sales Jul 

Sweden: Retail Sales Jul 

US: Personal Income & 

Spending Jul, Pending 

Home Sales Jul 

Japan: Labour Jul, 

Household Consumption 

Jul, Retail Sales Jul 

Eurozone: Business & 

Consumer Survey Aug, 

Retail PMI Aug 

UK: Net Consumer Credit 

Jul, Mortgage Approvals 

Jul 

Germany: HICP (Flash) 

Aug 

Italy: Retail Sales Jun, 

ISAE Business Conf Aug 

Spain: HICP (Flash) Aug 

US: S&P/Case-Shiller 

Home Prices Jun, 

Consumer Confidence 

Aug, FOMC Minutes 

During Week: UK Halifax House Prices Aug 


Japan: IP May 

Eurozone: HICP (Flash) 

Aug, Labour Jul 

UK: GfK Consumer 


Germany: Labour Jul 

Norway: Retail Sales Jul 

Italy: CPI Aug, PPI Jul 

US: Chicago PMI, Factory 

Orders Jun, ADP Labour 

Aug, Challenger Layoffs 

Aug 

Canada: GDP Q2 & Jun 

Australia: Retail Sales 

Jul 

Eurozone: PMI 

Manufacturing (Final) Aug 

UK: CIPS Manufacturing 

Aug 

Germany: GDP (Final) 

Q2, 

Italy: Wages Jul 

Switz: GDP Q2, PMI 

Manufacturing Aug 

US: Productivity and 

Costs (Final) Q2, ISM 

Manufacturing Aug, 

Construction Jul 

Eurozone: Industrial 

Production Jun 

France: CPI Jul, GDP 

(Prel) Q2, Non-Farm 

Payrolls (Prel) Q2, Wages 

(Prel) Q2 

Spain: CPI Jul 

Norway: Retail Sales Jun 

Italy: EU Trade Balance 

Jun, CPI Jul 

US: Retail Sales Jul, 

Business Inventories Jun, 

UoM Sentiment (Prel) Aug 

UK: PSNB Jul, PSNCR Jul 

Germany: PPI Jul 

Belgium: Consumer 


Canada: CPI Jul 

Japan: CPI Tokyo Aug, 

CPI National Jul 

Eurozone: Monetary 

Developments Jul, 

Eurocoin Aug 

France: Investment 

Survey Jul 

UK: GDP (Prel) Q2 

Germany: GfK Consumer 

Survey Sep 

Spain: GDP (Final) Q2 

Switz: KOF Leading 

Indicator Aug 

US: GDP (Rev) Q2, 

Corporate Profits Q2, UoM 

Sentiment (Final) Aug, 

Eurozone: PPI Jul, 

Norway: Labour nsa Aug 

US: Labour Aug 

Release dates as at c.o.b. prior to the date of this publication. See our Daily Spotlight for any revisions 

72 


Treasury and SAS Issuance Calendar 

In the pipeline - Treasuries: 

Japan: To buy back 15y floating-rate JGBs (JPY 600bn) and 10y Inflation-Indexed JGBs (JPY 150bn) in Q3 

France: Cancelled the auction initially planned for 4 August 

Italy: Still considering the launch of a new 30y syndicated BTP in the last four months of the year, subject to market conditions 

Italy: To issue four new securities in Q3 (BTPs Jul-14, Mar-22 & Sep-16 and CTZ Sep-13) 

Germany: In Q3, intends to issue inflation-linked federal securities (EUR 2 to 3bn) and reserves the right to issue foreign currency bonds 

Poland: Has no plans for benchmark foreign bond in Q3 

UK: Index-Linked Gilt Mar 2034 (tap, syndicated, GBP) scheduled for the week commencing 25 July 

UK: Mini-tender in the week commencing 5 September (choice of Gilt on Friday 6 August) 

UK: Long-dated Gilt (syndicated) in the second half of September (details around 2 weeks in advance) 

Finland: Planning to issue a new syndicated EUR benchmark bond (probably a 5y) in H2. To sell one more EUR benchmark bond in Q3 

(details one week prior to the auction). Will not issue T-bills in July 

Neths: Still looking to issue debt denominated in USD, depending on market conditions 

Czech Rep.: To launch a syndicated euro benchmark in H2 

In the pipeline - Agencies: 

EFSF: In addition to the issues for the Portuguese programme, is expected to issue two benchmark bonds in H2 2011 in support of the 

programme for Ireland 

EFSF: Expected to issue two further bonds in 2011 in support of the programme for Portugal, EUR 3-5bn per transaction 

During the week: 

FHLMC: First syndicated auction in August, details announced on Tuesday 2 August 

Date Day Closing Country Issues Details BNPP forecasts 

Local GMT 

29/07 Fri 11:00 15:00 US Outright Treasury Coupon Purchase (2014 - 

USD 2.5-3bn 

2015) 

02/08 Tue 12:00 03:00 Japan JGB 10-year JPY 2.2tn JPY 2.2tn 

10:30 09:30 UK Gilt 4.5% 7 Sep 2034 GBP 2bn 

04/08 Thu 12:00 03:00 Japan Auction for Enhanced-liquidity JPY 0.3tn JPY 0.3tn 

10:30 08:30 Spain Bono 3.4% 30 Apr 2014 29 Jul EUR 3-4bn 

11:00 15:00 US Outright Treasury Coupon Purchase (2017 - 

USD 2.75-3.5bn 

2018) 

08/08 Mon 11:00 15:00 US Outright TIPS Purchase (2013 - 2041) USD 0.25-0.5bn 

09/08 Tue 12:00 03:00 Japan JGB 40-year 2 Aug JPY 0.4tn 

13:00 17:00 US Notes 3-year (new) 3 Aug USD 32bn 

10/08 Wed 12:00 16:00 Canada CAN 3-year 4 Aug 


11/08 Thu 12:00 03:00 Japan JGB 5-year 4 Aug JPY 2.4tn 

10:30 09:30 UK Index-Linked Gilt 0.625% 22 Nov 2042 2 Aug 

13:00 17:00 US Bond 30-year (new) 3 Aug USD 16bn 

16/08 Tue Denmark DGBs 11 Aug 

17/08 Wed 11:00 09:00 Germany Schatz 13 Sep 2013 (new) EUR 7bn 

12:00 16:00 Canada CAN 2-year 11 Aug 

18/08 Thu 10:30 08:30 Spain Obligaciones 4 Aug EUR 2.5-4bn 

10:30 09:30 UK Gilt 22 Jan 2017 (new) 9 Aug 

13:00 17:00 US TIPS 5-year 11 Aug USD 12bn 

22/08 Mon 12:00 10:00 Belgium OLOs 16 Aug 

Slovak Rep. SLOVGB 4% 27 Apr 2020 (#214) 

23/08 Tue 12:00 03:00 Japan Auction for Enhanced-liquidity 16 Aug JPY 0.3tn 

10:30 09:30 UK Index-Linked Gilt 1.875% 22 Nov 2022 16 Aug 


24/08 Wed 11:00 09:00 Germany Bund 4 Sep 2021 (new) EUR 6bn 

12:00 16:00 Canada CAN 30-year (Repurchase-Switch) 18 Aug 


25/08 Thu 12:00 03:00 Japan JGB 20-year 18 Aug JPY 1.1tn 


Sources: Treasuries, BNP Paribas 



73 


Next Week's T-Bills Supply 

Date Country Issues Details 

29/07 UK T-Bills Aug 2011 GBP 0.5bn 

T-Bills Oct 2011 

GBP 1bn 

T-Bills Jan 2012 

GBP 1.5bn 

01/08 France BTFs Oct 2011 EUR 4.5bn 

BTFs Jan 2012 

EUR 2bn 

BTFs Jul 2012 

EUR 2bn 

Neths DTC Oct 2011 EUR 3bn 

DTC Jan 2012 

EUR 2.5bn 

DTC Apr 2012 

EUR 2bn 

US T-Bills Nov 2011 USD 27bn 

T-Bills Feb 2012 & 26- USD 24bn 

week 

FHLMC Bills 3-month & 6-month 29 Jul 

02/08 Belgium TC Nov 2011 29 Jul 

TC Jan 2012 

29 Jul 

US T-Bills 4-week 1 Aug 

FHLB Discount Notes 

03/08 Japan T-Bills 3-month 27 Jul 

Portugal BT Nov 2011 EUR 0.75-1bn 

FNMA Bills 3-month & 6-month 1 Aug 

04/08 Japan T-Bills 6-month JPY 3.5tn 

FHLB Discount Notes 

05/08 UK T-Bills 29 Jul 

Sources: Treasuries, BNP Paribas 

Comments and charts 

• EGB gross supply is expected to fall significantly 

next week, from EUR 12.8bn to EUR 3.5bn. In 10y 

duration-adjusted terms, it is equivalent to a decrease of 

EUR 9bn. In addition, the week ahead will see 

EUR 20bn redemptions from Italian government bonds. 

• Spain will be the only country to issue in the primary 

market, with a tap of Bonos 3.4% July 2014, likely to be 

around EUR 3/4bn. This will be the second tap of the 

bond since its inception in the market in March (the 

current outstanding amounts to EUR 7.4bn). 

• Outside of the eurozone, Japan will issue a 10y 

bond for an expected size of JPY 2.2trn, and the UK will 

launch a new 15y bond for an expected size of 

GBP 2bn. 

Next Week's Eurozone Redemptions 

Date Country Details Amount 

30/07 Spain Obligacion 5.4% EUR 15.5bn 

01/08 Italy BTP 5.25% EUR 20.2bn 

Total Eurozone Long-term Redemption EUR 35.7bn 

04/08 France BTF EUR 8.3bn 

05/08 Austria ATB (EU41) EUR 0.1bn 

Total Eurozone Short-term Redemption EUR 8.4bn 

Next Week's Eurozone Coupons 

Country 

Amount 

Italy 

EUR 11.0bn 

Greece 

EUR 1.6bn 

Total Long-term Coupon Payments 

EUR 12.6bn 

35 

30 

25 

20 

15 

10 

5 

0 

-5 

-10 

20 

18 

16 

14 

12 

10 

8 

6 

4 

2 

0 

Chart 1: Investors’ Net Cash Flows 

(EUR bn, 10y equivalent) 

Net Investors' Cash Flows 

(EUR bn , 10y equivalent) 

Week of Jul 25th Week of Aug 1st Week of Aug 8th Week of Aug 15th 

Chart 2: EGB Gross Supply Breakdown by 

Country (EUR bn, 10y equivalent) 

Germany Italy Portugal Belgium 

France Spain Netherlands Austria 

Finland Greece Ireland 


Chart 3: EGB Gross Supply Breakdown by 

Maturity (EUR bn, 10y equivalent) 

10 

9 

8 

EGBs Gross Supply (EUR bn, 10y equivalent) 

2-3-YR 

10-YR 

5-7-YR 

>10-YR 

7 

6 

5 

4 

3 

2 

1 

0 





74 


Central Bank Watch 

Interest Rate 

EUROZONE 

Current 

Rate (%) 

Minimum Bid Rate 1.50 

US 

Fed Funds Rate 0 to 0.25 

Discount Rate 0.75 

JAPAN 

Call Rate 0 to 0.10 

Basic Loan Rate 0.30 

UK 

Bank Rate 0.5 

DENMARK 

Lending Rate 1.55 

SWEDEN 

Repo Rate 2.00 

NORWAY 

Sight Deposit Rate 2.25 

SWITZERLAND 

3 Mth LIBOR Target 

Range 

CANADA 

0.0-0.75 

Overnight Rate 1.00 

Bank Rate 1.25 

AUSTRALIA 

Cash Rate 4.75 

CHINA 

1Y Bank Lending 

Rate 

BRAZIL 

Selic Overnight Rate 

6.56 

Date of 

Last 

Change 

+25bp 

(7/7/11) 

-75bp 

(16/12/08) 

+25bp 

(18/2/10) 

-10bp 

(5/10/10) 

-20bp 

(19/12/08) 

-50bp 

(5/3/09) 

+25bp 

(7/7/11) 

+25bp 

(5/7/11) 

+25bp 

(12/5/11) 

-25bp 

(12/3/09) 

+25bp 

(8/9/10) 

+25bp 

(8/9/10) 

+25bp 

(2/11/10) 

+25bp 

(6/7/11) 

12.50 +25bp 

(20/7/11) 

Next Change in 

Coming 6 Months 

+25bp (6/10/11) 

No Change 

No Change 

No Change 

No Change 

No Change 

+25bp 

(6/10/11) 

+25bp 

(7/9/11) 

+25bp 

(Aug/Sep 11) 

No Change 

+25bp (6/12/11) 

+25bp (6/12/11) 

+25bp 

(4/10/11) 

No Change 

+25bp 

(31/8/11) 


For the full EM Central Bank Watch, please see our Local Markets Mover. 

Comments 

Our forecast of a 25bp rise in the refinancing rate in October, after 

further upward revisions to staff inflation projections in September, 

is more uncertain given the recent weakness of activity data in the 

wake of financial market tensions. 

The FOMC is expected to maintain the Fed funds rate at 0 to 

0.25% until September 2012. We see the bar for another round 

of quantitative easing as high – requiring a further deterioration 

in the growth outlook and re-emergence of deflationary risks. 

We expect the BoJ to continue to respond to the developments 

surrounding the earthquake disaster by expanding liquidity. 

Given persistent headwinds to growth, and with inflation to fall 

next year, Bank Rate is forecast to stay at the current level for 

some time. We assume no change through 2011 and 2012. 

We expect the Danish central bank to follow the ECB in 

October, delivering a 25bp rate hike. 

The upward trend in inflation and wage expectations, as well as 

Sweden’s robust fundamentals, should lead to further rate hikes. 

We expect the Riksbank to deliver the next hike at its 

September meeting. 

We expect the next hike to come in August or September. The 

timing will depend on the flow of domestic and external news 

and developments in economic data. 

The Swiss franc has taken monetary conditions back to neutral 

levels rather than the SNB. Following the latest leg up in the 

franc to record highs, we do not expect a hike in 2011. 

Underlying inflation pressures remain subdued. Meanwhile, high 

levels of household debt tied to variable rate mortgages and the 

expected "temporary" inflationary pressures have left the BoC 

wary of normalising policy. We expect the BoC to remain on 

hold until at least December 2011. 

Stronger-than-expected underlying inflation should prompt the 

RBA to nudge up the cash rate by 25bp once current 

uncertainties in the global economy have dissipated somewhat. 

Inflation is set to peak in June/July and growth has lost more 

momentum than policymakers had anticipated. Hence we 

expect selective easing in H2 2011. We may have seen the last 

rate hike in this cycle unless July’s CPI inflation is higher than 

June’s. 

Copom again hiked by 25bp in July but dropped hawkish 

language saying hiking would be for a “sufficiently prolonged” 

period. While the central bank is keeping its options open, with a 

pause now possible, it still has tightening work to do in our view. 

Change since our last weekly in bold and italics 


Market Mover 

75 


Economic Forecasts 

GDP 

Year 2010 

2011 

(% y/y) ’10 ’11 (1) ’12 (1) Q1 Q2 Q3 Q4 Q1 Q2 (1) Q3 (1) Q4 (1) 

US 2.9 2.3 2.7 2.4 3.0 3.2 2.8 2.3 2.3 2.3 2.3 

Eurozone 1.7 2.0 1.5 0.8 2.0 2.0 1.9 2.5 1.9 1.7 1.9 

Japan 4.0 -0.8 2.1 5.6 3.1 5.0 2.2 -1.0 -1.3 -1.5 0.0 

World (2) 5.0 4.3 4.3 5.2 5.3 5.1 4.7 4.4 4.1 4.1 4.4 

Industrial Production 

Year 

2010 

2011 

(% y/y) ’10 ’11 (1) ’12 (1) Q1 Q2 Q3 Q4 Q1 Q2 (1) Q3 (1) Q4 (1) 

US 5.3 3.8 3.9 1.5 6.5 6.9 6.3 5.3 4.0 3.0 2.9 

Eurozone 7.4 4.4 2.2 5.1 9.3 7.3 8.1 6.6 4.6 3.8 2.5 

Japan 16.5 0.0 6.8 28.0 21.2 14.0 6.0 -2.6 -6.7 3.4 5.1 

Unemployment Rate 

Year 

2010 2011 

(%) ’10 ’11 (1) ’12 (1) Q1 Q2 Q3 Q4 Q1 Q2 (1) Q3 (1) Q4 (1) 

US 9.6 9.0 8.6 9.7 9.6 9.6 9.6 8.9 9.1 9.1 8.9 

Eurozone 10.1 9.8 9.4 10.1 10.2 10.1 10.1 9.9 9.8 9.8 9.7 

Japan 5.1 4.9 4.7 5.1 5.1 5.0 5.0 4.7 4.8 5.0 5.0 

CPI 

Year 

2010 

2011 

(% y/y) ’10 ’11 (1) ’12 (1) Q1 Q2 Q3 Q4 Q1 Q2 (1) Q3 (1) Q4 (1) 

US 1.6 3.1 1.9 2.4 1.8 1.2 1.3 2.1 3.4 3.6 3.3 

Eurozone 1.6 2.8 2.3 1.1 1.6 1.7 2.0 2.5 2.8 3.0 3.1 

Japan (Core) -1.0 0.6 0.7 -1.2 -1.2 -1.1 -0.5 -0.2 0.5 1.0 1.0 

Current Account 

(% GDP) ’10 

Year 

’11 (1) ’12 (1) General Government 

(% GDP) 

’10 (1) Year 

’11 (1) ’12 (1) 

US -3.2 -3.4 -3.2 US (4) -3.2 -3.4 -3.2 

Eurozone -0.4 -0.8 -1.1 Eurozone -0.4 -0.8 -1.1 

Japan 3.6 1.9 1.2 Japan 3.6 1.9 1.2 

Interest Rate Forecasts 

Year 

2011 

2012 

(%) ’10 ’11 (1) ’12 (1) Q1 Q2 Q3 (1) Q4 (1) Q1 (1) Q2 (1) Q3 (1) Q4 (1) 

US 

Fed Funds Rate 0.25 0.25 0.75 0.25 0.25 0.25 0.25 0.25 0.25 0.50 0.75 

3-month Rate 0.30 0.45 1.15 0.30 0.25 0.30 0.45 0.75 0.90 0.90 1.15 

2-year yield 0.61 1.00 2.45 0.83 0.47 0.75 1.00 1.50 2.00 2.25 2.45 

10-year yield 3.29 3.75 4.25 3.47 3.16 3.25 3.75 3.90 4.00 4.15 4.25 

2y/10y Spread (bp) 268 275 180 264 269 250 275 240 200 190 180 

Eurozone 

Refinancing Rate 1.00 1.75 2.25 1.00 1.25 1.50 1.75 2.00 2.25 2.25 2.25 

3-month Rate 1.01 2.00 2.50 1.24 1.55 1.75 2.00 2.25 2.40 2.40 2.50 

2-year yield (5) 0.85 2.30 2.30 1.80 1.61 1.80 2.30 2.45 2.65 2.80 3.00 

10-year yield (5) 2.96 3.75 4.10 3.35 3.01 3.30 3.75 3.85 3.95 4.05 4.10 

2y/10y Spread (bp) (5) 211 145 180 156 140 150 145 140 130 125 110 

Japan 

O/N Call Rate 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 

3-month Rate 0.34 0.35 0.35 0.34 0.33 0.35 0.35 0.35 0.35 0.35 0.35 

2-year yield 0.18 0.20 0.30 0.22 0.17 0.15 0.20 0.25 0.30 0.30 0.30 

10-year yield 1.12 1.40 1.50 1.26 1.14 1.30 1.40 1.40 1.40 1.50 1.50 

2y/10y Spread (bp) 95 120 120 104 96 115 120 115 110 120 120 

Footnotes: (1) Forecast (2) BNPP estimates based on country weights in the IMF World Economic Outlook Update 

April 2011 (3) End Period (4) Fiscal year Figures are y/y percentage change unless otherwise indicated (5) German benchmark 


Market Economics / Interest Rate Strategy 28 July 2011 

Market Mover 

76 


FX Forecasts* 

USD Bloc Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 

EUR/USD 1.50 1.55 1.45 1.40 1.35 1.35 1.30 1.30 1.30 1.30 1.34 

USD/JPY 78 83 85 90 95 95 95 95 95 95 92 

USD/CHF 0.83 0.83 0.90 0.93 1.00 1.00 1.04 1.04 1.04 1.04 0.97 

GBP/USD 1.65 1.68 1.59 1.56 1.53 1.53 1.53 1.53 1.53 1.53 1.70 

USD/CAD 0.98 0.93 0.95 0.97 1.01 1.01 1.04 1.04 1.04 1.04 1.00 

AUD/USD 1.09 1.13 1.07 1.04 0.99 0.99 0.96 0.96 0.96 0.96 0.95 

NZD/USD 0.82 0.84 0.81 0.80 0.76 0.76 0.74 0.74 0.74 0.74 0.76 

USD/SEK 5.93 5.48 5.93 6.21 6.67 6.67 6.92 6.92 6.92 6.92 6.94 

USD/NOK 4.98 4.77 5.07 5.26 5.56 5.56 5.77 5.77 5.77 5.77 5.07 

EUR Bloc Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 

EUR/JPY 117 129 123 126 128 128 124 124 124 124 123 

EUR/GBP 0.91 0.92 0.91 0.90 0.88 0.88 0.85 0.85 0.85 0.85 0.79 

EUR/CHF 1.25 1.28 1.30 1.30 1.35 1.35 1.35 1.35 1.35 1.35 1.30 

EUR/SEK 8.90 8.50 8.60 8.70 9.00 9.00 9.00 9.00 9.00 9.00 9.30 

EUR/NOK 7.47 7.40 7.35 7.37 7.50 7.50 7.50 7.50 7.50 7.50 6.80 

EUR/DKK 7.46 7.46 7.46 7.46 7.46 7.46 7.46 7.46 7.46 7.46 7.46 

Central Europe Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 

USD/PLN 2.60 2.48 2.69 2.75 2.81 2.78 2.85 2.77 2.85 2.85 2.65 

EUR/CZK 24.3 24.5 24.1 23.9 23.8 23.5 23.7 24.0 23.5 23.3 23.1 

EUR/HUF 275 275 269 265 265 260 260 255 260 260 250 

USD/ZAR 6.80 6.60 6.55 6.60 6.50 6.50 7.20 7.10 7.00 6.90 6.69 

USD/TRY 1.52 1.50 1.56 1.59 1.63 1.65 1.65 1.67 1.69 1.69 1.54 

EUR/RON 4.20 4.15 4.20 4.25 4.15 4.10 4.20 4.20 4.10 3.95 3.90 

USD/RUB 27.51 27.25 27.86 27.97 28.08 27.65 28.19 27.75 29.07 27.75 27.75 

EUR/PLN 3.90 3.85 3.90 3.85 3.80 3.75 3.70 3.60 3.70 3.70 3.55 

USD/UAH 7.8 7.8 7.5 7.5 7.5 7.5 7.5 7.5 7.5 7.3 7.4 

EUR/RSD 100 100 98 97 96 95 93 92 91 90 85 

Asia Bloc Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 

USD/SGD 1.20 1.19 1.18 1.17 1.16 1.15 1.14 1.13 1.13 1.13 ----- 

USD/MYR 2.95 2.90 2.87 2.85 2.83 2.80 2.77 2.75 2.73 2.70 ----- 

USD/IDR 8400 8300 8200 8100 8000 7900 7800 7700 7600 7500 ----- 

USD/THB 29.50 29.30 29.00 28.70 28.50 28.30 28.00 27.70 27.50 27.50 ----- 

USD/PHP 42.00 41.50 41.00 40.50 40.00 39.50 39.00 38.50 38.00 38.00 ----- 

USD/HKD 7.80 7.80 7.80 7.80 7.80 7.80 7.80 7.80 7.80 7.80 ----- 

USD/RMB 6.40 6.31 6.25 6.21 6.17 6.13 6.23 6.20 6.17 6.15 ----- 

USD/TWD 28.00 27.50 27.00 26.70 26.50 26.00 26.00 26.00 26.00 26.00 ----- 

USD/KRW 1040 1030 1020 1010 1000 990 980 970 960 950 ----- 

USD/INR 44.00 43.50 43.00 42.50 42.00 41.50 41.00 41.00 41.00 41.00 ----- 

USD/VND 20500 20000 20000 20000 20000 20000 20000 20000 20000 20000 ----- 

LATAM Bloc Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 

USD/ARS 4.18 4.25 4.34 4.43 4.51 4.60 4.69 4.78 4.86 4.95 ----- 

USD/BRL 1.58 1.55 1.53 1.55 1.56 1.58 1.59 1.60 1.61 1.62 ----- 

USD/CLP 450 435 425 430 435 440 442 445 447 450 ----- 

USD/MXN 11.40 11.10 11.00 10.90 11.00 11.10 11.10 11.17 11.25 11.30 ----- 

USD/COP 1730 1690 1690 1700 1710 1720 1725 1730 1740 1750 ----- 

USD/VEF 4.29 4.29 4.29 4.29 4.29 4.29 8.80 8.80 8.80 8.80 ----- 

USD/PEN 2.70 2.65 2.63 2.63 2.64 2.66 2.67 2.68 2.69 2.70 ----- 

Others Q3 '11 Q4 '11 Q1 '12 Q2 '12 Q3 '12 Q4 '12 Q1 '13 Q2 '13 Q3 '13 Q4 '13 Q1 '14 

USD Index 72.30 70.76 74.87 77.62 80.72 80.72 82.99 82.99 82.99 82.99 79.73 

*End Quarter 

Foreign Exchange Strategy 28 July 2011 


www.GlobalMarkets.bnpparibas.com 

77

Market Coverage 

Market Economics 

Paul Mortimer-Lee Global Head of Market Economics London 44 20 7595 8551 paul.mortimer-lee@uk.bnpparibas.com 

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Eurozone, Italy 

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Interest Rate Strategy 

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Patrick Jacq Europe Strategist Paris 33 1 4316 9718 patrick.jacq@bnpparibas.com 

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Eric Oynoyan Europe Alpha Strategist London 44 20 7595 8613 eric.oynoyan@uk.bnpparibas.com 

Matteo Regesta Europe Alpha Strategist London 44 20 7595 8607 matteo.regesta@uk.bnpparibas.com 

Ioannis Sokos Europe Alpha Strategist London 44 20 7595 8671 ioannis.sokos@uk.bnpparibas.com 

Camille de Courcel Europe Alpha Strategist London 44 20 7595 8295 camille.decourcel@uk.bnpparibas.com 

Bülent Baygün Head of Interest Rate Strategy US New York 1 212 471 8043 bulent.baygun@americas.bnpparibas.com 

Mary-Beth Fisher US Senior Strategist New York 1 212 841 2912 mary-beth.fisher@us.bnpparibas.com 

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Anish Lohokare MBS Strategist New York 1 212 841 2867 anish.lohokare@americas.bnpparibas.com 

Olurotimi Ajibola MBS Strategist New York 1 212 8413831 olurotimi.ajibola@americas.bnpparibas.com 

Koji Shimamoto Head of Interest Rate Strategy Japan Tokyo 81 3 6377 1700 koji.shimamoto@japan.bnpparibas.com 

Tomohisa Fujiki Japan Strategist Tokyo 81 3 6377 1703 Tomohisa.fujiki@japan.bnpparibas.com 

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Christian Séné Technical Analyst Paris 33 1 4316 9717 christian.séné@bnpparibas.com 

FX Strategy 

Ray Attrill Head of FX Strategy – North America New York 1 212 841 2492 raymond.attrill@us.bnpparibas.com 

Mary Nicola FX Strategist New York 1 212 841 2492 mary.nicola@americas.bnpparibas.com 

Steven Saywell Head of FX Strategy - Europe London 44 20 7595 8487 steven.saywell@uk.bnpparibas.com 

Kiran Kowshik FX Strategist London 44 20 7595 1495 kiran.kowshik@bnpparibas.com 

James Hellawell Quantitative Strategist London 44 20 7595 8485 james.hellawell@uk.bnpparibas.com 

Local Markets FX & Interest Rate Strategy 

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Jasmine Poh FX & IR Asia Strategist Singapore 65 6210 3418 jasmine.j.poh@asia.bnpparibas.com 

Gao Qi FX & IR Asia Strategist Shanghai 86 21 2896 2876 gao.qi@asia.bnpparibas.com 

Bartosz Pawlowski Head of FX & IR Strategy CEEMEA London 44 20 7595 8195 Bartosz.pawlowski@uk.bnpparibas.com 

Dina Ahmad FX & IR CEEMEA Strategist London 44 20 7 595 8620 dina.ahmad@uk.bnpparibas.com 

Erkin Isik FX & IR CEEMEA Strategist Istanbul 90 (216) 635 29 87 erkin.isik@teb.com.tr 

Raffaele Semonella EMEA Corporates Analyst London 44 20 7 595 8813 raffaele.semonella@uk.bnpparibas.com 

Diego Donadio FX & IR Latin America Strategist São Paulo 55 11 3841 3421 diego.donadio@@br.bnpparibas.com 

78

For Production and Distribution, please contact: 

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Danielle Catananzi, Interest Rate Strategy, London. Tel: 44 20 7595 4418 Email: danielle.catananzi@uk.bnpparibas.com, 

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Editors: Amanda Grantham-Hill, Interest Rate Strategy/Market Economics, London. Tel: 44 20 7595 4107 Email: amanda.grantham-hill@bnpparibas.com; 

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