global directions 063011

8/6/2019 Global Directions 063011

1/45

FIXEDINCOMEANDCURRENCYSTRATEGYIRESEARCH

Page16UnitedStatesWeremainoftheviewthat

thedebtceilingwillget

passed,buttheharshreality

isratherdaunting.If

politiciansdontcometo

theirsensesarecession

wouldensue.

Theincreaseinboth

municipalnewissuevolume

anddealsizeinJune

increasesthelikelihoodthat

issuancewillreach$230to

$250billionbytheendoftheyear.

Page20CanadaAfirmMayCPIprinthasput

BoCratehikesbackonthe

marketsradar.

Withonlyone25bphike

pricedinthroughthenext

fiveBoCmeetings,thefront

endremainsvulnerable.

Fornow,welike

representingourbearish

Canadianratesviewviaa5s

10sflattenerinswaps.

Page23EuropeTheGreekgovernment

securedapprovalforits

austeritymeasures.Focus

nowmovestoSunday's

Eurogroupmeeting.

Wepresentsome

normalisationtradesafter

marketslooksettorevert

fromtheEuropeanabyss.

Thefrontendgetsinthe

focusagainandweexpect

25bpratehikesnextweek

fromboththeECBandthe

Riksbank.

Page35Australia/NewZealandAUbondstaketheircues

fromtheglobalrallybutthe

pricinginofaratecutlooks

overdone.

Soaringunitlabourcosts

suggestthatinflationis

headinginonlyone

direction.AUsabysmal

productivityperformanceis

largelytoblame.

Policysettingswilleventually

needtobecomemore

restrictive.AH2hikeremains

morelikelythannot.

ThisreportispricedasofmarketcloseonJune30,2011.

AllvaluesinEURunlessotherwisenoted.

June30,2011

RegionalPerspectives

THEBIGPICTURE

The Perfect Storm?AftertheGreekvotes,wethinkfearsofanimmediatesovereigndefaultinEuropehavereceded.Thismightturnintoamore

lastingchangeinsentiment,butweneedtoseemorebondmarketnegativeindicatorsemerge,particularlyoutoftheUS,for

thistohappen.Wereentertacticalshortsandhighlightanumberofnormalisationtradesthatoughttobewatchedcarefully

ifsentimentturnsonamorelastingbasis.IntheUS,thequarterendbalancesheetsqueezelikelyexaggeratedmoves,someof

whichwedonotexpectwillbefullyunwound. Cont.onpg.5

The Glorious Summer ReturnsThereliefrallyonbreakeveninflationratessuggestsshiftingpositioningfromselectivelyshorttoneutralandalongstanceon

cashvs.swapsineuroinflation.WeretainourpreferenceforUSinflationagainsteuroinflationwhilestrongerthanexpected

Canadianinflationcaughtourlong10yTIPSvs.CADbreakeventradewrongfootedweshiftthetradetothe30ysector.

Cont.onpg.9


2/45

RBCCapitalMarketsGlobalDirections June30,20112

TradeRecommendations..............................................................................................................................................3

TheBigPicture:ThePerfectStorm?..............................................................................................................................5

AftertheGreekvotes,fearsofanimmediatesovereigndefaultinEuroperecedes.Whilstthismightturn

intoamorelastingchangeinsentimentifUSeconomicdatamanagestobeatexpectations.Weenter

tacticalshortpositionsandpresentanumberofnormalisation tradesthatoughttobemonitored.

TheGloriousSummerReturns ......................................................................................................................................9

Areliefrallyonbreakeveninflationratessuggestsshiftingpositioningfromselectivelyshorttoanda

longstanceoncashvs.swaps.WeretainourpreferenceforUSinflationagainsteuroinflation.Strongerthan

expectedCanadianinflationcaughtourlong10yTIPSvs.CADbreakeventradewrongfootedweshiftthe

tradetothe30ysector.

WhattoWatchFor.....................................................................................................................................................13

Data&EventsCalendar..............................................................................................................................................14

RBCEconomics&YieldForecasts................................................................................................................................15

U.S.Perspectives........................................................................................................................................................16

TheDebtCeilingfrom30,000Feet:Weremainoftheviewthatthedebtceilingwillgetpassed,butthe

harshrealityisratherdaunting.Ifpoliticiansdontcometotheirsensesarecessionwouldensue......................17

Municipals Astrongersecondhalf:MunicipalnewissuevolumepickedupappreciablyinJunefromthelevelsprintedearlierintheyear .......................................................................................................................19

CanadaPerspectives...................................................................................................................................................20

Somerespiteforthebears:FirmMayCPIputstheBoCbackontheradar ...........................................................21

EuropePerspectives...................................................................................................................................................23

Morethanaliveafterthevote:Wehighlightanumberofnormalisationtradesthatshouldscorewellif

sentimentturnsonamorelastingbasis .................................................................................................................24

PeripheryMonitor:Greekpoliticiansthisweekvotedinfavourofthelatestbatchofausteritymeasures.

WethinktheeurogroupmeetingonSundaywillthereforeapprovedisbursementofthenexttrancheof

funding,withIMFapprovallikelytofollowonFriday.............................................................................................27

ECBpreview:WefirmlyexpecttheECBtopressaheadwithtighteningmonetarypolicynextweek,despite

theweakereuroareaactivitydataoverthepastmonth.WeanticipateabroadlyneutralIntroductory

StatementwhichwillkeepopenallfutureoptionsfortheGoverningCouncil ......................................................28

UK:AsummarypreviewofGiltsupplyinfiscalQ2. ................................................................................................30

RiksbankPreview:WefullyexpecttheRiksbanktoraiseitsreporate25bpto2.00%.Ourviewisthatthe

frontendhaspricedouttoomuchinthewaytighteningandweseeopportunitiesforpositioningaheadof

nextweek'smeeting................................................................................................................................................31

Australia/NewZealandPerspectives...........................................................................................................................35

Australiasabysmalproductivity:SoaringunitlabourcostswillkeeptheRBAstighteningbiasintact................36

SupplyOutlook...........................................................................................................................................................39

Contacts.....................................................................................................................................................................43

Disclosures.................................................................................................................................................................44

InsideThisWeeksEdition


3/45


SellRXU1(pg.5)

Entry(30Jun11) Current Target CutOut 3mthCarry P&L

125.73ticks 125.73ticks 123.5ticks 126.2ticks

TNoteandBundfuturesthathavebothtakenouttheiruptrendsinplacesinceApril.Crucially,theyhavealsotakenout

theJunelowswheremarketsattemptedtoselloffthelasttime.10yUSyieldsstartedtheirdescentinFebruaryaround

3.75%anddeclinednearly90bpbeforestagingaturnaroundthisweek.A50%correctioncouldsee3.30%andourQ3/11

forecastsevenpencilin3.65%.Infutureterms,technicalssuggestevenaselloffinthelow120areaintheTNoteand

123.50intheBundfuture.Whileitisbynomeansadonedeal,weprefertradingthemarketfromtheshortsideandrec

ommendsmalltacticalshortsinBundfutures.

Long5yBTPvs.50%2yBTP&50%10yBTP(pg.24)


21bp 21bp 14bp 24bp 2.5bp

TheBTPcurvestillholdsdistressedtradeopportunities,whichhardlymoveddespitethereliefinperipheryversuscore

spreads.Forinstance,the510yASWcurveisstilltradingatextremelyflatlevelstherebyimplyingagloomypictureforthe

Italiancreditwhilethe5ysegmentoftheItaliancurveistradingextremelycheapinthe2y5y10yASWfly.Withabrighter

spreadpictureforthenearterm,wealsoexpecttheItalian510ycreditcurvetosteepenandthe2510yBTPflytore

treat

from

its

elevated

levels.

We

recommend

buying

the

current

5y

benchmark

BTP

3.75%

Apr16

vs.

50%

BTP

2%

Jun13

and50%BTP3.75%Mar21.

Tactical2ySpainvs.Germanyspreadtightener(pg.24)


200bp 200bp 165bp 220bp +30bp

Therisksstemmingfromthekeydriversoftheextremetier2spreadwideninginthepastfewweeks,animminentGreek

default,andthehugeuncertaintyabouttheprivatesectorinvolvementforanewGreekbailouthavebeensubstantially

reduced.Withinthetier2space,thefrontendoftheSpanishcurveshowedthestrongestperformanceversusGerman

paperamidthisweeksspreadtightening.Weseeagoodopportunityforthetighteningtolastfortheneartermsup

portedbythecarryadvantage.We,therefore,recommendbuyingtheSPGB4.2%Jul13vs.theDBR3.47%Jul13onatacti

calbasisandinasmallsize.

CAD5s10sswapflattener(pg.21)


95bp 90bp 75bp 105bp 0.5bp +5bp

WeenteredaCAD5s10sswapflattenerat95bp(target75bp,stop105bp)basedonanentrylevelsuggestedonJune9

(see

CanadaPerspectives

article

Bellyof

Canadas

curve

looking

stretched).

Canada's

5y

sector

continues

to

look

overex

tendedonthecurvebothonanequalweightedandaprincipalcomponent(PCA)weightedbasis.

OurTradeRecommendations


4/45


OpenTradeRecommendations

Source:RBC

Capital

Markets

Trade Entrydate Entrylevel Current Target Stoplo ss 3mthcarry P&L* Status

510yRAGBsteepener boxedvs.FRTR/BTNS 20Jan11 9.5bp 5bp 4bp 13bp 0.5bp +4.5bp Hold

FRTR2.5%Oct20vs.BTNS2%Jul15andRAGB3.9%Jul20vs.

RAGB3.5%Jul15

Tactical2y10yEURswapflattener 28Apr11 124bp 124bp 110bp 130bp 12bp 8.5bp Hold

2yRAGBvs.OATwidener 18May11 0bp 3bp 4bp 2.5bp +0.5bp +3bp Hold

SellRAGB3.8%Oct13vs.FRTR4%Oct13

Sweden1041assetswapwidener 19May11 65.5bp 74.0bp 80bp 58bp 4.5bp +6.5bp Hold

1041SGB6.75%2014

PayDecemberBoCmeetingOIS 26May11 1.25% 1.08% 1.60% 1.08% 12bp 20bp Stopped

Long

6y

NL

vs.

50%

6y

GE

and

50%

6y

FR 20

Jun

11 11

bp 9

bp 5

bp 14

bp +0.5bp +2

bp HoldBuyDSL4.5%Jul17vs.50%Bund4.25%Jul17and50%OAT

4.25%Oct17

CAD5s10sswapflattener 24Jun11 95bp 90bp 75bp 105bp 0.5bp +5bp Setup

SEKDec11Dec12FRAsteepener 30Jun11 20bp 20bp 40bp 10bp Setup

SellRXU1 30Jun11 125.73 125.73 123.5 126.2 Setup

Long5yBTPvs.50%2yBTP&50%10yBTP 30Jun11 21bp 21bp 14bp 24bp 2.5bp Setup

BuyBTP3.75%Apr16vs.50%BTP2%Jun13and50%BTP

3.75%Mar21

Tactical2ySpainvs.Germanyspreadtightener 30Jun11 200bp 200bp 165bp 220bp +30bp Setup

BuySPGBJul13vs.DBRJul13

*accountingforcostofcarry


5/45


The Perfect Storm?LifeaftertheGreekvoteharboursrisksofabondmarketnegativeoutcome

PeterSchaffrik+44(0)[email protected]

[email protected]

AftertheGreekvotes,fearsofanimmediatesovereign

defaultinEuropereceded.Whilstthismightturnintoa

morelastingchangeinsentiment,wecautionthatwe

needtoseemorebondmarketnegativeindicators

emerge,particularlyoutoftheUS.

Thespotlightturnstobreadandbutterbondmarket

drivers,namelyUSeconomicdata.Therearedecent

chancesthatthedownbeatexpectationsaresurpassed,

addingpressureonbondmarketsglobally.

Onecouldevenimaginethatahostofotherbond

marketnegativetopicsmayhavearevivalsoon,suchas

ECBratehikes,theendofQE2anddiminished

pessimismsurroundinggrowthprospectsintheUS.A

perfectstormmightbebrewingup.

Wehighlightanumberofnormalisationtradesthat

oughttobewatchedcarefullyifsentimentturns.

IntheUS,thequarterendbalancesheetsqueezelikely

shiftedreservesfromforeigntoUSbanks,exaggerating

pricemovesasUSbanksscrambledtoreducetheir

balancesheets.

Whileweexpectsomeofthesemovestobeunwound,

otherfactorsatplaygiveusdifferingdegreesof

confidenceinthemovesof30yrswapspreads,the

10s/30sbreakevencurve,and2yrswapspreads.

Achangeinsentiment

Byallmeans,marketswilljudgethisweekasamilestonein

theEuropeandebtcrisis.AftertheGreekvote(s),the

likelihoodishighthatthisweekendwillseetheEuropean

leadersapprovethenexttrancheofaidandmighteven

decideonthedetailsforthenextbailoutpackage.That

meansthattheimmediatethreatofadefaultwithall

potentialcascadingeffectsisremoved.Marketshaveand

shouldcontinuetotakeheed.Tobefair,webelievethatits

tooearlytoexpectafullfledgedreliefrallytounfoldonthe

backoftheGreekvotealone.Toomuchtrusthasbeenlost

inthemeantimeincontrasttothereliefralliesseenin

JanuaryandMarch.Yet,thereisadecentchancethatthe

votesmightbethemereharbingerofawholehostofbond

marketnegativestocome.Attentionshouldnextturnto

'breadandbutter'fixedincomedrivers,suchas(US)data

releases,markettechnicals,etc.Todaysreactiontothe

ChicagoPMIreleasealreadyindicatedhowvulnerablethe

marketisandFriday'sISMfigureaswellasnextweeksUS

NFPdatawillbecrucial.Importantly,technicalsalsolook

poor.

ThechartsBP1.1andBP1.2showtheTNoteandBund

futurethathavebothtakenouttheiruptrendsinplace

sinceApril.Crucially,theyhavealsotakenouttheJunelows

wheremarketsattemptedtoselloffthelasttime.How

steepcouldthereversallast?10yUSyieldsstartedtheir

descentinFebruaryaround3.75%anddeclinednearly90bp

beforestagingaturnaroundthisweek.A50%correction

couldsee3.30%andourQ3forecastsevenpencilin3.65%.

Usingthe10yBundasayardstick,yieldsdropped

approximately72bpfromthehighat3.49%inApril.A50%

correctionwouldstillrepresenta20bpyieldincreasetoan

equivalentof3.18%inthecurrentbenchmark.Infuture

termstechnicalssuggestevenaselloffinthelow120area

intheTNoteand123.50intheBundfuture.Andwhileitis

bynomeansadonedeal,weprefertradingthemarket

fromtheshortsideandaddasmalltacticalBundfuture

shortat125.73inourtradelistonpage3.

TheBigPicture


6/45

TheBigPicture ThePerfectStorm?


Frontendandcurveshape

Withnextweeklikelybringinganotherratehikeoutof

Europe(seealsoourECBpreviewonpage28),thefront

endoftheEuropeancurveispronetobeinthespotlight

again.Infact,ithasseensomeofthemostpronounced

stressmovesoverthelastweeksnotonlyinmarket

pricingbutalsoinbehaviourintheECBtenders.ECB

liquiditydemandssurgedasfundingstressincreased,just

tobeunwoundagainthisweek.Excessliquiditymoved

highertostandaboveEUR50bnforthefirsttimesince

May,puttingdownwardpressureonEONIAs.Thequestion

mustbewhetherthissetsaprecedentforthecoming

periodswhichinturnwouldjustifysignificantlylower

forwardEONIAratesforanygivenreporatewedoubtit!

ChartBP1.3showstheaverageEONIArepospreadover

thelasttwoyearsinrelationtotheaverageexcess

liquidity.Unlessweseeasustainedincreaseinliquidity

demands,theassumptionmustbethatthisfigureretreats

backtowardstheEUR20bnrangeitcamefromandthus

EONIAsshallremainataround1520bpbelowtherepo

rate.

Withthatinmind,1.54%forDecEONIApricesjustabout

onefullhikeafternextweekslikelyincreaseto1.50%in

theECBsreporateatbest.AgainstourviewthattheECB

willnotstopincreasingrates,wethinkthereisadecent

chancethatforwardEONIAswillriseagainandthatthe

EURyieldcurveresumesitsflatteningtrend.Wehave

beenholdingfirmtoourEUR2y10yflatteningexposure

overthelastweeksandseenoreasontochangethatview

overthecomingdays.

Euroareaspreadstighterbutcautiously

ThemostobviousnormalisationtradeinEuropeis

probablytheintraeuroareaspreadmarket,though.

ExhibitBP1.2:...andBundfuture,too!

Sources:RBCCapitalMarkets,Bloomberg

ExhibitBP1.1:TNoteonthewaydown...

Source:RBCCapitalMarkets,Bloomberg

ExhibitBP1.3:AverageexcessliquidityvsEONIArepobasis

Source:RBCCapitalMarkets,ECB

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0 100 200 300 400

excess reserves (average over RMP)

EONIAoverreporate(

RMPaverage

averages over last RMPs current value (not RMP average)

118

120

122

124

126

128

130

Jan-11 Apr-11 Jul-11

50%

correction

114

116

118

120

122

124

126

Jan-11 Apr-11 Jul-11

50%

correction


7/45



SpreadsofItalianandSpanishbondshavealready

tightenedagreatdealandwethinkthereismore

potential.Yet,weareawarethatalotoftrustandfaith

hasbeendestroyedmostrecentlyandthusdoonly

recommendtacticaltradesatthefrontendoftheSpanish

curve,whichalsooffersabout30bpofpositivecarryover

thenextcoupleofmonths(seepage24fordetails).

Europeinthespotlight,USinthedrivingseat

AndwhilethemajornewshasbeencomingoutofEurope,

thecurveandspreadmovementshavebeenevenmore

dramaticintheUS.Anumberofcurvesegmentsthathad

simplybeentrackingthelevelofrates,like5s30sand

2s5s10s,

moved

far

more

than

justified

by

the

move

in

yields.Shorterswapspreadswidened10+bpandthen

tightened5+bpatthesametimethatlongermaturity

swapspreadsinvertedalmost10bpandthenwidened

3bp.Also,the10y30ybreakevencurvesteepened14bp

andthenflattened9bps.

Recentmovesexaggeratedbybalancesheetsqueeze

Wethinktheseexaggeratedmovementsarerelatedtothe

balancesheetsqueezethatwediscussedinlastweeks

GlobalDirections.Asarecap:Oneofthedownsidesofhavingamassiveamountofliquidityinthesystemisthat

cashcanquicklyslosharoundthesystem,rapidly

expandingsomebanksbalancesheets.Foreignrelated

banksintheUSaccumulatedmorethanUS$900bnof

cashassets(nearly90%ofcashassetsofUSbanksare

reservesattheFed).JustasthestressintheEURmoney

marketindicated,aportionofthatreservesholdingis

presumablyaliquiditycushionincasestressinEurope

intensifies.Yet,US$900bnistoobigforaliquidity

cushionalargepercentageispresumablyforeignbanks

arbitragingthedifferencebetweenshortratesandthe

interestrateonreserves.SincethenewFDICfeelimitsUS

banksabilitytoarbitrageinterestonreserves,foreign

banksnowholdthemajorityofreservesattheFed.

Yet,giventhestressinEurope,weexpectthatsome

foreignbankswillaggressivelytrytoshrinktheirquarter

end

balance

sheets,

in

part

by

no

longer

arbing

interest

on

reserves.Thosereservesdonotdisappearinsteadthey

flowtoanotherbank,withlargeUSbanksbeingthelikely

recipients.ThatmeanstheseUSbankssuddenlyseetheir

balancesheetinflated,andtheytrytooffsetthis

expansionbycuttingthebalancesheetinotherareas.

Thetradesthatreducethebalancesheetmoveprices,

whichthentriggersstoplossesinamarketwithlittle

balancesheetroom.Accordingly,pricemovementsare

significantlyexaggerated.

Thismeanswethinkthebulkoftherecentprice

movementsarelikelytounwind,althoughwehave

ExhibitBP1.5:30yrswapspreadsthelatestmovehas

presumablyflushedoutsomeoftheweaklongs.


-36

-34

-32

-30

-28-26

-24

-22

-20

31-Mar-11 21-Apr-11 12-May-11 2-Jun-11 23-Jun-11

30yr swap spreads (bps)

ExhibitBP1.4:Therecentflushouthasleft5s/30slook

ingsteeptothelevelofrates.Overall,welikeforward

steepenersbutcurrentlevelsdonotoffertheidealentry

point.


R2 = 0.8838

2.20

2.30

2.40

2.50

2.60

2.70

2.80

2.90

1.30 1.50 1.70 1.90 2.10 2.30

5yr UST

5s30s

Since Marc h 31st

Since June 15th

Last


8/45



differentdegreesofconfidenceinthosemovements.A

detailedviewoneachfollows.

30yrspreadsIntheJune9thGlobalDirectionswewrotethatbeinglong30yrspreadsistherighttradeforthosewithalong

horizon,butwethoughttherewastoomuchriskofa

flushingoutofbadlongpositionstogetlong30yrspreads

immediately.Thislatestmovehaspresumablyflushedout

someofthosebadlongs,providingagoodentrypoint.In

addition,aggregateopeninterestintheultralong

contracthascontinuedtogrowandthelongsremain

primarilyrealmoneyinvestors,whichisconsistentwitha

migrationfromaddingdurationwithswapstoadding

durationwithfutures.

10s30sbreakevencurveFundamentally,wethinktheTIPSbreakevencurveshould

besteeper,astheweakeconomyandsofteroilprices

shouldweighonshorterbreakevens,whilelonger

breakevensshouldbesupportedbyconcernabouta

perceiveduptickintheFedinflationtarget(aftertwo

deflationscaresinadecade),heightenedpoliticalscrutiny

oftheFed,andrisksaroundtheinflatedFedbalance

sheet.Accordingly,wedonotthinkwewillseeafull

reversaloftherecentsteepening.

2yrspreadsWhilewethinkthemassiveamountofreservesheldby

foreignbankswillkeepLIBORextremelystable,weare

worriedthatinvestorswillmisinterpretwhatislikelytobe

adramaticdropincashassetsofforeignbanksthatthe

FedwillpublishonthenexttwoFridays.Aswediscussed

earlier,foreignbanksarelikelytocontinuetoscaleback

ontheirarbitrageinextremelyshortratesinorderto

shrinktheirbalancesheets.

WealreadysawaUS$123bndropincashassets(reserves)

heldbyforeignbankslastFriday(thatdatawasasofJune

15th).Weshouldseesignificantdeclinespublishedthis

weekandnextweek,andsomeinthemarketarelikelyto

misinterpretthismoveandextrapolatethetrendbeyond

quarterendinaflawedforeignbankswillexhausttheir

reserveholdingsinthreeweeksanalysis.Accordingly,we

thinktherewillbeapronouncedintraweeklypatternin

shortspreadsinvestorswillbebiasedtobelong2yr

spreadsonFridays(particularlybeforelongweekends)

andthatmovewillbeamplifiedbythesignsofforeign

bankcashassetsdecliningrapidly.Afullreversalofthe2yr

spreadwideningisunlikelyuntiltheFedshowsapost

quarterendriseincashassetsofforeignbanksinthedata

publishedonJuly15thand22nd.

Summaryandmarketconclusions Marketslooksettohaveturnedandoutrightyieldsare

rising.WebelievethataftertheEuropeandebtcrisis

hastakenastepback,USdatawillbedrivingoutright

moves.Weliketacticalshortsatthisstageandentered

Bundfutureshortstoexpressthatview.

WitharatehiketocomenextweekinEurope,wealso

believethatthefocusislikelytoturntotheEuropean

frontendagain,leavingthecurveexposedtocurve

flattening.

IntheUS,thebeginningofanewquartershouldbring

somebalancesheetreliefandreversesomeofthe

moredramaticmovesseenoverrecentweeks.

However,wedonotbelieveafullreversaliswarranted

insomepricemovements.30yrswapspreadsmay

widenasrealmoneyinvestorsmigratetowardsfutures,

butmarketsentimentshouldkeepthebreakevencurve

steepandafullreversalofthemovein2yrspreadsis

unlikelyuntillaterinJuly.


9/45


Reliefrallyonbreakeveninflationratessuggestsshifting

positioningfromselectivelyshorttoneutral(althoughnotlong)

andalongstanceoncashvs.swaps.

WeretainourpreferenceforUSinflationagainsteuroinflation.

StrongerthanexpectedCanadianinflationcaughtourlong10y

TIPSvs.CADbreakeventradewrongfootedweshiftthetrade

tothe30ysector.

Correctionandreliefrallyonbreakeveninflationrates

Inflationvaluationscorrectedsharplytotheupsideafter

thereleaseoftheoutlineofadebtrolloverproposalfor

Greeceandthevoteoffurtherfiscalconsolidation

measures.TheincreaseinnominalyieldsincoreEuropean

countriespermeatedtoothernominalyieldsworldwidebut

alsotobreakeveninflationrates.Indeed,flighttoquality,

flighttoliquidity,andtheabsolutepreferenceforcore

conventionalbondsareoftenaccompaniedbyan

underperformanceofrealyieldsILbondsaresomewhat

lessliquidthannominalbondsand,therefore,contracting

breakeveninflationrates.Anothersignoftheflightto

qualityonconventionalbondmarketsiswideningswap

spreadsananalogyoninflationmarketsisthe

underperformanceofcashbreakeveninflationratesagainst

inflationswaps.

Thereliefrallyfollowingstepstowardacredible

managementoftheGreekissuesproducedthereverse

outcomeoninflationvaluations.Itisenough,inourview,

tosuggestashiftinourstanceoneurobreakevenrates

fromshorttoneutral.Wepositionforfurtherreliefby

gainingexposuretocashbreakeveninflationratesagainst

inflationswapslong10ybreakevenratesonbundsor

OATeisvs.10yinflationswaps.Ourtakeonthepriceaction

isthatmostofthepriceactionremainsattributabletothe

unwindingofflighttoqualityandnotyettoagenuine

upwardrepricingofinflationexpectationsand/orupside

riskstoinflation.

Seasonalimbalances

Onereasonwhywerefrainfromalongstanceon

breakeveninflationfornowisthatthecarryonshort

inflationpositionsremainsverypositive.Withdifferent

magnitudesacrossinflationmarkets,thefirsthalfofthe

Summerusuallyexhibitsverynegativeseasonalinflation

seeExhibitBP2.1.Ifanything,seasonalinflationinJulyis

moremarkedintheeuroareathanintheUS,theUK,or

Canada.Interestingly,Augustisalsolargelynegativefor

Canadawhichisnotthecaseelsewhere.

Theotherreasonistheoutlookonoilprices,whichisnot

unambiguouslypositive.Thepassthroughofloweroil

pricesintomotorfuelsinpriceindicesgreatlyvariesacross

areas;itismuchfasterintheUSthanintheeuroareafor

instance.Contractionsinoilpricestakeroughlytwomonths

tobefullypassedthroughintheUSsothesharpdropof

The Glorious Summer ReturnsThediscontentedGreekWinterpauses

ChristopheDuvalKieffer+44(0)[email protected]

ExhibitBP2.1:monthlyseasonalinflation,%

Source:Bloomberg

-0.80%

-0.60%

-0.40%

-0.20%

0.00%

0.20%

0.40%

0.60%

May

June Ju

ly

Augu

st

Septem

ber

%

Canada US

UK France

Euro area

TheBigPicture


10/45

TheBigPicture TheGloriousSummerReturns


MayaffectsJuneandJulyindices,whileitmaytakeupto

fourorfivemonthsintheeuroarea.

Tothatextent,intheabsenceofasignificantoilpricerally,

euroinflationwillcontinuetobeaffectedbythesharpdrop

inpricesinMayandthroughouttheSummer.Therelease

oftheeuroHICPflashestimateforJuneshowedinflationat

2.7%,unchangedfromMayinyearonyeartermsand

slightlybelowexpectations.Ourquantitativemetric,which

doesnotembedtheeffectofflighttoqualitybutusesthe

flashestimate,remainsontheshortside,itisworthnoting.

Asaresult,weseetherallyineuroareabreakevenratesso

farasacorrectionfromexcesspessimismandflightto

quality.

DoesflighttoqualityaffectTIPSaswell?

ItisratherintuitivetounderstandwhyEuropeaninvestors

confrontedwiththeGreekcrisiswouldoverweighsafer

assetsintheirfixedincomeportfoliosandshiftfromshort

datedperipheralbondsintolongerdatedBunds.Yetthe

sharpreactionofUSbondmarketstotheprogressmade

towardarealisticmanagementoftheGreekissuesuggests

thatglobalinvestorsalsoshiftedtheirportfolioallocation

awayfromeurodenominatedassetsintoUSD

denominatedassetsduringthefirstweeksofJune.Thereboundinyieldsthatfollowedtheconfidencevotein

GreecewasofequivalentmagnitudeintheUSandon

Bunds20bpforTreasuriesfromtheir24Junetroughand

15bpforBunds.

Withasharpincreaseinnominalyields,USbreakeven

inflationwidenedandwidenedasfastaseurobreakeven

inflationratesby13bpon10yTIPSsincethe24June

against14bpfor10yBundei.Inotherwords,the

outperformanceofrealyieldscomparedtonominalyields

wasasmarkedintheUSasitwasincoreEurope.Giventhe

discrepancyintermsofinflationcarryprofilebetweenUS

andeuroinflationlinkedbonds,weseethisconvergencein

thepriceactionasfurtherevidencethatthesharpfallin

breakeveninflationrateswasdrivenbyflighttoquality

andthatthisflighttoqualityequallyaffectedGermanand

USassets.

Indeed,duringthepullbackinvaluationsinJune10yUS

breakeveninflationresistedmuchbetterthaneuro

breakevenrates;theinflationmarkethaspricedinthe

realityofamuchmorefavourablecarryonUSinflationthan

oneuroinflationduringthenextthreemonths.USinflation

swapshaveoutperformedmuchmoreconsistentlythan

euroinflationswapssincethebeginningofthemonth,

losinggroundonlyduringtheunwindingoftheflightto

quality.

We,therefore,retainalongbiasonUSinflationvs.euro

inflationafocusontheinflationviewimmunefromflightto

qualityeffectswoulduseinflationswaps.

Also,theUSrealcurveflattenedin5y10yaneffectofthe

strongdemandfor30yTIPSduringlastweeksauctionandalsooftheflighttoquality,whichessentiallyflattensthenominal

curveandtherealcurve,althoughlessso,therebyleavingthe

breakevencurvesteeper.Wecloseourrealflatteningstanceon

5y10yandexpectthenextstepofthepricingoutofflightto

qualitytoflattenthebreakevencurve.

ExhibitBP2.2:10yUSbreakevenratesoutperformanceover

eurobreakevenratessincesecondweekofJune

Source:Bloomberg

150

170

190

210

230

250

270

290

01/04/2011

08/04/2011

15/04/2011

22/04/2011

29/04/2011

06/05/2011

13/05/2011

20/05/2011

27/05/2011

03/06/2011

10/06/2011

17/06/2011

24/06/2011

bps

10

15

20

25

30

35

40

45

5010Y US/euro spread on BE, RHS

TIPS 21

Bundei 20

ExhibitBP2.3:10yinflationspread,US/euro,cashandswaps

Source:Bloomberg

30

40

50

60

70

80

90

100

01/04/2011

08/04/2011

15/04/2011

22/04/2011

29/04/2011

06/05/2011

13/05/2011

20/05/2011

27/05/2011

03/06/2011

10/06/2011

17/06/2011

24/06/2011

bps

10

20

30

40

50

60

70

8010Y US/euro spread on BE,

RHS

10Y US/euro spread onsw aps


11/45



Canada:CPIsurprisestotheupside

CanadianconsumerpricessurprisedtotheupsideinMay,

withtheheadlineincreaseup0.7%(consensus0.3%)anda

coreincreaseof0.5%(consensus0.2%).Giventhe0.4%

worthofseasonalinflationinMay,thesurpriseon

seasonallyadjustedinflationwaslarge:0.3%insteadofthe

0.1%expected.Theyearonyearinflationratemovedup

to3.7%forheadline(from3.3%inApril)and1.8%forcore

(from1.6%inApril)headlineyearonyearinflation,which

wasexpectedtoprintbelowUSinflationinMay,wasinfact

stillhigherby0.1pp.

Asaresult,10ybreakevenratesonCanadianinflation

widenedmorethanTIPSbreakevenrates,outperformingby

around5bp.OurpositioninglongUSbreakevenversusCAD

breakevenon10ywaspremisedonamuchweakerreading

oftheCanadianCPIinMayandhas,therefore,provedill

timedweusethesteepeningeffectofthe30yTIPS

auctionontheUSbreakevencurvetoshiftourexposureto

the30ysector,TIPS2041vs.RRBs2041onabreakeven

basis.

UK:DMOlaunchesconsultationonRPIandCPI

On29JunetheUKDebtManagementOffice(DMO)

launcheditsconsultationontheissuanceofCPIlinkedILbonds.Thisconsultationfollowsimportantstepstaken

previously:inJuly2010,theUKgovernmentannouncedits

intentiontousetheCPIasthemeasureofpriceinflationfor

determiningthestatutoryminimumincreasefor

revaluationandindexationofprivatesectoroccupational

pensions,alsoaffectingthePensionProtectionFundand

theFinancialAssistanceScheme.InDecember2010,the

DepartmentofWorkandPensionpublishedaconsultation

ontheuseoftheCPI.InJune2011,theUKgovernment

decidedthatitwouldnotintroducelegislationoverriding

theexistingrulesofpensionschemesandwouldfavoura

softtouchapproachtoindexation.

Acrucialfactorunderpinningtheseissuesisthedifference

betweenCPIandRPInumbersitisonlytotheextentthat

thereisasubstantialdifferencebetweenthesemeasures

thatthechangeinindexationandrevaluationhas

implications.Needlesstosay,thechangetoalower

measureofinflationdecreasespensionliabilitiesinthe

future.

TheissueoftheCPIandRPIwedgeiswellknown:thetwo

indiceshavedifferentpurposesandtheoretical

underpinnings.TheRPIincludesnotionalspendingsuchas

costsassociatedwiththemaintenanceofaproperty

(housingcostssuchasmortgagepaymentsand

depreciation);whereas,theCPIexcludessuchcosts.Asa

result,itemweightsaredifferent.Also,lowerlevel

aggregationmethodsaredistinctandarereferredtoasthe

formulabias.

Themeandifferenceover20052011ontheyearonyear

ratesisaround50bpRPIrate50bphigher.Therangeofpossibleoutcomesonthisdifferenceiswide,froma

minimumof230bptoamaximumof340bp(i.e.,CPI340bp

higherthanRPIasinmid2009).Asfarasthecontribution

tothevarianceoftheoveralldifferenceisconcerned,90%

ofthevarianceisaccountedforbythehousingcomponent,

6%bytheformulaeffect,2%forthecoverage,and1.5%for

theweights.

ExhibitBP2.4:shiftinglongTIPSBEexposureto30y

Source:Bloomberg

230

240

250

260

270

280

290

1

7/02

/2011

0

3/03

/2011

1

7/03

/2011

3

1/03

/2011

1

4/04

/201

1

2

8/04

/201

1

1

2/05

/201

1

2

6/05

/2011

0

9/06

/201

1

2

3/06

/201

1

bps

RRB 2041, BE TIPS 2041, BE

ExhibitBP2.5:CPI/RPIwedge,yoy,%

Source:Bloomberg

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

2005

Jan

2005

Nov

2006

Sep

2007

Jul

2008

May

2009

Mar

2010

Jan

2010

Nov

pp

Diff erence betw een CPI and RPI

Housing component, total

Diff erence in coverage

Formula effect

Other differences incl. w eights


12/45



Thehousingcomponent,therefore,isthemostimportant

factorintermsofvariance,althoughitisnotintermsof

averagecontribution.Inotherwords,whiletheRPIdoes

notdepartmuchfromtheCPIinthelongrunbecauseof

thehousingcomponent,theaverageofthehousing

contributiontothespreadissmallitisbecauseofthe

housingcomponentthatitcandepartalotfromtheCPIin

theshortrunthecontributiontothevarianceofthe

spreadishigh.Tocomplicatethematterfurther,thereare

planstoincludenotionalhousingcostsintheCPIinthe

mediumtermnotbefore2014,however,accordingto

ONS.

Followingtheconsultation,after22September,theDMO

willdecideontheopportunityofissuingCPIlinked

instruments.ItwillassesswhethertheILmarketcanstomachfurthersegmentationtherearealreadytwo

differentsortsofILGiltswiththreemonthandeightmonth

indexationschemeswithaslightlyhighershareforthree

monthlinkersatpresent.Itwillalsoassessthedemandfor

specificCPIindexationfrompensionfunds.Needlesstosay,

thedecisionmadeafterSeptemberwillbeofgreat

importanceforthefutureoftheUKILmarket.

ExhibitBP2.6:BreakdownofthedifferencebetweenCPIandRPIrates,y/y,contribution/component

Source:ONS

TOTAL MIP HD COVERAGE FORMULA WEIGHTS

Mean 0.47 0.01 0.33 0.12 0.60 0.33

Median 0.95 0.25 0.44 0.13 0.55 0.36

Maximum 3.44 2.76 0.61 0.34 0.43 1.01

Minimum 2.29 1.51 0.99 0.15 1.03 0.18

Std.Dev. 1.59 1.17 0.39 0.11 0.15 0.30


13/45


UnitedStates EmploymentReport(Fri):Theemploymentreportistheobvioushighlightinanotherwiselight,holiday

shortenedweek.Whileweanticipatesome

improvementfromthedreadfulMayreport,wesuspect

theJunenumberswillbenothingtowritehomeabout.

Thefactisthatemploymenthaslaggedtheoverallsoft

patchthathasbeenwithusforthebetterpartofthe

lastthreemonths,andwebelieveatleastanotherpoor

payrollreportisinstore.WethinkheadlineNFP

advancesjust85,000inJune,withprivatepayrolls

increasingby110,000(governmentrelatedlayoffs

shouldcontinuetorunatarounda 25,000clipforthe

foreseeablefuture).Thiswouldleavethesixmonth

averageforprivateNFPat170,000.Weanticipate

payrollgrowthwillremainrelativelymodestandright

aroundthatzoneinH2/11,anumberconsistentwitha

2.53.0%realconsumptionbackdrop.Intermsof

unemployment,thereisagoodchance(giventhe

declineinconfidenceasitrelatestojobs)thatthelabor

forcecontractsslightlyanddrivestheratedownto9.0%

from9.1%previously.

Canada EmploymentReport(Fri):RBCislookingfora18,000increaseinemploymentduringJune,whichwouldbring

totalH1/11jobsgainstoahealthy180,000.Theservice

sector,onceagain,isexpectedtodrivejobgrowth,while

manufacturingemploymentwilllikelyremainflatdueto

lingeringglobalsupplychainissues.Areboundinthe

labourforceshouldseetheURtickupto7.5%inJune.

Thepositiveemploymentshouldhelpallaysome

concernsattheBoCoverafurtherdeteriorationin

consumptionamidelevatedhouseholddebtlevels.

Europe ECBinterestratedecision(Thurs):WelookfortheECBtoraiseitsrefirateby25bponThursdayto1.50%.We

expectabroadlyneutralaccompanyingStatement,

whichwillkeepopentheGoverningCouncilsoptions.

BoEinterestratedecision(Thurs):BankRateis

unanimouslyexpectedtobeleftonholdat0.50%,and

theAPTunchangedat200B.

Riksbankinterestratedecision(Tues):WeexpecttheRiksbanktoraiseitsreporateby25bpto2.00%,andwe

lookfortheRiksbank'sratepathtobelittlechanged.

EurogroupandIMFmeetings:ThespeciallyconvenedeurogroupmeetingonSundayisexpectedtoapprove

disbursementofthenexttrancheofbailoutfundingfor

Greece.WealsoexpecttheIMFtofollowsuit(Fri). UKJuneservicesPMI(Tue):TheUKservicesPMIhasfalleninthepasttwomonths,butiftheJunereadingis

stable,thentheQ2/11readingswouldstillmechanically

implyrelativelysolidservicesectorgrowthof0.6%q/q.

Mayindustrialproductiondata:IPdataforMaywillbepublishednextweekforanumberofeconomies,

includingSpain(Wed),theUKandGermany(Thu),and

Italy(Fri).

Australia/NewZealand RBAJulyRBABoardMeeting(Tue)WeexpecttheRBAtoleavethecashrateat4.75%,yetatighteningbias

remainsclear;however,givenEuropeandevelopments

havedominatedthelastmonth,theriskisfora

balancedstatementhighlightingcontinuedglobal

uncertaintyandriskstogrowth.

AUJuneLabourForce(Thu)Employmentgrowthmoderatedinrecentmonthsfollowinganunsustainably

strongpacein2010,consistentwithsofteninginactivity

andweaknessintheinterestratesensitivesectors.We

seelittlechangetothistrendinJune(RBC15,000).

Watchthefulltimecomponent,whichhasbeenweakin

thelasttwomonthsamodestbounceislikely.Thekey

unemploymentrateshouldholdaround5%(RBC4.9%)

withthelabourmarketremainingnearfullcapacity.

NZQ1/11GDP(Thu)Whilesomeofthepartialshavebeenslightlystronger,thesecondlargeChristchurch

earthquakehitinFebruaryandwillunderpinanother

sluggishquarterofgrowth.Weexpectanearflat

outcomeinQ1.Thenumbersaredatedwithmore

timelydatasomewhatfirmer.TheRBNZisexpectinga

0.3%riseinGDP(P)inQ1.

WhattoWatchFor


14/45


DataandEventsCalendar

*Variablereleasedate,#Followingday,+Previousday;Source:Bloomberg,ReutersandRBCCapitalMarketsestimates

EDT BST AEDT

SunJul03Euroarea 11:00 16:00 01:00# E xtraordinaryeurogroupmeetingtodiscussdisbursementofnexttrancheofGreekbailoutfunding

MonJul04USMarketsClosed IndependenceDay

A us tr al ia 2 1: 30 2 :30 1 1:3 0 Ma y R et ai lSales,m/m(%) 0.3 1.1

A us tr al ia 2 1: 30 2 :30 1 1: 30 M ay Bui ld in gApprovals,m/m(%) 2.0 11.5

Aust ralia 21:30 2:30 11:30 May ANZJobVacancies,m/m(%) 6.5

UK tba tba tba Jun Halifaxhousepriceindex,m/m,3m/y(%) 0.1, 4.2

Spain 3:00 8:00 1 7:00 Jun Unemployment ,m/mnsa(000s) 50.0 79.7

UK 4:30 9:30 18:30 Apr ConstructionPMI 54.0

UK 4:30 9:30 18:30 Apr BoEhousingequitywithdrawal,bn 7.0

Euroarea 5:00 10:00 19:00 May PPI,m/m,y/y(%) 0.0,6.3 0.0,6.5 0.9,6.7

Canada 8:30 13:30 2 2:30 May IndustrialProductPrices,RawMaterialPrices,m/m,y/y(%) 0.5,6.8

Canada 9:30 14:30 2 3:30 June RBCPurchasingManagers'Index 54.8

Tue05Global ChristineLagardebeginsworkasIMFManagingDirector

Aust ralia 21:30 2:30 11:30 May T radeBalance,A$bn 2.0bn 1.6bn

Australia 0:30 5:30 14:30 Jul RBAratedecision,% 4.75% 0.0 4.75%

France tba t ba tba BanquedeFranceGovernorNoyerspeaksinParisSpain 3:13 8:13 17:13 Jun ServicesPMI 47.5 50.9

Italy 3:28 8:28 17:28 Jun ServicesPMI 47.5 50.1

Sweden 3:30 8:30 17:30 Jul Riksbankratedecision,% 2.00 2.00 1.75

France 3:48 8:48 17:48 Jun ServicesPMI ('flash':56.7) 56.7 62.5

Germany 3:53 8:53 17:53 Jun S ervicesPMI ('flash':58.3) 58.3 58.3 56.1

Euroarea 3:58 8:58 17:58 Jun S ervicesPMI('flash':54.2) 54.2 54.2 56.0

Euroarea 3:58 8:58 17:58 Jun C omposit ePMI('flash':53.6) 53.6 55.8

Euroarea 4:00 9:00 18:00 ECBExecutiveBoardmemberBiniSmaghispeaksatanECBconferenceonemergingEurope

Germany 4:00 9 :00 18:00 FederalConstitutionalCourthearschallengeagainstGermanparticipationintheeuroareabailoutfundandrescueofGreece

UK 4:30 9:30 18:30 Jun ServicesPMI 53.8

Euroarea 5:00 10:00 19:00 May Retailsales,m/m,y/y(%) 1.2, 1.0, 0.6 0.9,1.1

Euroarea 13:30 18:30 03:30# ECBExecutiveBoardmemberStarkspeaksatanECBconferenceonemergingEurope

Wed06Germany tba tba t ba IMFBoarddiscussesArticleIVconsultationwithGermany

Spain 3:00 8:00 17:00 May Industrialproduction,y/ywda(%) 1.6

Euroarea 5:00 10:00 19:00 Q1F G DP ,q/q,y/y(%)(preliminary:0.8,2.5) 0.8,2.5 0.3,1.9

G er ma ny 6 :0 0 1 1: 00 2 0:0 0 Ma y F ac to ryorders,m/m,y/y(%) 0.1 2.8,10.5

Canada 8:30 13:30 2 2:30 May BuildingPermits,m/m(%) 21.1%

US 10:00 15:00 0:00# Jun ISMNonManufacturing 52.0 53.5 54.6

Thu07NZ 18:45 23:45 8:45 Q1 GDP,q/q(%) 0 0.2

Aust ralia 21:30 2:30 11:30 Jun L abourForce,'000,% 15,4.9 7.8,4.9

France 2:45 7:45 16:45 May Tradebalance,bn 7.1

N et he rl an ds 3 :3 0 8 :30 1 7: 30 J un H ICP ,m/m,y/y(%) 0.5,2.6 0.1,2.4

Sweden 3:30 8:30 17:30 May Servicesproduction,m/m,y/y(%) 0.3,5.6

Norway 4:00 9:00 18:00 May Industrialproduction,m/m,y/y(%) 1.7, 8.7

N or wa y 4 :0 0 9: 00 18 :0 0 M ay Ma nuf act ur in gproduction,m/m,y/y(%) 1.1,0.6

UK 4:30 9:30 18:30 May Industrialproduction,m/m,y/y(%) 1.7, 1.2

UK 4:30 9:30 18:30 M ay Manufacturingproduction,m/m,y/y(%) 1.5,1.3

Greece 5:00 10:00 19:00 Jun HICP,m/m,y/y(%) 0.2,3.1

G er ma ny 6: 00 1 1:0 0 2 0:0 0 M ay In du st ri alproduction,m/m,y/y(%) 0.7,7.0 0.6,9.6

Ireland 6:00 11:00 20:00 Jun HICP,m/m,y/y(%)(to12July) 0.0,1.2

UK 7:00 12:00 21:00 Jul BoEBankRatedecision,% 0.50 0.50 0.50

UK 7:00 12:00 21:00 Jul BoEAssetPurchaseTarget,bn 200 200 200

Euroarea 7:45 12:45 2 1:45 Jul ECBrefiratedecision,% 1.50 1.50 1.25

US 8:00 13:00 22:00 Jul RBCConsumerOutlookIndex 46.7

Euroarea 8:30 13:30 2 2:30 Jul ECBmonetarypolicypressconference

US 8:30 13:30 22:30 01Jul InitialJoblessClaims(Thous.) 435 428

Canada 8:30 13:30 22:30 May NewHousingPriceIndex,m/m,y/y(%) 0.3,1.9

Canada 10:00 15:00 00:00# Jun IveyPMI 69.1

UK 10:00 15:00 00:00# J un NIESRGDPestimate,3m/3m(%) 0.4

Fri08UK 21:45+ 2:45 11:45 BankofEnglandInterimFPCmemberAndyHaldanespeaksinBeijing

Australia 22:45 3:45 12:45 RBA'sAGDebelle'sspeech"InDefenceofCurrentAccountDeficits"

Greece tbc tbc t bc (Tentative)IMFBoardmeetingtodiscuss4threviewofbailout,incl.disbursementofnexttrancheoffunding

Germany 2:00 7:00 16:00 May Tradebalance,bn 10.5 10.9

France 2:30 7:30 16:30 Jun BdFbusinesssentiment,index 102 103

N et he rl an ds 3 :3 0 8 :3 0 1 7: 30 May I n du st ri alproduction,m/m,y/y(%) 0.3,0.8

Sweden 3:30 8:30 17:30 May Industrialproduction,m/m,y/y(%) 0.7,12.0

Italy 4:00 9:00 1 8:00 M ay Industrialproduction,m/m,y/y(%) 0.3,0.8

UK 4:30 9:30 18:30 J un PPIinputprices,m/m,y/y(%) 2.0,15.7

UK 4:30 9:30 18:30 J un PPIoutputprices,m/my/y(%) 0.2,5.3

UK 4:30 9:30 18:30 J un PPIcoreoutputprices,m/my/y(%) 0.2,3.4

Ir el an d 6 :0 0 1 1:0 0 20 :0 0 Ma y I nd us tr ia lproduction,m/m,y/y(%)(to12July) 1.4,2.7

Canada 7:00 12:30 2 1:30 Jun E mploymentChange,UnemploymntRate 18k,7.5% 10k,7.4% 22.3k,7.4%

US 8:30 13:30 22:30 Jun Chng.innonfarmpayrolls,privatepayrollsm/m(Thous.) 85,110 85,110 54,83

US 8:30 13:30 22:30 Jun UnemploymentRate(%) 9.0 9.1 9.1

Euroarea 13:30 18:30 03:30# ECBExecutiveBoardmemberBiniSmaghispeaksinGreeceon"Adjustingtothecrisis:policychoicesandpoliticsinEurope"

US 15:00 20:00 5:00# May ConsumerCredit(Bn.$) 5.0 6.24

Region Data/Event PriorConsensusRBCTime Period


15/45


RBCEconomicsandYieldForecasts

Sources:ECB,BoE,RBCCapitalMarkets

USD 30Jun Q311 Q411 Q112 Q212 CAD 30Jun Q311 Q411 Q112 Q212

Fedrate 0.25 0.25 0.25 0.25 0.50 BoCrate 1.00 1.25 1.75 2.25 2.50

3mTbill 0.02 0.20 0.25 0.35 0.65 3mCTB 0.93 1.70 2.15 2.40 2.65

2yTSY 0.46 0.90 1.10 1.25 1.60 2yCAN 1.59 2.15 2.40 2.80 3.00

5yTSY 1.76 2.30 2.60 2.80 3.05 5yCAN 2.34 3.00 3.30 3.50 3.65

10yTSY 3.16 3.65 4.00 4.15 4.25 10yCAN 3.11 3.50 3.80 3.95 4.05

30yTSY 4.37 4.60 4.85 4.90 4.95 30yCAN 3.55 4.00 4.30 4.45 4.50

2yASW 24 20 15 13 7

10yASW 11 15 20 20 1530yASW 31 25 25 20 15

EUR 30Jun Q311 Q411 Q112 Q212 GBP 30Jun Q311 Q411 Q112 Q212

ECBreporate 1.25 1.50 1.75 2.00 2.25 BoErate 0.50 0.50 0.75 1.00 1.25

3mEONIA 1.34 1.50 1.80 2.00 2.25 3mSONIA 0.54 0.60 1.00 1.25 1.35

3mEURIBOR 1.55 1.65 1.90 2.10 2.30 3mLIBOR 0.83 0.85 1.20 1.40 1.45

2ySchatz 1.61 2.00 2.25 2.45 2.60 2yGilts 0.83 1.50 1.80 2.00 2.20

5yOBL 2.28 2.70 2.85 3.05 3.15 5yGilts 2.07 2.35 2.60 2.75 2.90

10yBund 3.03 3.50 3.60 3.75 3.75 10yGilt 3.38 3.70 3.85 4.00 4.10

30yBund 3.77 3.75 3.80 3.85 3.85 30yGilt 4.29 4.20 4.30 4.40 4.40

2yASW 54 50 45 45 40 2yASW 53 55 55 50 50

5yASW 47 35 35 40 40 5yASW 31 40 40 45 30

10yASW 38 25 30 30 35 10yASW 5 25 25 30 15

30yASW 6 5 5 5 10 30yASW 21 15 15 10 10

AUD 30Jun Q311 Q411 Q112 Q212 NZ 30Jun Q311 Q411 Q112 Q212

RBARate 4.75 5.00 5.00 5.25 5.25 RBNZRate 2.25 2.50 2.75 3.00 3.25

3mBankBill 4.96 5.15 5.20 5.40 5.40 3mBankBill 2.92 2.85 3.00 3.15 3.50

2yTSY 4.74 5.10 5.20 5.30 5.40 2ySwap 3.36 3.60 3.85 4.10 4.30

5yTSY 4.87 5.25 5.40 5.50 5.60 5ySwap 4.38 4.85 5.10 5.30 5.35

10yTSY 5.21 5.65 5.75 5.85 5.85 10ySwap 5.16 5.50 5.65 5.75 5.80

SEK 30Jun Q311 Q411 Q112 Q212 NOK 30Jun Q311 Q411 Q112 Q212

Reporate 1.75 2.25 2.50 2.75 3.00 DepositRate 2.25 2.50 2.75 3.00 3.25

3mSTIBOR 2.42 3.00 3.25 3.50 3.60 3mNIBOR 2.92 3.00 3.10 3.30 3.50

2ySwap 2.97 3.90 4.00 4.20 4.30 2ySwap 3.62 4.20 4.40 4.65 4.75

5ySwap 3.26 4.10 4.20 4.30 4.35 5ySwap 3.99 4.60 4.80 4.90 4.95

10ySwap 3.51 4.20 4.30 4.40 4.40 10ySwap 4.37 4.90 5.00 5.10 5.10

Q111 Q211 Q311 Q411 2010 2011 2012 Q111 Q211 Q311 Q411 2011 2012

US US

RBC(Mar) 1.8 2.2 3.1 3.1 2.9 2.5 3.0 RBC(Mar) 2.1 3.4 3.6 3.1 3.1 2.3

Fed(Apr) 3.2 3.9 Fed(Apr) 2.5 1.6

Canada Canada

RBC(May) 3.9 2.8 3.8 3.3 3.2 3.2 3.1 RBC(May) 2.6 3.2 2.7 2.1 2.6 2.1BoC(Apr) 3.9 2.0 2.7 2.7 3.1 2.9 2.6 BoC(Apr) 2.4 2.7 2.5 2.5 2.5 2.1

Euroarea Euroarea

RBC(Jun) 0.8 0.3 0.4 0.5 1.7 2.0 1.8 RBC(Jun) 2.5 2.7 2.8 2.7 2.7 2.2

ECB(Jun) 0.8 0.3 0.3 0.3 1.7 1.9 1.7 ECB(Jun) 2.6 1.7

UK UK

RBC(Feb) 0.5 0.3 0.7 0.6 1.3 1.5 2.4 RBC(Jun) 4.1 4.4 4.7 4.8 4.5 2.1

BoE(May) 0.5 0.1 0.9 0.5 1.3 1.4 2.1 BoE(May) 4.1 4.5 5.0 5.0 4.6 2.9

RealGDP Headlineinflation(avg),%y/y


16/45


QE2,quarterendintherearviewmirror,betterdataahead? Intherecentweek,severalviolentselloffsensuedfollowingbothpoorauctionsandabetterthanexpectedChicagoPMIprint,providing

someevidencethatratesareinfactvulnerableatthecurrentlevels.AnyprogresstowardashortertermsolutioninEuropewillonly

increasethisvulnerability.AsJulyprogresses,webelievethedataflowwillcontinuetoimprovemuchaswewitnessedwithdatainthe

backhalfofJune.Ofcourse,nextweekspayrollreport,whichweexpecttobemodestatbest,willbeasignificanthurdletowardhigher

yields.

After140purchaseoperations,QE2hasfinallycometoanend.WecontinuetobelievethebiggesteffectofQE2sendwillbeseeninthe

cheapening

of

off

the

runs

relative

to

on

the

runs.

After

a

string

of

three

poor

auctions,

however,

we

believe

more

volatility

surrounding

auctionsmaylieaheadastheprimarydealercommunitynolongerhasabuyerofunwantedinventories.TheFedhaspurchased$288B

ofissuessettlingsinceQE2began,morethanonethirdoftheallocationsprimarydealersreceivedduringthatsametimeperiod.

AsdiscussedinTheBigPicture(page5),theendofQ2shouldrelievesomestressinthefrontend. TheincreaseinbothmunicipalnewissuevolumeanddealsizeinJuneincreasesthelikelihoodthatissuancewillreach$230250billion

bytheendoftheyear.

U.S.Perspectives

QuickViewProduct ViewRates Higher

Europeansovereigndebtissueswillprovidesomeresistancebuttheselloffs,

whichensuedfollowingpoorauctionsandstrongerthanexpecteddata

affirmedthatratesareveryvulnerable.

Curve SteeperDirectionalitywillpersistinthenearterm,butthecurveshouldsteepengiven

supplydynamicsandtheFedsunconventionaltighteningpath.

Spreads 30yrspreadswider

Aftertherecentflushout,wethinkthecurrentlevelsprovideagoodentry

pointforlongspreadwideners(SeeBigPictureonpage5).Wearewaryofoverreactionstodeclinesinforeigndollarreserveshavinganeffectonfront

endspreads.

TIPS Neutral

Afterrecentsteepening,fundamentalsshouldsupportasteepbreakeven

curve,withconcernsoveraweakereconomyandsofteroilpricesweighingon

shorterbreakevensandinflationriskspushinglongerbreakevenswider.

Agencies Neutral

Lackofsupplyoutsideofthefrontendshouldkeepagencieswellbidinanysell

off.OnaLiborbasis,wecontinuetoexpectagenciestoperformwellifspreads

widenonanyrenewedfearsoutofEurope.

FrontEnd Repocheapening Dislocationsshouldebbafterquarterendwithrepocheapening.

Vol SlightlyhigherWithratesclosertothezerobound,directionalitywillremainsignificant,but

wethinkdeliveredswillremainrelativelyhigh.

MBS Neutral Shortterm,weareneutralbutstillseevaluehereoverasomewhatlongerhorizon.


17/45

U.S.Perspectives


Letuswrapsomecontextaroundthedebtceilingnotbeing

passed.Aswediscussbelow,itwouldalmostcertainly

resultinarecession.Inotherwords,wequiteliterallyview

notraisingthedebtceilingasanimpossibilityonlymade

possiblebypoliticiansnotgraspingtheramifications

highlightedbelow.Westillthinktherearegreateroddsitis

passed,butyoucannotruleoutthepossibilitythatthe

braintrustinDCinventsanotheraccountinggimmicktobuy

moretime.Remember,whentheyfirststartedthisdebt

ceilingdancemanyyearsago,itoccurredtofewpeople

thattheywouldtaptheGfund,asanexample,tobuytime.

Itwasanovelapproachatthetime,andsuchnovelty

cannotberuledoutthistime.Barringanyadditional

accountingshenanigans,themusicstopsonAugust2.

Tosaythattheeffectfromasharpcontractionin

obligationstothebroadereconomywouldbequitesevere

mightbeanunderstatement.Weestimatethegovernment

needsnetissuanceofmarketablenotesandbondsofabout

$109BpermonthfromAugustuntiltheendof2011to

meetitsspendingobligations.Throwinanother$24Bper

monthincreaseinthenonmarketablesliceandyouare

dealingwithaprojectedexpansioninTreasurydebt

outstandingof$133Bpermonthonaverageforthatfive

monthspan.

Totaloutlays(exinterestpayments)haveaveragedroughly

$290Bpermonthforthepastyear.Inotherwords,even

excludinginterestpayments,thegovernmentwouldneed

toreducespendingonobligationsbyabout46%acrossthe

boardtoavoidpiercingthroughthedebtceiling.Ona

dollar

for

dollar

basis,

the

cuts

that

would

be

needed

wouldequatetoabout 5%ofannualGDP.Withthe

economybarelyclockinginabove2.5%sincetherecession

Debt Ceiling from 30,000 FeetTomPorcelli(212)[email protected]

JacobOubina(212)[email protected]

ExhibitUS1.1:Themagnitudeofcutsthatwouldbeneededtobridgethefundinggapisstaggering

Source:RBCCapitalMarkets,Haver

0 20 40 60 80 100 120 140

Social Secur ity

National Defense

Income Security

Medicare

Health

Educat ion, Training, Social Services

Veterans Benefits and Services

Transportation

Administration of Justice

Natural Resources and Environment

International Affairs

Science, Space and Tech

Community and Regional Development

Agriculture

General Government

Energy

Net Treasury Issuance

$b, monthly average out lay last 12 months

$b, projected monthly average

from Aug-11 to Dec-11


18/45

U.S.Perspectives


ended,anotherseveredownturnwouldbejustabouta

donedeal.

Thismassivecontractioninspendingwouldnecessarily

emanatefromreductionsinSocialSecurity,Medicare,

NationalDefense,andthesocalledIncomeSecurity.These

arethelargestcategoriesofspendingbyfarandgiventhe

sizeofthefundinggap(netissuance),itwouldbenecessary

toparethemback.Frankly,thereisnotenoughmeatinthe

othercategoriestobridgethegap.Giventhesensitivityof

thoseitemsonbothsidesoftheaisle,itishardtothinkany

politicianwouldrisknotraisingtheceilingandpotentially

creatingafundingcrisisinthosecategoriesandthelossof

votesthatwouldfollow.


19/45

U.S.Perspectives


MunicipalnewissuevolumepickedupappreciablyinJunefrom

thelevelsprintedearlierintheyear.Additionally,thesizeofthe

individualdealscomingtomarkethasincreasedsignificantly

withseveralverylargeissuespricedthismonth.

Theserecentsignsoflifeinthenewissuemunicipalmarket

pointtoamoreactivecalendarforthesecondhalfoftheyear.

Thisincreasesthelikelihoodthatissuancewillreach$230250

billionbytheendoftheyear.

TheUSmunicipalmarket,whichhadbeensufferingunder

anaemicnewissuevolumethroughoutmostofcalendar

2011,enjoyedahealthypickupinissuanceinJune.Weekly

municipalbondissuance,whichhadbeenaveraging

between$24billionallyeartickeduptothe$67billion

rangeduringthemonth.Monthlyvolume,whichhadbeen

aslowas$12billioninJanuaryandhadbeenstuckinthe

$1520billionrangefromFebruaryuntilMay,isexpected

tototalapproximately$27billioninJune.WithJunes

beefiercalendar,H1/11volumewilltotal$110billion,still

about50%ofH1/10volumeandthelowesttotalforfirst

halfissuancesince2000.Nevertheless,therecentsignsof

lifeinthenewissuemarketbodewell,wethink,forthe

volumeinH2/11.

Wethinkthepickupinissuanceinthepastfewweeksis

duetoanumberoffactors.First,theheavyoversupply

fromQ4/10,whenissuersrushedtomarkettotake

advantageoftheexpiringBuildAmericaBondprogram,has

finallybeendigested.Second,statebudgetissues,which

haddominatedthefiscallandscapeduringthefirstfive

monthsoftheyear,therebyovershadowingcapital

programsandalmostallotherstatefiscaland

administrativeissues,finallybegantorecedeinimportance.

TheNovember2010electionresultedintheturnoverof

morethanhalfofthenationsgovernors.Manyofthese

newgovernorswereelectedonanausterityplatform,

forcingthemtofocusexclusivelyonbudgetmattersduring

the

first

several

months

of

their

administrations.

With

the

budgetyeardrawingtoaclose,thesefiscalissuesare

slowlybeingresolved,andbudgetsarebeingadopted.

Additionally,recentdatafromtheUSCensusconfirmsthat

statetaxcollectionsarebeginningtoimprove.Thisis

providingissuerswithasmalldegreeoffinancialbreathing

roomandallowingthemtorefocussomewhatontheir

capitalprograms.

Inadditiontotheencouragingincreaseinweeklynewissue

volume,weareparticularlyenthusiasticaboutthemore

constructivecompositionofthisvolume.Junesnewissue

calendarsawadiscernableincreaseinthenumberoflarger

dealscomingtomarket.Theweeklycountofissuesof$100

millionorlargerreached20forthefirsttimethisyearlast

week.Additionally,weestimatethatthenumberofissues

of$200millionorlargerwilltotal27inJune.Thisstatistic

hadbeeninthe10to15permonthrangefromJanuary

untilMay.IfthistrendcontinuesandH2/11volume

averages$5billionaweek,total2011issuanceshould

reach$230billion.Anincreaseinaverageissuanceto$6

billionaweekwouldbring2011volumeto$250billion.Asa

result,wearestickingwithourvolumecallof$250billion

fortheyear,realizing,however,thatthisfigureisprobably

onthehighsideoftherangeoflikelyoutcomes.

ExhibitUS2.1:Municipalnewissuevolumeanddealsize

haveincreasedinrecentweekswithanotablepickupin

thenumberofissuesof$100millionandlargercomingto

marketperweeksincemidMay2011.

Source:Bloomberg

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

Jan Feb Mar Apr Apr May Jun

$

MM

0

2

4

6

8

10

12

14

16

18

20Weekly Issuance Volume

100MM+ Deals (rhs)

Municipals: A Stronger Second Half

Junes

new

issue

volume

suggests

a

better

second

half

for

2011

ChrisMauro(212)[email protected]


20/45


Somerespiteforthebears AfirmMayCPIprinthasputBoCratehikesbackonthemarketsradar,withcoreCPInowonly0.2ppawayfromthemidpointofthe

Banksinflationtarget.ThereportrepresentsthefinalinflationreadingaheadoftheJulyratedecisionandMPR,and,attheveryleast,

shouldforcetheBanktomaintainitstentativetighteningbias.

Withonlyone25bpratehikepricedinforthenextfiveBoCmeetings,thefrontendremainsvulnerableoncemarketattentionshiftsback

tofundamentals.

Fornow,welikerepresentingouroverallbearishCanadianratesviewviaa5s10sflattenerinswaps,withthe5ysectorstilllooking

overextended

on

the

curve,

both

on

an

equal

weighted

and

a

principal

component

(PCA)

weighted

basis.

The

position

offers

a

near

flat

carryandhasthepotentialtobenefitfromanyunderperformanceatthebellyofthecurveasQE2intheUScomestoanend.

CanadaPerspectives

QuickViewProduct View

Rates Higher

TheBoCrecentlyswitchedtoatentativehikingbias,suggestingthatmonetary

stimuluswillbeeventuallywithdrawn.Fornow,theunderlyingglobalrisk

aversiontoneshouldkeepthesafehavenbidinGoCsintact.Withthemarket

pricinginonlyone25bpratehikeuntilQ1/12andGovernorCarneyrecentlyfiringashotacrossthebowonundesiredhouseholddebtlevels,thefrontend

remainsvulnerableinourview.

Curve Neutral/flatter

WhileaneventualrefocusingonfundamentalsshouldpushshortertermGoC

yieldshigher,Canadasgenerallypositivedebtdynamicsandanchoredinflation

expectationswillprovidesomeshelterforlongtermyields.Wecontinuetolook

fortheGoC2s10scurvetoflattento105bpbyQ2/12,ledbythefrontend.

Swap

Spreads

Neutral/Wider

Therecenttentativemovewiderinswapspreadscouldgainsomesteamasthe

spreadbetweenfixedrateandfloatingratemortgagesnarrows,potentially

enticingsomeadditionalratelockingactivity.Giventhatwearenowbeyond

peakmortgageseason,however,wedonotexpecttoseeamovemuchbeyond

20bpinfiveyearspreads.

CADUSD

Spreads

FrontEndWider/

LongEndTighter

OngoingmonetarypolicydivergencebetweenCanadaandtheUSleavesroom

forshorterdatespreadstopushwiderbyatleast25bporsointhemedium

term.Atthelongerendofthecurve,Canadianratesareexpectedtotrade

throughUSratesofthesametenorgiventhemorepositivedebtanddeficit

dynamicsinCanada,althoughtherecentriseinriskaversioncoulddelaythe

move.

RRBBreak

evens Neutral

RRBbreakevenrateshavecollapsedsincehittingafiveyearhighof270bpin

April,withrisingglobalriskaversionandlowercommoditypricesbeingthe

catalystforthemove.Untilsignsofdomesticwagepressuresappear,breakeven

ratesnear250bpseemmoreappropriatetous.


21/45

CanadaPerspectives


AfirmMayCPIprinthasputBoCratehikesbackonthemarkets

radar,withcoreCPInowonly0.2ppawayfromthemidpointof

theBanksinflationtarget.

Withonlyone25bpratehikepricedinoverthenextfiveBoC

meetings,thefrontendremainsvulnerableoncemarket

attentionshiftsbacktofundamentals.

Fornow,welikerepresentingouroverallbearishCanadianrates

viewviaa5s10sflattenerinswaps,withthe5ysectorstill

lookingoverextendedonthecurvebothonanequalweighted

andaprincipalcomponent(PCA)weightedbasis.

FirmMayCPIdataputsBoCratehikesbackontheradar

ThereleaseoffirmMayCPIdatahasputBoCratehikes

backonthemarketsradar,fullyreversingthedeclinein

expectationsseenafterlastFridaysWallStreetJournalarticle,whichemphasizedsomedovishcommentsfrom

GovernorCarney.Bothheadlineandcoreinflation

resoundinglysurprisedtotheupside,pushingtheannual

ratesupto3.7%and1.8%,respectively.Someofthemove

canbeattributedtoseasonalfactors,whichadded0.5ppto

theheadlinemonthlyincreaseand0.2pptothecore

measure,butpressureswerealsoreasonablywidespread,

andtheoveralltrendpointshigher(seeCAD1.1).

The1.8%y/yprintoncoreleavestheQ2/11averageat

1.7%,0.3pphigherthanexpectedbytheBoCattheApril

MPR,andonly0.2ppawayfromthemidpointoftheBanks

inflationcontroltarget.Coreinflationcouldmoderate

slightlyinJuneassometransitoryincreasessuchastherise

inautoprices(whichcouldbeduetosupplyconstraints

causedbytheJapaneseearthquake)areunwound.The

spikeduringMay,however,stillhighlightstheriskofthe

BoCfallingbehindthecurve,especiallygivenitscurrent

expectationfortheoutputgaptocloseandcoreCPItohit

2.0%inQ2/12.

TheMayCPIreportrepresentsthefinalinflationreading

headingintotheJuly19ratedecisionandsubsequentMPR,

and,attheveryleast,shouldforcetheBanktomaintainits

tentativetighteningbias.TheflatprintonAprilGDPleaves

somewoodtochoponQ2/11growth,butmodestgainsof

0.2%inMayandJunewouldstillleaveit1.8%upatan

annualrateoverQ1/11.Thismeansthereisafighting

chancethattheBoCs2.0%Q2/11GDPforecastmightstill

beachieved(whichwouldalsobealittlebrighterthan

recentcommentsfromGovernorCarneypointingtoan

advanceinthe1%range).NextweeksCanadian

Some respite for the bears

Firm

May

CPI

puts

the

BoC

back

on

the

radar

[email protected]

[email protected]

ExhibitCAD1.1:CanadianInflationtrendinghigher

Source:Bloomberg,RBCCapitalMarkets

ExhibitCAD1.2:Ratehikeexpectationsmoderate


-6

-4

-2

0

2

4

6

8

Jan-

07

May-

07

Sep-

07

Jan-

08

May-

08

Sep-

08

Jan-

09

May-

09

Sep-

09

Jan-

10

May-

10

Sep-

10

Jan-

11

May-

11

Core CPI 3-mth saar pace

Headline CPI 3-mth saar pace

%

44

46

84

59

80

37

-5

46

42

101

-10 10 30 50 70 90 110

Canada

U.S.

U.K.

Eurozone

Australia Mkt Expectations (as at Apr 29, 2011)

Mkt Expectations (current)

Implied policy rate expectations through June 2012 (bp)


22/45

CanadaPerspectives


employmentreportwilllikelyreinforcethepositivelabour

marketbackdrop,withtheeconomyexpectedtoadd

18,000jobsinJune,bringingtheH1/11totaltoavery

respectable180,000.Theunemploymentrateisexpected

totickupto7.5%asthelabourforceexpands,thereby

leavingitonly0.3ppabovethe10yearaverage.

WeweretakenoutofourpaidpositioninDecember

meetingOISlastFridayasthemarketreactedtosome

reportedlydovishcommentsfromGovernorCarney.The

BoCGovernorreportedlydownplayedtheroleofmonetary

policyinahousingbubbleandsuggestedthatthecentral

bankdoesnothavetopushtheshorttermratebackto

neutralastheeconomynearsfullcapacity.Withrespectto

thelatter,assumingaconservative3.00%estimatefora

neutralovernightratebyQ2/12(theBankscurrent

forecastfortheclosingoftheoutputgap),wecaneasilyget

backtosomethingwellabovewhatispricedinforward

marketsandstillbeconsideredcomfortablyinstimulative

territory.Onthesecondpoint(thequestionabouthow

monetarypolicyshouldrespondtoahousingbubble),the

remarksmayhavebeentakenoutofcontext.Thisdebateis

alsolonginthetooth,andtheBank'spolicyisprettyclear:

ifitisjustahousingissue,thenusedirectmeasuresasa

firstdefence.However,aswehavearguedrecently(seelastweek'sCanadaPerspectivesarticleonhouseholddebtissues)thatapproachdoesnotappeartobeworkingaftera

fewkicksatthecan,andmonetarypolicymaynowhave

toplayacomplementaryrole.

CA5s10sswapflattenerremainsanattractiveplay

WeenteredaCAD5s10sflattenerinswapsat95bplast

week(target75bp,stop105bp)basedonanentrylevel

suggestedonJune9(seeGlobalDirectionsarticleBellyofCanadascurvelookingstretched).Canada'sfiveyearsectorcontinuestolookoverextendedonthecurvebothonan

equalweightedandaPCAweightedbasis1.ThePCA

weightedflyhasonlyrecentlybouncedbackfromlevels

overtwostandarddeviationsrichrelativetothe2s10s

swapcurve(seeExhibitCAD1.4).Atthetimeofourinitial

recommendation,theflywasroughlyonestandard

deviationrichtothecurveandhadjustbeguntowiden.

TheCADswapcurvecarryprofileisalsorelativelyflatoutto

the10yearsectoratpresent,whichfavours5s10s

flatteners(0.2bp/monthcarry)overlongerdatedpositions

(5s10spositionoffersabetaadjusted0.3bpimprovement

overa5s30sflattener).Canadasfiveyearsectorhas

outpacedmostinternational marketssincethebeginningof

April,havingralliedalmostlockstepwiththeUS.Thisweek,

thebellyofCanadascurveunderperformedintandemwith

theUSasthemarketprovedtobelessthanenthusiasticfor

shortandintermediateTreasurysupply.Thehistorically

elevatedcorrelationbetweenCanadianandUSfiveyear

ratesshouldhelptheCanadian5s10scurveflattenfurther

astheFedsdisproportionatesponsorshipofthebellyvia

QE2comestoanend.Wewouldalsoexpecttoseeapick

upinmortgagefixingactivityastheBankofCanadamoves

closertohikingrates,whichwouldputadditionalpressure

onthebellyofCanadasswapcurve.

ExhibitCAD1.3:Stillroomforbellyunderperformance


ExhibitCAD1.4:BellystillrichonaPCAweighted2s5s10sfly


PCA Weighted Fly Residual Z-Scores

(3.0)

(2.0)

(1.0)

0.0

1.0

2.0

3.0

Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11

%

1NotesonthePCAweightedfly:Aftercomputingtheprincipalcomponentweightedbutterflyseries,thisseriesisregressedontheslopeofthecurveovertheanalyzedperiod.Therelativerichnessor

cheapnessofthebellyisthenassessedbythedivergenceofthePCAweightedflyfromthefittedvalue(i.e.,thenumberofdeviationsofthezscorefromzero).Apositiveornegativezscoreindicatesa

cheaporrichbelly,respectively.

60

40

20

0

20

40

60

80

Jan1 0 Ma r10 May1 0 Ju l1 0 Sep10 Nov1 0 Ja n1 1 Ma r11 May11

USD EUR GBP CAD

bp

5yrraterich

relativeto2s and10s

2s 5s 10s swapfly


23/45


Disasteraverted...fornow EURLifeafterthevote:Whilewethinkitistooearlytoassumethatafullyfledgedtrendreversalsetsin,wehighlightanumberoftrades

thatshouldworkinanormalTacticalSPGBBundtighteneratthefrontend,2y5y10yBTPfliesandcashbondB/Ewidenersversusthe

swapcurvelookattractive.

PeripheryMonitor:Greekpoliticiansthisweekvotedinfavourofthelatestbatchofausteritymeasures.WethinktheEurogroup

meetingonSundaywill,therefore,approvedisbursementofthenexttrancheoffunding,withIMFapprovallikelytofollowonFriday.

WefirmlyexpecttheECBtopressaheadwithtighteningmonetarypolicynextweek,despitetheweakereuroareaactivitydataduring

the

past

month.

We

anticipate

a

broadly

neutral

Introductory

Statement

that

will

keep

open

all

future

options

for

the

Governing

Council.

WealsopresentasummarypreviewofGiltsupplyinfiscalQ2/11.

WefullyexpecttheRiksbanktoraiseitsreporate25bpto2.00%.Ourviewisthatthefrontendhaspricedouttoomuchintheway

tightening,andweseeopportunitiesforpositioningaheadofnextweek'smeeting.

EuropePerspectives

QuickView

Product View

Outright SidewaystohigherTacticallyshorttechnicallevelshavefallenandmarketslooksettoturn

directionforlonger.

Curve FlatterIntheearlyphasesofahikingcycle,curvestendtooutflattentheforwards.We

expecttheflatteningtoresumegoingintonextweeksECBratehike.

Cross

currency

spreads

TighterWecontinuetolikeGiltBundtightenersfrom5yonwardand,ingeneral,

expectBundstounderperformmostotherfixedincomemarkets.

ASW

Bunds/Giltsneutral

totighter,Sweden

wider

Ingeneral,weexpectamoreneutralASWenvironmentinEurope,butduringa

correctionofthecrisismode,tighteningshouldsetin.

IntraEMU

spreadsTighter/RVplays

Strategicallyneutral,tacticallytighterSPGBBundspreadsin2y,2y5y10yBTP

flies.

Inflation Wider Welikeb/ewidenersincashversustheswapcurve.

Money

marketsShort/Steeper

Moneymarketpricingappearsexpensiveonallcounts,andwelikeshortsfrom

Dec11onward.Themoneymarketcurveshouldresteepen.


24/45

EuropePerspectives


AftertheGreekvotes,fearsofanimmediatedefaultreceded.

Weseegoodsigns(outrightandinspreads)thatthismightturn

intoalastingchangeinsentiment.

Wehighlightanumberofnormalisationtradesthatoughttobe

watchedcarefullyifsentimentturns.

Thetradesthatwelikebestatthemomentare2ySPGBvs.

Bundtighteners,buyingthebellyin2y5y10yBTPflyand2y

10yflatteners,10yb/elongsvs.theILswapcurve.

1)Assetswapspreads

Oneofthemorevisiblesignsofstresshasbeenthe

significantwideninginBundassetswapspreadsduringthe

lastfewweeksfromthelow30bpareato45bpinthe10y

partofthecurve.Asshouldbeexpected,thereisagood

chancethatthisretreatssayinthehigh30bparea.Yetit

isherewhereweseegoodentryopportunitiesinwideners

again.SaythatgrowthandGreekdefaultfearstrulyrecede,

theimplicitassumptionshouldalsobethatGermanywill

growsignificantly, therebyreducingdeficitsandgovie

supply,whichshouldsupporttheBundASWspread.Inthe

oppositescenariowherestressresumes,theflightto

qualitytradesshouldalsokeepBundsindemand.Inshort,

weseelittlereasontoexpectBundASWtoretreattoo

significantly.

2)Intraeuroareaspreads

Wemakeoutbetteropportunitiesforrelieftradesat

presentintheeuroareagovernmentspreaduniverse.The

risksstemmingfromthekeydriversoftheextremetier2

spreadwideninginthepastfewweeks,animminentGreek

default,andthehugeuncertaintyabouttheprivatesector

involvementforanewGreekbailouthavebeen

substantiallyreduced.

Fromthisperspective,weprefertobetacticallylongtier2

spreadsgoingintothisSundaysEurogroupmeeting,where

thepotentialforadisappointingoutcomeshouldbe

limited.Withinthetier2space,thefrontendofthe

Spanishcurveshowedthestrongestperformanceversus

Germanpaperamidthisweeksspreadtightening.The2y

ESversusGEspreadtightenedover50bpgoingintoand

afterthefirstGreekausterityvoteonWednesday(Exhibit

EUR1.1).Althoughthisperformanceholdssetback

potential,weareconfidentthatthespreadreliefcould

persistforthenearterm.Furthermore,thecarryadvantage

forthenextmonthsislargelyinfavourofSpainversus

Germanyspreadtightenersatthefrontendofthecurve

(ExhibitEUR1.2).We,therefore,recommendbuyingthe

SPGB4.2%Jul13vs.theDBR3.47%Jul13atayieldspread

of200bponatacticalbasisandinasmallsize.Thetrade

offersanattractivepositivecarryofaround30bpoverthe

nextthreemonths,andweareaimingforaperformance

potentialofsome35bp.Wesetatargetatthespreadlow

ofmidMay(165bp),andastopataspreadlevelat220bp.

More than alive after the vote

EGB

spread

trades

to

watch

if

normalisation

takes

hold

NorbertAul+44(0)[email protected]

PeterSchaffrik+44(0)[email protected]

ExhibitEUR1.1:2ySpainvs.Germanyand10yItalyvs.Ger

many(ASWspreadsinbp)


100

120

140

160

180

200

220

240

260

280

300

Oct-10 Dec-10 Feb-11 Apr-11 Jun-11

10y IT vs. GE

2y ES vs. GE


25/45

EuropePerspectives


Furtheroutonthecurve,weprefertoexpressperiphery

versuscoretighteningexposureviathe10yBTPvs.Bund

spread.Despitethepoliticalpressuresurrounding

Berlusconi,todayspassofthepotential47bnindeficit

cuttingmeasure(tryingtobalancethebudgetby2014)has

been

an

encouraging

sign

for

the

market.

Againstthisbackdropthe10yBTPvs.Bundspreadholds,in

arelativecomparison,stillthemostreliefpotentialacross

tier2curves.Atacurrentlevelofaround170bpfortheBTP

4%Sep20vs.DBR2.25%Sep20,theyieldspreadstilltrades

over23bpaboveitslowon3June(ExhibitEUR1.1)andoffersaround7bpofpositivecarryforthenextthree

months.

3)OntheItaliancurve:CheapbellyintheBTP2y5y10yfly

StayingwithItalianpaper,theBTPcurvestillholds

distressedtradeopportunities, whichhardlymoveddespite

thereliefinperipheryversuscorespreads.

Forinstance,the510yASWcurveisstilltradingcloseto

flatoreveninvertedlevels(dependingontheissuesusedin

thecurvespread),therebyimplyingagloomypicturefor

theItaliancredit.TheBTP3%Nov15vs.BTP3.75%Mar21

spreadinASWterms(ExhibitEUR1.3)iswidelydetached

fromits25yand210ypeersontheItaliancurveand

hardlysteepenedduringthecourseofthepastweek,

despitethatperipheralpaperswitchedbackinriskon

mode.

Theunderperformanceofthe5yBTPsegmentbecomes

evenmoreapparentwhenfocusingonthe2y5y10yBTP

flywitha50:50riskweightinginthewings(greylinein

ExhibitEUR1.3).ThebellyoftheItaliancurve

underperformedconsistentlyintheASWflyalongside

wideningBTPvs.BundspreadssincelateApril,and

currentlystilltradesataround18bpusinglongBTP3%

Nov15vs.50%BTP2%Jun13and50%BTP3.75%Mar21as

depictedinExhibitEUR1.3.Withabrighterspreadpicture

forthenearterm,wealsoexpecttheItalian510ycredit

curvetosteepenandthe2510yBTPflytoretreatfromits

elevatedlevels.

Withrespecttothelatter,werecommendbuyingthe

current5ybenchmarkBTP3.75%Apr16vs.50%BTP2%

Jun13and50%BTP3.75%Mar21atayieldspreadof21bpaimingataperformanceof510bp.Wefavourbeinglong

theBTPApr16alsofromasupplyperspectivebecausethe

bondisgettingclosertotheendofitsontheruncycle

(potentiallyonlytwomoretapstocomeon14Julyand12

August)and,therefore,holdsthepotentialtorichenonthe

BTPcurve.

4)Cashb/einflation

One

of

thenot

most

intuitivegauges

of

stress

in

the

systemisthedevelopmentofcashbondb/einflationrates.

Notonlydoinflationexpectationsretreatoncemarkets

priceinascenariothatcouldhavepotentialnegative

ramificationsforeconomicactivity(suchasaGreek

ExhibitEUR1.2:1mand3mcarryof2yEGBspreadtighten

ersoverGermanpaper(inbp)

Source:RBCCapitalMarkets

0

5

10

15

20

25

30

35

2y ES

vs. GE

2y IT

vs. GE

2y BE

vs. GE

2y AT

vs.GE

2y FR

vs. GE

2y NL

vs. GE

2y FI

vs. GE

3m Carry 1m Carry

ExhibitEUR1.3:Cheapbellyinthe2y5y10yBTPfly(ASW

levelinbp)


-10

-5

0

5

10

15

20

25

Dec-10 Feb-11 Apr-11 Jun-11

-20

-10

0

10

20

30

40

50

60

70

80

BTP 2-5-10y fly (50/50)

BTP 5-10y (rhs)

BTP 2-5y (rhs)

BTP 2-10y (rhs)


26/45

EuropePerspectives


default),butalsothesafetyandliquidityifnominalcash

bondsareindemand.Withcashbondb/ebeingdefinedas

thespreadbetweena(liquid)nominalanda(lessliquid)

realbond,intimesofstress,cashbondsb/econtractmore

thantheyotherwisewould.Thiscanbedepictedquite

clearlyinthedifferencebetweenthecashb/erateandthe

ILswapcurve,asExhibitEUR1.4does.Ifmarketscontinue

toreturnfromthestresspricedin,thenb/eshouldrise

andthedifferencebetweencashbondb/eandswaps

shoulddecline.Onpage9,weelaborateonthis

relationshipinmoredetailandrecommendholdingb/e

widenerversustheswapcurveusingthe10yBUNDeior

OATeicurve.

ExhibitEUR1.4:10yBundb/eandILswap


1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

Jun-10 Sep-10 Dec-10 Mar-11 Jun-11

(%)

0

5

10

15

20

25

30

35

40(bp)

10y Bund b/e 10y IL swap spread (rhs)


27/45

EuropePerspectives


TheGreekparliamentvotes

TheGreekgovernmentsecuredapprovalthisweekonthe

latestausteritymeasuresrequiredtobringtheexisting

bailoutprogrammebackontrack.OnWednesday,MPs

passedtheausteritypackageby154votesto138,while

Thursdaysimplementationbillalsopassedwiththevotes

similarlysplitbroadlyalongpartylines.Separately,Greece

metitsendJuneprivatisationtarget.

FrenchbankproposalforGreekdebtrollover

AFrenchproposalforavoluntaryrolloverofGreekdebt

providedtwooptions.Onewouldseebanksrollingover

70%oftheirGreekholdings50ppwouldgointoanew30

yearbond(withpotentialincentiveslinkedtoGreekGDP

growth)and20ppintoahighqualityzerocoupon

instrument;theotherproposalwouldhavebanksrolling

over90100%ofholdingsintonewfiveyearbonds.The

formerproposalappearstohavebeengarneringmore

supportinrecentdays,andtherehavebeenmediareports

thatGermanbanksarealsoreceptivetothisidea.Indeed,

GermanFinanceMinisterSchubleusedapressconference

onThursdayafternoontoannouncethatanagreementhas

beenreachedwiththeGermanbankstorolloverdebt

holdingsmaturingupto2014.Butmediareportsalso

suggesttheplaniscontingentonratingsagenciesnot

deemingittoconstituteaselectivedefaultatthetimeof

writing,theagencieshavenotyetgivenanyindication.

Italy:politicalcrisisinthemaking?

FinanceMinisterTremontipreparedanausteritypackage

withmeasuresworthupto47B(1.8Bthisyear,5.5B

nextyear,and20Binboth2013and2014).Thepackage

wasscheduledtobepassedbycabinetdecreeonThursday

afternoon(nonewsatthetimeofwriting),beforegoingto

parliamentforconfirmationpriortothesummerrecess.

ButUmbertoBossi,leaderoftheNorthernLeague(PM

Berlusconismaincoalitionally),warnedthatthisplanhad

thepotentialtocauseacollapseofthegovernment.

Portugal:focusonstickingtobailoutconditions

ThenewPortuguesegovernmentpresenteditsfouryear

fiscalprogrammetoparliamentthiswasinlinewiththe

conditionssetoutintheIMF/EUbailoutpackageagreedto

inMay.FiscaldataforQ1/11wereweakerthanexpected.

Ourviews

Thetraindidnotderailthisweek,yetthedirectionoftravel

hasnotchangedalongtermsolutionisstillrequiredto

theGreekfiscalcrisis.Animmediatedisasterhasbeen

avoided,andthefocusnowshiftsbacktoEuropeanpolicy

makersandtheirnegotiationsonSunday.WiththeGreek

parliamenthavingfulfilleditssideofthebargain,weexpect

theEurogrouptoapprovedisbursementofthenexttranche

offunding(withIMFapprovallikelytofollowonFriday).

SundaysEurogroupmeetingisalsoexpectedtooutlinethe

scopeofprivatesectorinvolvement(PSI)insupporting

Greekpublicfinances.TheFrenchrolloverproposalappears

tohavebeengainingtractioninrecentdays,with

policymakersreportingpositivefeedbackfrominitial

soundings.Inourview,suchaproposalcouldbepotentially

beneficialforGreecesshorttermliquidityandforanew

bailoutpackage,provideditisstructuredinawaytoavoida

crediteventoraratingdefault.

Onthehorizon

July3:Eurogroupfinanceministersmeet.

July8(tbc):IMFBoardmeetingonGreece;fourthreviewto

bepublishedshortlythereafter.

July1112:EurogroupandECOFINfinanceministersmeet.

July13:Europeanbankstresstestresults.

BymidJuly:planned12BdisbursementtoGreeceunder

currentprogramme,before7Bincouponandbill

repaymentsaredueduringJuly1522.

Aug1219:Greece:3.7Bincouponandbillrepayments

aredue.

Aug20:Greece:6.6Bbondredemptionaredue.

Periphery Monitor

Greek

parliament

backs

austerity

measures,

now

for

PSI

pressure

JamesAshley+44(0)[email protected]

GustavoBagattini+44(0)[email protected]


28/45


29/45

EuropePerspectives


wouldnotnecessarilyexpectstrongguidanceatthisstage

(i.e.,anabsoluteminimumoftwomorelikelythree

monthsbeforethenextratehike).

Butinadditiontosuchinnatecentralbankconservatism,

thereisheighteneduncertaintyovertheoutlookforthe

euroareaeconomy,whichsurelydictatestheneedforeven

greatercautionthanusual.Unquestionably,theworries

overhowtheGreekdebtcrisiswillunfoldinthemonths

aheadareimportantconsiderations.YettheECBwillbe

thinkingofthatasarisktoitscentralmacroprojections

ratherthansomethinghavingamaterialeffectonthe

centralprojectionsthemselves.Forsure,itisariskfactor

withthepotentialtocausehugedisruption,butsofara

riskiswhatitis.Fornow,theECBwillseenopressingneed

toreviseitsviewonthegrowthandinflationoutlookfor

theeuroareaasawhole.

Bycontrast,thegeneralweakeningofthe(core)economic

datainthepastmonthissomethingthatshouldfeedin

directlytotheGoverningCouncilsviewofhowthe

recoveryisprogressing.Fornow,thesofterdatawillnotbe

undulytroublingaslowdowningrowthispreciselywhat

theECBandEurosystemstaff(andourselves)hasbeen

forecasting(weexpect2011growthof2.0%,andthe

Eurosystemstaffexpects1.9%).Buttheconcernisthepace

atwhichtheactivityindicatorshavesoftenedifthatpace

ofslowdowncontinuesinQ3/11,thentheriskstogrowth

willbecometiltedtothedownside(ExhibitEUR2.1).

Allofwhichistosay,thatwhiletheGoverningCouncilwill

besanguineabouttheslowdownobservedsofar(hence

theveryhighprobabilitythatweattachtoaratehikeon

Thursday),thereisacaseforproceedingwithextracaution

untilthegrowthoutlookinQ3/11andbeyondhasbeen

clarified.Againstthatbackdrop,wedonotexpectstrong

guidancefromtheECBnextweek.Itmaybethatthe

GoverningCounciliscurrentlymindedtoraiseratesagainin

October(whichisourforecast),butthereislittleobvious

advantagetobegainedfromdeclaringsoat

global directions 063011

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