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Recherche Economique de March | Stratgie Taux dIntrt |Stratgie Change 31 mars 2011

Market MoverPerspectives hebdomadaires et stratgies

www.GlobalMarkets.bnpparibas.com

Merci de vous reporter l'information importante en dernire page de ce documentCertaines sections de ce document ont t rdiges par nos quipes Stratgies. Cedocument ne constitue en aucun cas une analyse exhaustive et peut faire l'objet de conflitsd'intrts rsultant de son interaction avec les ventes et le trading pouvant affecter sonobjectivit.

Perspectives de March 2-3

Fondamentaux

Japan: Funding Reconstruction 4-7

Japan: Prices to TurnPositivefrom April

8-9

US: The Big Squeeze Ahead 10-11

France: Looking Beyond Local

Elections12

Australia: On Hold 13-15

Global: Supply Chain Disruptions

Update

16

Stratgie Taux d'Intrt

US: Buybacks Suggest Bearish

Positioning17

US: Comparing Option Plays For

Steepeners

18-20

US: A Barbell Strategy in

Agencies for Q2

21-22

MBS: If Agency MBS Is Not

Exempt

23-25

EUR: Curve Reactionto

ECB

Rate Hike

26-28

EUR: Q1 EGB Issuance Summary 29-30

EMU Debt Monitor: CDS, RV

Charts, Downgrades, Trade ideas,

SSA & Covered Bonds,

Redemptions

31-38

EUR: Update on CMS 39-40

JGBs: Steamrolling the Yield

Curve

41

JGBs: Rally Before a Sell-Off 42

Global Inflation Watch 43-46

Inflation: La Courbe BEEuro s'aplatie

47-49

Technical Analysis 50-51

Trade Reviews 52

Stratgie Change

Strategy: Liquidity: Here to Stay 53-55

Technical Strategy: 56-57

Prvisions & Calendriers

1 Week Economic Calendar 58-59

Key Data Preview 60-64

4 Week Calendar 65

Treasury & SAS Issuance 66-67

Central Bank Watch 68

FX Forecasts 69

Contacts 70

La tendance reste baissire moyen terme sur lesemprunts dEtat. court terme, lapprciation du risque parles marchs est susceptible dtre rvalue en cas dedtrioration de la situation au Japon et dans le monde arabe.

Toutefois, les conditions de liquidit restent abondantes,ce qui devrait permettre lapptit pour le risque desurmonter des chocs majeurs.

Lorientation du march sera dtermine par lesstatistiques attendues la semaine prochaine. Globalement, lerisque parat asymtrique : des chiffres meilleurs que prvuauraient sans doute un impact plus marqu.

Le march intgre dj la dcision de la BCE de porter letaux de refinancement 1.25 % la semaine prochaine.Toutefois, la dcision qui sera prise et le ton de la confrencede presse auront un impact sur la courbe : la tendance longterme reste la pentification de la partie courte et laplatissement de la partie longue.

La Banque dAngleterre pourrat emboter le pas la BCEds sa runion de mai mme si sa prochaine dcision reste

difficile prdire. Les JGB devraient rester soutenus sur toutes lesmaturits au moins jusqu'aux vacances de la golden week .

Tout repli de la parit EUR / USD aprs la runion de laBCE sera sans doute limit et temporaire.

Un nouveau rebond des devises des pays exportateurs dematires premires offre un potentiel plus lev via les paritsavec le JPY que via des shorts USD purs et simples.

Anticipations

Actuel 1 semaine 1 mois

Etats-Unis T-note 10ans (%) 3.42 2/10ans (pb) 264

Zone euro Bund 10ans (%) 3.34 2/10ans (pb) 156

Japon JGB 10ans (%) 1.26 2/10ans (pb) 105

Change EUR/USD1.4176

USD/JPY 82.86

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Cyril Beuzit 31 March 2011

Market Mover www.GlobalMarkets.bnpparibas.com

Perspectives de march

La semaine se termine en beaut pour les donnes aux Etats-Unis.Concernant lISM, nous tablons sur une bonne tenue de lactivit. En Europeles chiffres montrent que les vnements du Japon nont eu quun impactlimit sur lactivit. Le contexte est galement favorable au rapport surlemploi. Selon la dernire tude ADP, le secteur priv a enregistr uneacclration relle et soutenue de lemploi. Dans son valuation desperspectives conomiques, la Fed va certainement se projeter au-del de lachute rcente de la confiance des mnages mais elle continueraprobablement de considrer que les pressions inflationnistes doriginedomestique sont ngligeables.

Nous conservons une opinion bearish sur les Treasuries, opinion que nousrvaluerons en la rajustant - renforant aprs la publication desstatistiques sur lemploi. Le march continue de se positionner dans un sens

baissier. En termes de courbe, nous avions tendance privilgier lesflatteners 5-10ans, mais nous avons rcemment chang davis dans uneperspective de court terme, la zone 5-10ans ayant dsormais atteint un plusbas sur six mois. Au-del du durcissement de ton de certains responsables dela Fed, les signes dune croissance auto-entretenue pourraient amener lapartie courte intgrer une politique montaire moins conciliante. De quoientraner un bear steepening dun bout lautre de la courbe ED et despressions laplatissement par la suite.

La confiance en zone euro est solide eu gard au flux de mauvaises nouvellesde ces dernires semaines. Aussi les discours de plusieurs responsables dela BCE vont-ils tous dans le mme sens : les taux vont tre relevs de 25 pb loccasion de la runion du 7 avril. Une telle dcision tant dj intgre, lemarch va dsormais attendre les prochains signaux concernant lvolutionultrieure de la politique montaire. M. Trichet conservera probablementtoutes les options ouvertes. Nous tablons pour notre part sur un nouveaurelvement 1.50% en juillet.

A 2.6 %, linflation a dpass les prvisions. Les projections de la BCE pour lemois de mars taient trop conservatrices ; elles seront probablement rvisesde nouveau la hausse en juin, ce qui laisse augurer un nouveauresserrement. La projection de la BCE concernant linflation moyenne en 2011se situe 2.3 %, contre 2.7 % selon nos propres prvisions et les risquesnous semblent de plus orients la hausse. Les hypothses relatives aux prixdu ptrole retenues par le personnel dans ses projections taient trop faibles :aux environs de USD101pb et USD102pb, respectivement, pour 2011 et2012.

Les proccupations relatives aux effets de second tour en Allemagne sont trsrelles. Le chmage a enregistr une baisse bien plus nette que prvu enmars (55k) aprs avoir dj recul de 54k en fvrier. Le taux de chmage, 7.1 % en mars, est le plus bas depuis le dbut des annes 1990 et se situebien en dessous du NAIRU (environ 8% selon lOCDE). Comme lindiquent lesenqutes de conjoncture, la pnurie de main-duvre a atteint des niveauxexceptionnellement levs dans le secteur manufacturier, laissant entrevoirune tendance la hausse des salaires.

Pour ce qui est des emprunts dEtat europens, sauf dception majeure, leschiffres US devraient renforcer le biais bearish qui prvaut en ce moment. Lesemprunts dEtat du noyau dur ont offert une certaine rsistance. Ils ontbnfici du rallongement des durations en fin de mois et de conditionsfavorables concernant loffre. Ce ne sera plus le cas la semaine prochaine. Deplus, la perspective dun relvement des taux par la BCE (le premier depuis33 mois) ne peut que renforcer les pressions de vente. En termes de courbe,

Poursuite du biais bearishpour les emprunts dEtateuropens du noyau dur

Tous les regards seronttourns vers la BCE lasemaine prochaine

Les statistiques US vontprobablement donner leton court terme

Risque asymtrique sur lesTreasuries

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Ryutaro Kono 31 March 2011


Japan: Funding Reconstruction

The cost to the central government ofreconstruction will probably top JPY 10 trillionand could even reach JPY 15-20 trillion. To finance this, the priority should be to cutoutlays in the current budget where possible.Scrapping the governments favoured projectswould yield revenue of JPY 4-5 trillion. Theremaining JPY 10-15 trillion should come fromissuing special reconstruction bonds and acorresponding 1pp hike in the consumption tax.

If the governments fiscal reform target

dates need to be modified, the governmentshould clearly explain this. It would be a mistaketo scrap the consolidation plan just because thetarget dates become unrealistic.

Some lawmakers are urging the BoJ todirectly underwrite the cost of reconstruction,saying costs of 2-3% of GDP should not lead toinflation. But if history is a guide, oncemonetising begins, the debt being targeted maynot stop at reconstruction bonds.

Employing discretionary macro policies forpurposes other than reconstruction could

worsen economic conditions as the stimulatedaggregate demand tightens the supply ofresources needed for construction.

Cost of reconstruction could reach JPY 20 trillion

The government calculates that the recentearthquake/tsunami in northern Japan directlydestroyed JPY 16-25 trillion worth of public andprivate capital stock. Our own estimate is in the JPY20 trillion range and we suspect that reconstructionwill take about four years to complete. Given thetremendous hardships faced by people in thedevastated areas, rebuilding must be carried out asquickly as possible. But repairing the damagedinfrastructure (roads, bridges, ports etc.) will take agood amount of time and the various supplyconstraints hindering rebuilding must be tackled,beginning with the electricity shortage. Overcomingthese bottlenecks will also require effort andingenuity.

Of the JPY 20 trillion we estimate reconstruction willcost, roughly one-third will go on repairing publicinfrastructure. This cost will have to be borne bycentral and local governments. What is more, untilthe economies in the quake-hit areas return tonormal, the areas will need as much public support

as possible, beginning with the provision of reliefsupplies. This will have to come from the centralgovernment as the affected local municipalities areshort of manpower and struggling financially.Additionally, the rebuilding of destroyed privatecapital stock will require financial assistance andother kinds of public support.

Central governments total bill could come to JPY15-20 trillionUltimately, we suspect the cost to the centralgovernment will probably top JPY 10 trillion andcould even reach JPY 15-20 trillion. The question is,how to finance it? In Japan: Fiscal Sustainability Now,Market Mover, 24 March 2011, we cautioned that if

Chart 1: Combined Central and LocalGovernment Debt (% of GDP, FY)

0

20

40

60

80

100

120

140

160

180

200

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Source: Cabinet Office, MOF, BNP Paribas. Note: FY 2010 is our

estimates.

Chart 2: Public Debt and Primary Balance(central government + local governments,

% of nominal GDP)

-10

-8

-6

-4

-2

0

2

4

40 60 80 100 120 140 160 180

1981

2010

1992 2002

2002 20072009

primary fiscal balance

long-term national debt, end of previous fiscal year

Source: MOF, Cabinet Office, BNP Paribas

Note: Transfers from FILP special account and from long-term JNR

bonds are excluded.

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the authorities did not specify how reconstructionwould be financed, there was a risk that policies tocounter one crisis (the earthquake disaster) couldcreate the conditions for another (fiscal meltdown). Inthis report, we present our ideas for financingreconstruction.

Should the cost be financed by issuinggovernment bonds?If the central governments total bill over four years isJPY 15-20 trillion, that is equivalent to 3-4% of GDP.Currently, the budget deficit is running at almost 9%of GDP (the primary deficit was 6.5% of GDP in FY2010). Seeing how the public debt has alreadyswollen to 180% of GDP (in FY 2010), most peopleprobably think that the addition of an extra 3-4ppwont make matters any worse. While the addition of

such an amount should indeed be manageable,should the financing, like previous deficit spending,come from issuing more government bonds?

Should future generations foot the bill?

When the government issues new bonds, the publicmight not immediately face the bill but ultimatelysomeone has to pay. The Kan government knowsthat reconstruction will require a source of financing,but it cannot bring itself to decide on tax hikes orspending cuts because both would undermine thealready-fragile economy. But there is no such thingas a free lunch, and issuing bonds to pay for

reconstruction would oblige future generations to footthe bill.

Future generations should not carry the canOf course, the authorities might not intend to pushthe entire burden onto future generations. Instead,they might hope that the economy improves enoughover the next year or two that discussions can thenbegin on dealing with the burden. However, over thepast decade, whenever the economy soured theauthorities responded with tax cuts and spendingincreases (that expanded the budget deficit), but theyscarcely cut spending or raised taxes when the

economy improved. During the 2002-2007 expansion,the longest in post-war history, the authorities didrein in some spending but plans for tax hikesremained on hold. Although tax receipts picked up onimproved economic activity, the business cycleincludes downturns so fiscal deficits continued. Theresult is the public debt of 180% of GDP that willweigh heavily on future generations. Promising todiscuss the debt burden once the economy improvesis tantamount to deferring the problem indefinitely.

Fiscal reform was not the main cause of the 1997financial crisis

It seems that lawmakers have been traumatised bythe ill-fated attempt at fiscal restructuring by theHashimoto government in 1997. Hashimotos Fiscal

Structural Reform Act was followed almostimmediately by a financial crisis and severeeconomic contraction, with the result that the viewholding sway among lawmakers is that fiscal reforms including tax hikes should never be attemptedunless the economy is expanding robustly. But it iswrong to think that fiscal reforms were the maincause of the crisis. The reason the economydeteriorated is because the financial system already unstable owing to a mountain of unresolvednon-performing loans fell into crisis when fiscaltightening began. The problem, therefore, is that the

order in which policies were implemented wasinappropriate. NPL resolution should have come first,rather than being deferred.

Re-directing budget outlays could yield JPY 6trillion in revenue

So how should funds for reconstruction be procured?The first priority should be to re-direct as manyoutlays in the current budget as possible. Rebuildingthe disaster-hit regions should in our view takeprecedence over things such as child allowances andtoll-free expressways. The first outlays available fortapping are the left-over contingency funds from the

FY 2010 budget (JPY 203.8 billion) and thecontingency funds from the FY 2011 budget (JPY1.16 trillion). Second, ending the governmentscontentious projects such as child allowances (JPY2.2 trillion), income compensation for farmers (JPY600 billion), and toll-free expressways (roughly JPY 2trillion) would secure revenues of JPY 4.8 trillion.With the contingency funds, the total comes toroughly JPY 6 trillion.

Consumption tax for reconstruction to fund theremaining JPY 10-15 trillionThe remaining JPY 10-15 trillion should come from

hiking for a specified duration the consumption tax(consumption tax for reconstruction). No one wantshigher taxes and lawmakers are naturally loath to

Chart 3: Milestones on the Route to FiscalSoundness

GoalMilestones (example) Timeframe

(1) Set medium-term spendingframework for FY2011-FY2013

FY2013

(2) Cut primary deficit (as % of

GDP) in halfFY2015

(3) Achieve pr imary surplus FY2020

(4) Debt-to-GDP ratio must be

steadily reduced (stock target) andthe primary balance must achieve a

requisite surplus (flow target)

From FY2021

Source:Prepared by BNP Paribas Securities, from National Policy Office'srecommendations of the Medium-Term Fiscal Management Task Force.

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impose higher taxes on voters. But if the governmentcannot suggest tax hikes in crisis times, it evidentlyhas no intention of devising plans to equitably sharethe burden of reconstruction. The choice thenbecomes no reconstruction or reconstruction paid forby future generations.

Reconstruction bonds redeemable in 4-6 yearsOf course, we are not arguing that the JPY 10-15trillion in new tax revenue be levied all at once.Rather, we think that the authorities should issuespecial reconstruction bonds redeemable in 4-6years with the consumption tax for reconstructionbeing hiked 1pp (=JPY 2.5 trillion annually) for aduration of 4-6 years. The revenue from the hikewould be earmarked to retiring the reconstructionbonds. Such a modest tax hike would be a very

effective way of equitably spreading the burden ofreconstruction. It would also be palatable with thepublic, especially since everyone would know thatthey are personally contributing to the reconstructionefforts. By getting the public thus involved, closerscrutiny of public finance would ensure that pork-barrel spending is not passed off as reconstruction.And if a new sense of fiscal discipline was therebyinstilled, it might just pave the way for Japan toseriously tackle other pressing issues such as socialsecurity/tax reform.

Have fiscal reform targets been abandoned?We have made clear in previous reports our view thatthe authorities should concurrently announce plansfor reconstruction and long-term fiscal restructuring.Here we elaborate on the latter. There are growingconcerns that the latest crisis may have caused thegovernment to give up on the fiscal reform targetsoutlined in the Fiscal Management Strategy adoptedon 22 June 2010. Those targets include halving theprimary deficit by 2015 and achieving a primarysurplus by 2020.

Crisis might necessitate modifying fiscal reformtarget datesOf course, faced with the worst national crisis sinceWWII, the timeframe for achieving these targets mayhave to be modified. But if there are changes, itwould behove the government to explain this when itperiodically reviews its medium-term fiscal spendingframework this coming June. The government needonly state that the target dates have had to beadjusted somewhat because events beyondanyones control have caused the trajectories of theprimary deficit and public debt to deviate from thebaseline scenario.

Grave mistake to give up on targets for fiscal

reformWhile modifying the target dates would beacceptable, abandoning the targets all together

would not. The Hashimoto governments fiscalreforms were abandoned when the financial crisis hit.A decade later, Koizumis comprehensivespending/revenue reforms (adopted in 2006) weredropped when the Lehman shock hit. Unfortunately,Japans history of fiscal restructuring shows thatwhen one attempt at reform is abandoned, recklesspork-barrel spending becomes rampant until the nextattempt is announced. When targets are forsaken,there is nothing to guarantee fiscal discipline. Itwould be a grave mistake to give up on a targetbecause a date becomes unrealistic.

The government could also announce that the cost offinancing reconstruction would be handled separatelyfrom long-term fiscal management. It could then re-confirm that the current targets of 2015 for halvingthe primary deficit and 2020 for a primary surplusremain intact. (In fact, if our ideas for financingreconstruction were adopted, these target dateswould not have to change.) In any event, giving upon the targets for fiscal reform must be avoided.

Direct underwriting of reconstruction by BoJwould have serious side effectsMeanwhile, numerous lawmakers are urging the BoJto directly underwrite the cost of reconstruction. Thisis something we vehemently oppose due to theinherent side effects. Direct underwriting might makeit unnecessary to discuss raising taxes but would kick

the fiscal can down the road for future generations topick up. The inflation produced by such monetisationwould become a stealth tax in future years, erodingconsumers spending power.

On the argument that burdens should be clearlyassigned, we strongly oppose correcting the publicdebt with an inflation tax. Making matters worse,high inflation not only erodes trend growth bydistorting the allocation of resources, it also hurtslow-income earners especially hard via reduced realpurchasing power.

Monetisation could spark a new crisis

Some might argue that as long as reconstructioncosts just 3-4% of GDP, the BoJs underwriting of theextra debt would not lead to inflation. But onceunderwriting commences, the debt being targetedmay not stop at reconstruction bonds. History hasshown that emergency measures all too often morphinto routine policy. And if monetisation continues, theresult could be soaring inflation and a fiscal crisisfrom soaring term interest rates.

Macro-stabilisation for a supply shock?Another thing that is not needed at this juncture is

more macro-stabilisation. As pointed out in earlierreports, the economy is expected to contract in thefirst half of 2011. With many manufacturers and

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retailers forced to reduce operating hours because ofinsufficient electricity supply, companies have beenstoic throughout this power rationing because theyknow that the burden of reconstruction is beingshared by the entire nation.

But if the current conditions continue, it is possiblethat lost sales could cause some companiessolvency problems. And if that were to happen, weworry that near-sighted lawmakers could again startclamouring for increased fiscal spending to stave offsuch deteriorating economic conditions.

Given the fact that the economic slowdown this timeis due to a supply shock (destroyed factories,disrupted supply chains, power shortages etc.), isdiscretionary fiscal/monetary policy the answer?

Stimulating aggregate demand could makeeconomic conditions worseOf course, there is a demand-side dimension to thecoming slowdown, as weakening sentiment amonghouseholds and business will weigh on spending. Butthe primary cause of the slowdown is a supply shock.

If macro-stabilisation is employed in such a setting, itcould make economic conditions worse. Supplyconstraints could be aggravated because thestimulation of aggregate demand might tighten thesupply of resources needed for construction,beginning with electrical power (derived demand).

Policies needed now should focus on disasterrelief/reconstruction and ending bottlenecksCurrently, the BoJ is supplying the market withmassive liquidity. With mounting uncertaintyintensifying the preference for liquidity, aggressiveliquidity provisions are appropriate for curbing thecost of capital and risk premia. But if additionalmonetary easing is aimed at sparking aggregatedemand via a reduction in the cost of capital and riskpremia, such a policy could have a contrary effect.

Fiscal stimulus, which in our view is rarelyappropriate due to its huge costs,

would also magnify

supply constraints (and obstruct reconstruction) ifemployed in ways other than for reconstruction.Consequently, the policies needed should be gearedtoward disaster relief/reconstruction and endingbottlenecks, not stimulating aggregate demand.

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Ryutaro Kono/ Azusa Kato 31 March 2011


Japan: Prices to Turn Positive from April

The national core CPI fell 0.3% y/y inFebruary, exceeding the previous months fallby 0.1pp, as the rate of price growth eased forpetroleum products.

The national core CPI will likely return topositive territory from April, as the tuition feeexemptions for public high schools etc. that haslowered the core CPI by 0.5pp since April 2010will fall out of the index.

Price growth is also being fuelled by soaringcrude oil prices, reflecting geopolitical unrest in

the MENA region and accommodative monetaryconditions globally.

Fallout from 11 March should also exertupward pressure on prices as the supply shockhas reduced the potential GDP level. Also, whenreconstruction begins in earnest in H2 2011,demand for materials etc. will push prices up.

Based on the effects of the disaster, our(CY-based) price forecasts have been revised to+0.7% in 2011 (from +0.4%) and +0.8% in 2012(from +0.2%).

Februarys national core CPI: Essentially nochange

The national core CPI (which excludes perishables)fell 0.3% y/y in February, exceeding the previousmonths fall by 0.1pp. The rate of price growth easedfor petroleum products (to 7.8% from 8.5% inJanuary, reflecting unfavourable y/y base effects);rates for electricity turned negative (-0.3% from0.4%); and food prices were again down 0.9% y/y.

However, the rate of price decline is not necessarilyaccelerating as readings were unchanged for boththe US-style core-core CPI (which excludes energyand food), at -0.6% for a second straight month, andthe 10% trimmed mean CPI (which excludes thetop and bottom one-tenth of components ranked bythe size of year-on-year price changes). This was at-0.3% for a fifth straight month.

This latter price trend indicator has levelled off of lateafter steadily improving from a low of -1.3% inNovember 2009, thanks to improvements in theoutput gap. As for the breakdown of CPI gainers-

decliners, gainers edged down to 32.6% (33.3% inJanuary) and decliners inched up to 56.4% (55.9%).

Marchs Tokyo core CPI: Slight improvement

In contrast to the national index, price decline easedfor Tokyos prices. The March CPI report, whichprecedes the nationwide release by one month,showed the core CPI improving 0.1pp to-0.3% y/y, as soaring crude oil prices linked to

geopolitical turmoil in the MENA region causedprices of petroleum products to surge 12.3% (6.4% inJanuary).

As for other price indices, Tokyos US-style core-coreCPI was unchanged for a third straight month at-0.3%, while the price drop deepened 0.1pp to -0.4%for Tokyos 10% trimmed-mean CPI. The breakdownof Tokyos CPI gainers-decliners has the formerunchanged at 32.6% and the latter edging down to49.0% (49.6% in February).

Meanwhile, the Tokyo CPI report for March does not

reflect any fallout from the 11 March earthquakedisaster (hoarding of food, daily essentials, etc.) as

Chart 1: 10% Trimmed Mean CPI (% y/y)

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

06 07 08 09 10 11

National Tokyo

Source: MIC, BNP Paribas

Chart 2: Crude Oil Prices (USD/bbl)

65

75

85

95

105

115

125

7 8 9 1 0 11 12 1 2 3

Brent

Dubai

WTI

2010 2011

Source: Bloomberg, BNP Paribas

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Ryutaro Kono/ Azusa Kato 31 March 2011


the survey was concluded prior to the quake (9-11March).

Drawing on the latest Tokyo CPI numbers, weestimate that the national core index in March should

improve 0.1pp to -0.2%. The survey period for thenational CPI also ran from 9-11 March, so with thedisaster making it impossible for some areas tosubmit their reports, the authorities will rely onestimates for those areas.

If, however, fallout from the earthquake is registeredin the national CPI, we suspect that it will largely beupward marginal pressure from product shortages,though price movement may differ depending on theproduct.

Core CPI to turn positive from April

Looking further ahead, we expect the national coreCPI to return to positive territory from April, as thepolicy factor of tuition fee exemptions for public highschools etc., which has lowered the core CPI by0.5pp since April 2010, will be taken out of the index.The end of such special factors wont be the onlything driving the CPI higher, as commodities priceshave also revived on the back of voracious demandfrom the emerging economies (EMs), fuelled by boththe aggressive monetary easing in the developednations and the accommodative policies in the EMsaimed at staving off currency appreciation.

While prices for some commodities have eased sincemid-February, the strong tone of crude oil prices(WTI on 25 March hit USD 105/bbl) is having a directimpact on the CPI via petroleum products (core CPIshare: 3.7%) and, after a short lag, via electricity(3.0%), city gas (1.0%) and overseas package tours(0.5%) from higher fuel surcharges. While higher fuelcosts will ultimately weigh on domestic demand,having a depressing impact on prices, upwardpressures will prevail for now.

11 March to have inflationary consequences

We also expect fallout from the earthquake disaster,which will cause the economy to contract in the first

half of 2011, to exert upward pressure on prices.Normally, an economic contraction causes prices toweaken, but that is when the contraction is due to ademand shock. This time around, the cause ofnegative growth will be a supply shock destroyedfactories, disrupted supply chains, power shortages.

The output gap should shrink due to the economysreduced potential GDP level. Prices could experiencedownward pressure from the hit that aggregatedemand will take from reduced household andcorporate spending, as mounting uncertainties causeeveryone to tighten their purse strings. However, we

feel that inflationary pressures will get the upperhand due to severe supply bottlenecks in many areas.On this score, concerns about supply shortages havealready caused panic hoarding in Tokyo of food,

gasoline, bottled water, toilet paper and other dailyessentials. While the products concerned are unlikelyto impact the CPI, the worry is that such panic buyingcould lead to an inflationary mindset. Additionally, inH2 2011, when reconstruction begins in earnest, thedemand for materials etc. will push prices higher.Thus, a combination of Japanese reconstruction andgeopolitical unrest in MENA could cause thecommodity market to surge.

CPI could be positive even after index rebasing

Based on the latest CPI numbers and our post-earthquake GDP forecasts, our (FY) price projectionsare as follows: -0.8% in 2010 (unchanged), 1.1% in2011 (up from 0.6%), and 0.7% in 2012 (up from0.2%). CY: +0.7% in 2011, +0.8% in 2012. Quarterlyforecasts are -0.2% in Q1 2011, 0.7% in Q2, 1.3% inQ3, 1.2% in Q4, and 1.1% in Q1 2012. Although notfactored into our forecasts, we expect electricity ratesto rise sharply owing to greater reliance on morecostly thermal power generation.

This and the other factors mentioned above couldmean prices in FY 2011 stay positive even after the

CPI index is rebased in August. Our price forecastscited above do not reflect index rebasing, but, asmentioned in earlier reports, we think rebasing couldlower the index by 0.7pp.

Chart 3: Food and Petroleum Products (% y/y)

-3

-2

-1

0

1

2

3

4

5

02 03 04 05 06 07 08 09 10 11

-30

-20

-10

0

10

20

30

40

50

Food, excluding fresh food

Petroleum products (RHS)

Source: MIC, BNP Paribas

Chart 4: Expected Power Demand versus Power

Capacity (10k kw)

3000

3500

4000

4500

5000

5500

6000

6500

March

April

May

June

July

August

Se

ptember

October

N

ovember

D

ecember

January

February

Mar. 2008 - Feb. 2009Mar.2009 - Feb.2010Maximum capacity (our estimate)

Source: TEPCO, BNP Paribas

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Yelena Shulyatyeva 31 March 2011


US: The Big Squeeze

Corporate profits increased 29.2% in 2010,following a fall of 0.4% in 2009.

In the last expansion, the decline incorporate profits started well before the peak inoutput and was the most pronounced since WWII. In Q4 2010, after eight quarters of rapidincreases, profits finally regained their previouspeak.

Profits at financial companies surged 15.6%q/q in Q4 2010 following a 10.4% increase in Q3,while profits at non-financial companies

declined for the first time since the end of therecession, by 1.1% q/q. Rest-of-world profitsdropped most in Q4, declining 2.5%.

In 2011, corporate profits may get squeezedon all sides. Corporations have limited ability topass higher input costs onto consumers givensluggish wage growth. In addition, continuinggradual increases in payrolls should curbproductivity growth.

Stocks viewed from a price to corporateprofits ratio appear moderately cheap by thestandards of the past 30 years. Going forward,

limited growth in corporate profits will militateagainst rapid gains in the stock market.

Corporate profits increased 29.2% in 2010 and inQ4 reached their previous peak

Corporate profits surged 29.2% in 2010, the biggestfull-year increase in more than six decades (Chart 1).Profits had plunged 16.4% in 2008, the biggestcalendar-year decline in profits since WW II, andwere virtually flat in 2009.

The peak in corporate profits occurred in Q3 2006,well before the peak in the last expansion. Profitstroughed in Q4 2008 and, after eight quarters of rapidincreases, finally regained their previous peak in Q42010 (Chart 2). Corporate profits made up almost12.7% of national income in Q4, close to all-timehighs and well above the long-term average of10.6%.

The outlook for 2011 presents more of achallenge

Last years healthy increase in corporate profits isimpressive and was driven by cost cutting, continued

productivity gains and growing revenues around theworld. Rising input costs and limited scope for further

productivity gains suggest a more challengingenvironment for 2011. Indeed, while domesticfinancial firms profits continued to rise rapidly in H2

2010, profits at domestic non-financial companiesdeclined 1.1% q/q in Q4 the first drop since the end

Chart 1: Corporate Profits Surged in 2010

Source: Reuters EcoWin Pro

Chart 2: Regaining Their Pre-Recession Peak


Chart 3: Non-Financial Profits Dropped in Q4


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Yelena Shulyatyeva 31 March 2011


of the recession (Chart 3). Rest-of-world profitsdropped most, declining 2.5% last quarter.

Squeezed from all sides going into 2011

Commodity prices are rising, pushing companiesinput costs higher. The Commodity Research Bureau(CRB) index has surged 7.5% so far this year,helping to push the producer-price index up 5.6% y/yin February. Meanwhile, consumer prices onlyincreased 1.1% y/y in February (Chart 4) asproducers have limited ability to pass higher costsalong to cash-strapped consumers.

What we are likely to witness in 2011 is a battlebetween corporations and consumers. The formerwill try to pass higher input costs onto consumers,whereas the latter will resist by reducing theirspending or shifting toward lower-cost alternatives.

Profit margins will also get squeezed as the labourmarket continues its gradual improvement.Productivity has surged in recent years ascompanies fired a record number of workers duringthe last recession (Chart 5) and demanded morefrom their remaining workers. Employeecompensation as a percentage of national incomedropped to 62.2% in Q4, only a tad above its 45-yearlow.

Productivity growth slowed to 1.9% y/y in Q4 2010from 6.7% in Q1 2010, which was close to a 50-year

high. This year, even a gradual pick-up in payrollswill substantially limit productivity growth in theabsence of a rapid expansion in output.

A potential squeeze in corporate profits this yearcould limit further gains in the stock market

Stocks viewed from a price (S&P 500 index) tocorporate profits ratio appear moderately cheapcompared to the average of the past 30 years (Chart6). Of course, standard metrics need to be viewedwith a sceptical eye real returns on equity haveaveraged roughly 5% over the past 30 years and

have been highly volatile.US stock prices have recently been supported bystrong profits, plentiful liquidity from loose globalmonetary policy and a flight from emerging markets;they are up roughly 6% year to date, despite anabundance of risks to the outlook. However, the pathahead for equity markets looks more uncertain withmonetary policy set to tighten around the globe,notable risks to the growth outlook and firms facing amore challenging environment for maintaining andexpanding margins.

Chart 4: Higher Input Costs Will Hurt Profits


Chart 5: More Hiring Will Limit ProductivityGrowth


Chart 6: Price-to-Profit Ratio Still Below ItsLong-Term Average


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Dominique Barbet 31 March 2011


France: Looking Beyond Local Elections

The local elections painted a new politicallandscape. However, there will be no impact oneconomic policy in the short term.

Uncertainty over the 2012 election hasincreased.

Why so little interest in the elections?

For the local elections held on 20 and 27 March, halfof the French electorate were eligible to vote to elect2026 representatives in 100 general councils (oneper dpartementexcluding Paris). In the past, 50% of

all seats were renewed every three years. However,the new members have been elected for only half a6-year term since a new system will come into forcein 2014. With the same representative at the 100general councils and the 22 regional councils, this ispart of a move to unify regions and dpartements inorder to simplify structures and cut costs.

The turnout was very low at 44.3% in the first roundand 45% in the second. Fewer than 10mn peopleactually cast a vote, compared to the 43mn who areeligible to vote next year. The post-electionscomments focused more on the outcome of the

opinion polls than on the actual election results. Thepolls were naturally focused on the likely outcome ofnext years presidential elections, scheduled for 22April and 6 May. They indicated that the SocialistParty is now the most likely winner.

Real political shift

Local elections are always a warning shot for theincumbent government; this one was no different.Only 17.0% of the votes went to the UMP, thepresident's party. A few key figures very close to thepresident did particularly poorly. UMP allies gotanother 14.8%, leaving the total far below an

absolute majority.The main outcome of the elections was the break-through of the extreme-right National Front (FN)party. The efforts by new party leader Marine Le Pen,daughter of the former leader, to reposition the partyfrom extreme-right to conservative can thus bejudged a success. The FN won 15.1% of total votesin the first round, although it had candidates in only71% of the voting areas and had won no seats in theprevious elections. Moreover, the 400 FN candidateswho have got through to the second round havebeen able to significantly increase their voting base(+47%), which was not the case when Jean-Marie LePen was leading the FN. The political safety wall,built by the other parties to isolate the FN, is now

much weaker. This, combined with the new strengthof the party, caused major internal disagreementswithin the UMP and muddied its strategy.

On the left, the Socialist Party did well. It won 24.9%of the vote with its closest allies gaining a further6.9%. The extreme-left parties collected a total of9.5% and the Greens gathered 8.6%. Total votes forall left-leaning opposition parties reached a solid49.9%

1.

but little change in the balance of power

The extreme right, despite its success in terms of

votes, made little material progress. It won only twoof the 2026 seats at stake, showing it still struggles toconvince voters outside its own electoral base.

The left wing will win two new mainland departments,plus two others overseas. Two departments areundecided (in the event of equal votes, the oldestcouncil member is elected president, unlessmembers change coalition). At the same time, thecentre-right won 1 department from the left. This hasleft the opposition with a solid majority of 61-63dpartementsout of 100 (vs. 58 previously).

Consequently, the left wing should gain new seats inthe upper house when a third of its members are re-elected this September (only already-elected peoplecan vote for upper house members). It is not yetclear whether the left-wing coalition will be able towin a majority in the Senate or not.

Impact on policy

The upper house majority is not a major issue as thelower house normally prevails. However, itscomposition matters when it comes to changing theconstitution as Sarkozy wishes to do, to include aGerman-style debt brake (see France ObstinatelySeeking Credibility, Market Mover, 10 February).

The economic policies of dpartements shouldremain broadly intact, even where the majority haschanged. Their leeway is limited, as they are boundby a golden rule that prevents them from running abudget deficit apart from for investment spending.

Conversely, the coalition's weakness is a concern forits MPs, who will seek re-election in June 2012,especially as budget issues do not appear to be apriority for the electorate. In any case, thegovernment has made clear that France has nochoice but to cut the deficit in line with the stability

plan.1 Others amount to 3.3%; including the centrist Modem

(1.2%) and local parties (1.9%), in particular overseas.

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Dominic Bryant 31 March 2011


Australia: On Hold

The consensus forecast remains for 50bp ofRBA rate hikes this year. But recent data areunlikely to lead the RBA to upgrade itseconomic assessment at its April meeting.

In fact, developments since March have, ifanything, been dovish. Domestic demandgrowth is soggy and external uncertainty hasincreased.

We remain comfortable with our below-consensus call for an unchanged RBA cash ratethrough 2011.

The key releases

The upcoming RBA meeting provides a goodopportunity to review the latest developments in theAustralian economy and in which direction they arelikely to push the RBA. At this point it is worthremembering that some data are still being affectedby the Queensland floods, so have to be treated witha little more caution than usual.

The key releases since the last RBA meeting are: Q4

GDP; February labour data; building approvals/starts;NAB business confidence; and consumer confidence.On balance, we judge these as neutral to slightlydovish for the RBA.

We also need to consider global events, such as theJapanese disaster, and developments in Australiaslargest trade partner, China. Our conclusion is againthat these lean in the direction of the RBA remainingcautious on the need to raise rates. We therefore donot expect the RBA to make any significant changesto its language on the outlook. Unchanged monetarypolicy in the coming months continues to look the

most likely scenario.

Below trend

Q4 GDP growth of 0.7% q/q was broadly in line withexpectations and a notable improvement on Q3spaltry 0.1% q/q. However, 0.7% q/q, or 2.8%annualised, is only around the trend growth rate ofthe Australian economy. Taking the two quarterstogether, therefore, the economy grew below trend inH2 2010. Even assuming that the flooding at the endof Q4 shaved 0.1-0.2pp off q/q growth, theconclusion would remain the same. The economygrew below trend in H2 2010. For 2010 as a whole, a

stronger start to the year meant growth was aroundtrend. But such a performance is hardly a compellingargument for the RBA to tighten policy further.

Final domestic demand in Q4 was disappointing. Itgrew at an annualised pace of only 1.4%, theweakest performance since Q3 2009 and confirmingthat there was a clear deceleration in domesticmomentum through 2010 (Chart 1). While the seriescan be volatile and throw up some quarters of

exceptional strength, it is clear that the domesticeconomy is struggling to regain the pace of growthseen prior to the global financial crisis.

Squeezing domestic demand

Soft domestic growth reflects both disappointingconsumption and private investment. In both casesstructural factors are supportive of robustperformances: the saving ratio is close to 10%,meaning households have ample firepower toincrease spending; and the mining boom should bedriving investment spending. But in both casessomething is holding back growth. That something

is probably tight financial and monetary conditions.As we have long noted, interest rates are abovenormal, once the widening of lending spreads are

Chart 1: Soft Domestic Demand

Source: Reuters EcoWin Pro, BNP Paribas

Chart 2: Restrictive Real Rates

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Q193 Q195 Q197 Q199 Q101 Q103 Q105 Q107 Q109 Q111

Real Effective Cash Rate (%)

Deflated by Underlying CPI

Mean 1993-2008

Mean 1998-2008


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taken into account. This is true in nominal and realterms. In fact, the effective real cash rate (the cashrate plus the widening in mortgage lending spreads,deflated by underlying CPI) is higher now than in2007 thanks to the significantly lower rate ofunderlying inflation (Chart 2). When taken togetherwith the elevated level of the AUD, this leavesAustralian financial and monetary conditions tighterthan for any other developed or Asia-Pacific country.

Undermining confidence

When our Australian Financial and MonetaryConditions Index is plotted against businessconfidence, it points to a notable downside risk laterin the year. This is a key reason why we do notexpect the surprise jump in NAB business confidencein February to be sustained (Chart 3). Further factors

that are likely to bring confidence back down areglobal concerns about events in Japan; and slowingdemand in China.

While business confidence jumped in February,consumer confidence declined further in the Marchsurvey. It is still broadly in line with its long-runaverage, but some way short of the highs seen in2009 and early 2010. Moreover, with mortgage ratesnow moderately restrictive, it is difficult to seeconfidence picking up significantly again during thecourse of 2011 (Chart 4). This is especially so giventhe labour market has started to soften in recent

months.

Past the peak

The latest employment numbers show growth hasstalled since November 2010. Total employment wasflat in December, up marginally in January while theFebruary data, released since the last RBA meeting,showed a 10k decline. The full-time and part-timenumbers have been far more volatile, but the keydevelopment has been a marked slowing inemployment growth on a 3-month basis.

Indicators such as the NAB employment index

suggest the slowdown in recent months is somewhatexaggerated so there may be some recovery in thecoming months. Nonetheless, it looks unlikely thatemployment growth will regain the momentum seenin 2010.

Despite the marked slowdown in employment growth,the unemployment rate has fallen since November to5.0% from 5.2%. This reflects a 0.3pp fall in theparticipation rate. In the absence of this, theunemployment rate would have ticked up. However,it would be wrong to read too much into moves in theparticipation rate. For example, it increased sharply

from May to November, which stopped theunemployment rate falling more quickly. The bigpicture is currently that the participation rate is close

to the level seen prior to the intensification of theglobal financial crisis. Hence, there is no particularreason to think the unemployment figures do notcurrently give a reasonable guide to the degree ofspare capacity in the labour market. In fact, they fitclosely with survey evidence suggesting the labourmarket is operating at close to full capacity.

From the perspective of the RBAs upcomingmeeting, the fact that the unemployment rate was

Chart 3: Business Confidence


Chart 4: Consumer Confidence


Chart 5: Employment Growth


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unchanged in February means it will do little to affectthe RBAs view on the outlook.

Housing subsiding

Housing data over the month were weak. Buildingapprovals fell by almost 12% m/m in January and7.4% in February, albeit following a 10% rise inDecember. A negative impact from the Queenslandand Victoria floods played a role in this, withapprovals there down by 20% and 29% respectivelysince December. Nonetheless, this will clearly dragon housing investment and GDP in Q1. Later in theyear, there should be a boost from rebuilding. Butheading into the RBAs April meeting, housingactivity data do not give any reason for the monetaryauthority to upgrade its assessment of growth.

Mortgage approvals data were also soft in January,falling by 4.1% m/m. Again, the data are probablydistorted by the floods. However, even prior to thelatest falls in mortgage and dwelling approvals,weakness was evident. Mortgage approvals haddropped back to the levels seen in the crisis whiledwelling approvals were falling quickly in y/y terms,consistent with the tightening of monetary policy(Chart 6). Restrictive policy appears to be weighingon the interest rate sensitive areas of the economy.

External uncertainty

Developments globally have been dominated by the

terrible events in Japan. While the human cost isincalculable, we expect the disaster to knock around3pp off Japanese GDP growth this year. Importantlyfor Australia, much of this hit comes through reducedJapanese exports resulting from supply chaindisruptions. Japanese imports may initially bedisrupted too, but the disaster is fundamentally asupply shock to the Japanese economy, rather thana demand shock. Imports should therefore hold upbetter. In particular raw materials imports needed forrebuilding should be supported.

Australia may initially suffer some negative effects

from the Japanese disaster through supply disruptionin manufacturing (Japan accounts for 9% ofAustralian imports); and a short-lived reduction inexports (Japan accounts for 19% of Australiasexports). But under our central scenario that Japanbegins to recover during Q2, Australian exportsshould recover and potentially to a higher level.Overall, we judge that Australia will be lessnegatively affected by the terrible events in Japanthan a number of other countries in the Asia-Pacificregion. Nonetheless, the disaster has added greateruncertainty to the global environment. Other thingsequal, this should make the RBA more cautious

about the outlook.

Events in Japan mean Chinese data have receivedless attention than usual. There have been a numberof key releases, namely the manufacturing PMI andthe money and credit data. The headline PMI pickedup on the month, driven by strong output. However,new orders fell and inventories rose, suggestingoutput will fall back again in April (Chart 7). Moneyand credit data were weak, although distortions fromChinese New Year mean these data have to betreated with considerable caution. Ultimately, the jury

is still out on the speed at which the Chineseeconomy is slowing but it is slowing. From theRBAs perspective, this again leans in the direction ofkeeping policy on hold and awaiting furtherinformation.

Overall, developments over the month suggest theRBA can comfortably leave rates on hold in April.There also seems little need for it to upgrade itsassessment. If anything, developments have been onthe dovish side: domestic demand growth is soggyand the external environment more uncertain. Weremain comfortable with our forecast of an

unchanged cash rate in 2011.

Chart 6: Dwelling Approvals & Mortgage Rates


Chart 7: Chinese Manufacturing PMI


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Gizem Kara/Hiroshi Shiraishi/Mole Hau/Bricklin Dwyer 31 March 2011


Global: Supply Chain Disruptions Update

Further anecdotal evidence suggests supplychain disruptions caused by the Japanearthquake are unlikely to disappear anytimesoon, causing cuts to production and higherprices.

Following our piece on global supply chaindisruptions in last weeks Market Mover, below wepresent further stories on the effects of the Japaneseearthquake and the following tsunami on the globalsupply chain.

The news flow over the past week suggests morecompanies in Japan resumed their operations, whichis encouraging. However, the negative impact of theearthquake and subsequent events on global supplychain and production is severe and unlikely to

disappear anytime soon.

There continues to be global anecdotal evidence thatsupply chain disruption is causing delays or cuts toproduction. In Japan, some companies are shiftingoutput elsewhere to assist suppliers. In the rest of theworld, there are some indications that companies aretrying to find new sources of supply. As wehighlighted last week, concerns that furtherdisruptions to supply and therefore to productioncould drive prices of key technology parts andconsumer electronic goods higher remain. There isalready evidence in China that the recent eventshave pushed prices up in the electronics market.

Overall, anecdotal evidence so far continues tosupport our view that the recent adverse events inJapan will dampen global growth this year.

Box 1: Anectodal Evidence of the Impact of Japan Quake on Supply Chain and Production

Japan

Hitachi Ltd. partially resumed operations at its biggest factory complex on 29 March, with output expected to return to pre-disasterlevels next month. (30 March, nikkei.com)

Toyota Motor Corp. said it is finding it hard to procure 500 types of auto parts needed to build vehicles. It is uncertain when thecarmaker's domestic production will return to normal. (30 March, nikkei.com)

Nissan Motor Co. CEO Carlos Ghosn vowed to rebuild the Nissan Motor Co. plant in Iwaki, Fukushima. He said the plant will be ableto restart some operations in mid-April and begin operating on a full scale in early June. (30 March, nikkei.com)

With production halted at quake-stricken plants, office equipment manufacturers Ricoh Co. and Fuji Xerox Co. are rushing to shiftoutput elsewhere and assist suppliers. (30 March, nikkei.com)

Asia Ex-Japan

Taiwan Semiconductor Manufacturing Company does not recognize itself as a beneficiary of increased outsourcing by Japan-basedIDMs, which have seen production at their plants interrupted by the recent earthquake and tsunami. (28 March, digitimes.com)

Plant shutdowns in Japan has disrupted supply chains and pushed up prices in the electronics market in China, which is largelydependent upon Japan for key electronic components and automobile parts. (29 March, chinadaily.com)

Nissan Motor Co. expects its Chinese output to come in about 10% below target next month as the result of disruptions in the supplychain from the disaster in eastern Japan. (30 March, nikkei.com)

US

Ford Motor Co. has suspended orders for certain black and red vehicles because a Tier 2 supplier in Japan can no longer make ametallic paint pigment called Xirallic. (28 March, thestar.com)

Toyota Motor Corp. asked U.S. dealers to limit replacement-parts orders to those that are "critically needed" because supplies ofsome components from Japan likely will be disrupted. (29 March, businessweek.com)

Honda Motor Corp. will cut back on production in the United States and Canada from 30 March due to parts supply shortages in thewake of Japan's earthquake and tsunami earlier this month. (30 March, nikkei.com)

A number of the McDonald's Corp.s processing plants and a distribution centre were damaged by the tsunami, so the company hasbeen forced to step up importation of some food items. (31 March, WSJ)

Europe

Volkswagen, PSA Peugeot Citroen, Ford and other European automakers may be forced to halt production in coming weeks ascomponent suppliers in Japan struggle to restart factories. (28 March, just-auto.com)

Production of some Peugeot and Citroen models will fall as much as 60% because of a shortage of Hitachi diesel engine parts,Peugeot has said. (28 March, just-auto.com)

General Motors Opel unit last week axed shifts at plants in Germany and Spain before finding a new source of electronicscomponents in the US. (28 March, just-auto.com)

German container shipping giant Hapag-Lloyd has halted services to the ports of Yokohama and Tokyo, the two major facilities onTokyo Bay, over fears of radiation contaminating its vessels, crew or cargo. (31 March, baomoi.com)

Source: The date and sources are in parentheses after each story.

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Suvrat Prakash 31 March 2011

Market Mover, Non-Objective Research Section www.GlobalMarkets.bnpparibas.com

US: Buybacks Suggest Bearish Positioning

CFTC positioning suggests that the net longhas been increasing since last week eventhough Tsys have sold off.

However, the Fed buyback data suggest thatcash positioning has lightened. This fits wellwith the recent narrowing of the net basis, orcheapening of cash vs futures.

This could be the most timely data toprovide information on market positioning. Wewill monitor it closely for signs of a reversal.

The net long position by speculators on the CFTCexchange has typically tracked the movement in Tsyyields fairly closely (see Chart 1). In recent weeks,the net long has swung upwards although the Tsymarket has not rallied as much as implied. Thedivergence may not be particularly large, but we findit interesting that this coincides with a lightening incash positions that the Fed buyback data issuggesting. We think much of the selling may havebeen in cash rather than futures.

The Fed typically pays a slight premium (versus themarket offer side) when conducting buybacks. Whenthose premiums turn out to be less than usual, thatsuggests that the offers to the Fed were moreaggressive (i.e. closer to the market offer side, andsometimes even below).

In Chart 2, we attempt to quantify the purchaseoperations that are conducted almost daily. Eachsector has its own tendency to trade at a higher orlower premium at the buybacks. For example, in the7-10y sector, the Fed has paid an average of 1.33ticks above the offer side, whereas for the 2.5-5y

sector, the average has been 0.5 ticks (data sinceNovember). For each operation, we measure thedistance of the premium from the average that hasbeen paid in that sector. Chart 2 shows a time seriessince we have a data point for almost every day. Wehave consistently seen the offers become moreaggressive since last week, suggesting a desire tolighten cash positions.

The analysis above suggests that cash has comeunder more pressure than futures, which suggests anarrowing in the net basis (which measures therichness of cash vs futures). We have indeed noticed

that, as shown in Chart 3, and this fits well with thediverging flows between cash and futures.

Chart 1: Futures Positioning Suggests a LongBias (as of 22 Mar) Although Tsys Have Not

Rallied as the Relationship Suggests

-30

-20

-10

0

10

20

30

Jun-09 Nov-09 Apr-10 Oct-10 Mar-11

-80

-60

-40

-20

0

20

40

60

80

4W Change, CFTC Speculative DV01 Risk ($mm)

4W Change, 10y Tsy Yield (Inverted R.H.S)

Source: BNP Paribas. Spec Risk calculated by combining risk on

Eurodollar, 2y, 5y, 10y and 30y Futures.

Chart 2: Premium Paid at Fed Buybacks(relative to avg. premium in that curve sector)

-1.5

-1

-0.5

0

0.5

1

3-Dec-10 29-Dec-10 24-Jan-11 19-Feb-11 17-Mar-11

Source: BNP Paribas. Premium Paid in 32nds, moving average over 5

most recent buybacks.

Chart 3: Cash Has Cheapened vs Futures

0

2

4

6

8

10

12

14

16

18-Jan-11 6-Feb-11 25-Feb-11 16-Mar-11 4-Apr-11

TYM1 Net Basis (adjusted for length of option)

USM1 Net Basis (adjusted for length of option)

Source: BNP Paribas. Option length = distance (in days) to delivery date.

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Rohit Garg 31 March 2011


US: Comparing Option Plays for Steepeners

1y forward 2s10s swap curve (200bp) iscurrently pricing in about 60bp flattening fromthe spot (~260bp). Our forecasts indicate thatin a years time, 2s10s curve will be somewhatsteeper than 200bp.

STRATEGY: We recommend using singlelook 1y fwd 2s10s curve cap to hedge againststeepening of the curve.

In our article Rates Outlook after Macro Revisions

dated 10 March 2011, we revised our rates forecasts indicating a bear-steepening theme would be inplace for the next three months before flatteningstarted. Despite the improving US economicnumbers, various global risk events in last few weekshave kept a lid on rates. Currently, the forward curveis pricing in a 60bp flattening from spot in a yearstime. We think that the flattening priced in is toomuch and hence it is prudent to look at variousmethods to play for a steeper 2s10s curve in a yearstime than is being implied by the forwards.

Using curve cap to position for steepening

Currently, 1y forward 2s10s swap curve is around200bp while the spot is around 257bp. While weconsider various methods to play for a steeper curvethan is being implied by the forwards, single look ona 1y 2s10s curve cap is probably the best way toplay it when considering the pros and cons versusconditional option plays.

Chart 1 shows that on a 1 year history, the impliedspread correlation is at the highs and the impliedspread volatility is at the lows increasing theattractiveness of the curve cap.

Chart 2 shows that during periods (Dec-09 Mar-10and Dec-10 Jan-11) when the curve was at similarlevels to now (257bp), the implied spread volatilitywas at much higher levels than it is currently. Thisadds to the case for harnessing the attractiveness ofthe curve cap.

Chart 3 shows the indicative pricing of the single look1y 2s10s curve cap at different strikes. There is animportant point we would like to make as to why it isjustifiable to use the curve cap as a hedginginstrument against 2s10s steepening. With the 1y rollup in the curve close to 60bp, we feel comfortable

paying 33bp for a hedge rather than enteringbear/bull steepening trades using payers/receivers

Chart 1: Comparison of Implied Spread Vol (bpNorm Vol) and Implied Correlation (%) for Last

Year

50

55

60

65

70

75

80

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

60

80

100

120Implied Spread Correlation

Implied Spread Vol (RHS)

Source: BNP Paribas

Chart 2: Implied Spread Vol Looks Low forComparable 2s10s Curve

0.5

1

1.5

2

2.5

3

Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11

60

80

100

120

1402s10s Swap Curve

2s10s Implied Spread Vol (RHS)

Current Value

Source: BNP Paribas

Chart 3: 1y 2s10s Curve Cap Prices for VariousStrikes (bp)

Strike Offer

ATMF 33

220 26

240 18

260 12.5

Source: BNP Paribas, Indicative Prices

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for lesser upfront cost but then taking the risk thatyou lose money in the event the curve bear/bullflattens. While we see the Fed hiking in around ayear, there is a very real risk that the market priceshikes sooner kick-starting a bear-flattening. Ratherthan taking on this risk, we prefer limiting thedownside to the premium we pay upfront.

Positioning for steepening using payers

We could also position for a steeper 2s10s curve in ayears time than implied by the forwards by buyingpayers on 1y10y vs 1y2y. Table 1 gives us the tradedetails for such a costless trade. Note that, while thecurrent 2s10s curve is about 260bp, we can strike acostless trade at around 202.5bp.

However, also note that by pushing the strikes out ofthe money for both legs of the trade, one will be ableto enter this trade at better levels and perhaps pocketsome money as well. 1y2y payer skew for 100bpOTM is around 120% while 1y10y payer skew for100bp OTM is only about 108% (Chart 5). Hence,while the vol ratio (1y2y / 1y10y) for ATMF is justbelow 100%, when pushing both the legs 100bpOTM, the vol ratio we achieve is about 109%.

Table 1 gives the trade details for variations ofexpressing a bear-steepening view.

Trade 1.1

Entry Level: 202.5bp. Spot Level: 257bpIn this trade, you are short the market and long vega,which is how you would like to be positioned giventhat volatility is likely to increase as rates sell-off.

Trade 1.2

Entry Level: 200bp. Spot Level: 257bp

In this trade, one is able to pocket 40k USD upfront.However, this structure is short the market and shortvega.

Trade 1.3

Entry Level: 200bp. Spot Level: 257bp

Note the change in notionals in this structure. Thisstructure is not DV01 neutral at expiry. The fact thatthis structure is loaded up on the 1y10y payer leggives an added advantage in the event that expirythe curve ends up where the entry level is. Also, inthis structure, you are short the market and long

vega (by virtue of increased notional on the 1y10yleg), which is how you want to be positioned giventhat volatility is likely to rise as rates sell off.

Chart 4: Vol Ratio at AMF + 100bp OTM is nearthe highs and more attractive than Vol Ratio at

ATMF

0.4

0.6

0.8

1

1.2

1.4


1y2y f + 100/1y10y f +100

1y2y / 1y10y

Source: BNP Paribas

Chart 5: 1y2y Payer Skew is More than 1y10yPayer Skew for ATMF + 100bp

0.8

1

1.2

1.4

1.6


1y2y 100 OTM Payer Skew

1y10y 100 OTM Payer Skew

Source: BNP Paribas

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Table1.1: Trade Details for Costless Bear Steepener Trade Struck at the Forwards

Structure Strike Norm Vol (bp) Notional ($) PV01 ($) Vega ($) Gamma ($) Theta ($)

Sell 1y2y payer ATMF 109.5 (100,000,000) 8,094 (82,991) (723) 1,652

Buy 1y10y payer ATMF + 2.5 112.2 23,000,000 (8,889) 85,317 713 (1,662)

Net 795 2,326 (9) (10)

Table1.2: Trade Details for Bear Steepener Trade Struck at AMTF + 100bp Receiving 40k USD


Sell 1y2y payer ATMF + 100 132.0 (100,000,000) 2,536 (71,572) (535) 1,497

Buy 1y10y payer ATMF + 100 121.1 23,000,000 (3,232) 64,587 535 (1,277)

Net (663) (6,986) 0 220

Table1.3: Trade Details for Costless Bear Steepener Trade Struck at ATMF + 100bp With IncreasedNotional on the 1y10y Leg


Sell 1y2y payer ATMF + 100 132.0 (100,000,000) 2,536 (71,572) (535) 1,497

Buy 1y10y payer ATMF + 100 121.1 27,000,000 (3,794) 75,820 628 (1,499)

Net (1,258) 4,248 93 (2)

All Sourcse: BNP Paribas

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Mary-Beth Fisher 31 March 2011


US: A Barbell Strategy in Agencies for Q2

Agency bullets outperformed bothTreasuries and swaps across the curve in thelatter half of Q1. Spreads in the 5y sector areparticularly tight, with 5s back to +20/T and-6/L, the lower end of their multi-year range.

Due to the attractive spreads in the bellyfor issuers, the agencies have cheapened uptheir callable financing levels in the sector,making the OASes look compelling. The 5nc1and 7nc1 Berms in particular have an OAS of -2bp, compared to double digit OAS in most of

the very short and very long end structures. Agency debt supply will continue to beconstrained this year. The rise in rates sinceQ4 10 has eased callable redemptions, Fannieand Freddies financing needs will shrink ~10%in line with their portfolio, and low mortgageoriginations will cap needs at the FHLBanks asfew banks tap them for advances.

STRATEGY: We are constructive on agencyspreads in the long term due to shrinkingsupply and few alternative AAA-rated assetclasses. However, in the near term we think

supply could pick up in the belly and pressurespreads wider in April. We recommend abarbell strategy in both bullets and callables,being underweight the belly and overweightthe wings.

Bullets richen in the belly

Over the past few years 5y agency bullet spreadshave traded in roughly a 20-35bp spread to matched-maturity Treasuries. From mid Q4 10 to early Q1 11,5y agency spreads traversed this range (see Chart

1), widening versus both Treasuries and swaps. Thiswas partially due to some large domestic moneymanagers selling agencies across the curve, andnervousness due to headline risk as the Treasurydelayed their housing finance reform white paper.

The trend reversed when a combination ofgeopolitical risks provoked a flight to quality rally andthe Treasury reiterated its support for all agency debtand MBS particularly the debt that matures beyondthe Q4 12 explicit guarantee period. Agency debtbegan to tighten across the curve, but mostmeaningfully in the belly and longer maturities. This

outperformance occurred despite ongoing, significantprogrammatic selling by some large investors, whowere shifting into higher yielding assets.

Investors consider alternatives amid shrinkingagency supply

The shrinking supply of agency paper as the GSEswind down and mortgage originations stay lightcontribute to our long-term fundamental view thatspreads will tighten. Moreover, the rise in rates hasresulted in an extension of many existing callablesand lowered the pace of callable redemptions. Thisalso reduces the financing needs of the GSEs.

Investors still have money to put to work, and thereare few alternatives among liquid, AAA-rated assetclasses for those who are limited to Treasury spreadproduct. Such investors include central banks,investment portfolios of commercial banks, and manymunicipal and state financing portfolios.Supranational and sovereign agency (SSA) paper isone alternative, as are Yankee covered bonds (USD-denominated bonds from non-US issuers) which aretypically AAA-rated.

Chart 1: 5y Agency to Tsy and Libor spreads

-10

-5

0

5

10

15

20

25

30

35

40

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

Spread(bps)

spd to Treasasset swap

Source: Bloomberg, BNP Paribas

Chart 2: Comparison of Projected TROR

-200-180-160-140

-120-100

-80-60-40-20

020406080

100120140160180200

-30 -20 -10 0 10 20 30 40 50 60 70 80 90 100

Parallel Shift (bps)

To

talRateofReturnDifference(bp

7nc3m berm vs. bullet

7nc6m berm vs. bullet7nc1y berm vs. bullet

Source: Yield Book, BNP Paribas

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Mary-Beth Fisher 31 March 2011


Both SSAs and covered bonds have had significantrecent issuance and appear, on the margins, to bedeveloping crossover bids from traditional agencyinvestors. But neither market has yet developed theliquidity or depth to match agency paper, and there isan education hurdle for investors to clear regardingnon-US issuers. Early adopters have pushed intocovered bonds, as they offer the greatest yield pick-up among most AAA assets. Several issues havenoticeably tightened over the past few weeks andtrading flow has increased in the secondary market.

Agencies cheapen financing levels in the belly

The tightening of agency spreads in the belly looksrich to investors who want to buy paper, but cheap tothe agencies looking for financing. To provideinvestors some incentive to buy callables in the belly

when spreads are tight, the agencies cheapen uptheir financing levels. This has pushed the OAS ofthe 5- and 7-year final maturity structures into the lowsingle digits. The 5nc1 and 7nc1 berms in particularhad an OAS of -2 this morning on our Yield Book run(see Table 1). That compares to the low double-digitOASes in the rest of the grid.

Though we appreciate the cheaper financing levels,the spread risk (spread DV01) is almost as great as

the duration risk (DV01, shown in Table 1). All threehousing GSEs are on the calendar in the next 3weeks and any or all of them might choose to addsupply in the 5y sector. So short term were a touchbearish on 5y spreads and dont recommend buyingcallables or bullets in the belly at the tights. However,for investors tempted by the cheap OAS, werecommend 7y structures over 5y structures becausethey have greater yield pick-up, a greater potential tooutperform but slightly narrower breakeven ranges(Total Rate of Return comparison to duration-matched bullets shown in Chart 2).

Volatility in mid-range, curve bear flattening

A glance at volatility shows that most of the grid isback to the mid-range of the past few months innormalized vols. For Q2 we think that rates will

slowly sell off and volatility is likely to stay stagnantor even fall. Over the next few weeks as the Fedcontinues QE2 but is still a month or so away fromexiting, the sell-off is likely to result in a bearflattening of the curve. This also makes us prefer thewings the short end and the long end over thebelly in both callables and bullets, as the belly tendsto lead in a sell-off.

Table 1: Agency Bermudan Callables vs. Duration-Matched Bullets

Callables YieldDV01

($/mm) ConvexityVol(%)

Vega($/mm) OAS

OptionValue

Matched-DurationBullets

Yield pick-

up overbullet (bp)

Max Out-

performance(bp)

LowerBE (bp)

Upper BE(bp)

Width of BERange (bp)

2nc3m berm 0.84 113 -1.9 55 54 -13 0.36 FNMA 4 7/8 05/18/12 42 80 -1 100 1012nc6m berm 0.84 141 -1.2 60 63 -11 0.30 FHLMC 5 1/2 08/20/12 25 64 -9 116 1242nc1y berm 0.80 171 -0.3 69 62 -10 0.19 FHLMC 4 1/8 12/21/12 1 26 -12 118 130

3nc3m berm 1.50 154 -2.4 44 152 -9 0.81 FHLMC 4 5/8 10/25/12 81 112 9 100 913nc6m berm 1.46 192 -1.6 46 172 -10 0.69 FNMA 4 3/8 03/15/13 53 64 1 99 993nc1y berm 1.44 235 -0.6 49 179 -5 0.49 FNMA 1 1/4 08/20/13 28 29 -5 117 121

5nc3m berm 2.59 212 -3.0 34 485 -9 2.22 FHLMC 3 1/2 05/29/13 155 148 13 91 785nc6m berm 2.56 267 -2.1 35 566 -7 1.94 FHLMC 4 1/2 01/15/14 121 96 -6 92 985nc1y berm 2.52 336 -1.1 36 628 -2 1.48 FNMA 3 09/16/14 83 46 -13 93 106

7nc3m berm 3.39 254 -3.6 30 871 -8 3.98 FHLMC 4 7/8 11/15/13 213 171 2 78 767nc6m berm 3.33 323 -2.6 30 1,035 -9 3.57 FHLMC 3 07/28/14 170 103 -9 76 847nc1y berm 3.29 412 -1.4 31 1,154 -2 2.85 FHLMC 4 3/8 07/17/15 117 32 -8 57 65

10nc3m berm 4.07 298 -4.3 27 1,426 -20 7.16 FHLMC 2 1/2 04/23/14 257 168 4 66 6210nc6m berm 4.06 382 -3.2 27 1,717 -13 6.52 FHLMC 2 7/8 02/09/15 217 96 -9 59 6810nc1y berm 4.01 491 -1.8 27 1,980 -6 5.48 FNMA 5 1/4 09/15/16 138 6 9 40 31

Projected Performance across Scenarios (6m hzn)

Source: Yield Book, BNP Paribas

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Anish Lohokare/Timi Ajibola 31 March 2011


MBS: If Agency MBS Is Not Exempt

While risk retention rules exempt agencyMBS, with Barney Frank in agreement withRepublicans to remove this exemption, weanalyse the potential impact on agency MBS.

Among other underwriting requirements,QRMs would be limited to 80% LTV forpurchases, 75% for rate-term refis and 70% forcash-out refis. Only existing mortgages with 2

nd

liens would be allowed 2nd

liens in case of refis,but not purchases and refis where there isnt acurrently a 2

ndlien. Borrowers cannot be 30

days or more past due.

Up in coupon would be heavily supportedby such a change. We continue to remainoverweight mortgages, but shift our stance fromwings vs the belly to up in coupon.

Regulatory agencies including the OCC, Fed, FDIC,Commission, FHFA and HUD proposed rules oncredit risk retention requirements for securitizedmortgages in the context of the SEC Act of 1934, theDodd-Frank Wall Street Reform Act and theConsumer Protection Act. The proposal lays down

underwriting requirements for what classifies as aQRM (Qualified Residential Mortgage), which wouldbe completely exempt from risk retention. AgencyMBS received a blanket exemption under section15G of the SEC Act by regulators, on theinterpretation that GSEs are effectively backed by theUS Government. But Congress seems to disagree,and the Dodd-Frank Act did not outline such anexemption. With Barney Frank in the House ofRepresentatives in agreement with Republicans tosubject Fannie Mae and Freddie Mac to risk retentionrules, it makes sense to gauge its potential impact.

1) Delinquencies:As the proposal states: Specifically, under theproposal, a mortgage loan could qualify as a QRMonly if the borrower was not currently 30 or moredays past due, in whole or in part, on any debtobligation, and the borrower had not been 60 or moredays past due, in whole or in part, on any debtobligation within the preceding 24 months.

Chart 1 shows the 30 day delinquencies for FG 30Ysby coupon and vintage. The proposal is more severethan just the 30-day delinquency requirement, butdata are limited. Clearly the refinanceability of higher

coupons would be most affected by this rule.

2) LTVs:

Based on historical loan performance data, theAgencies are proposing a requirement for a LTV ratioof 80% for purchase mortgage transactions. Theproposed rules put a combined LTV ratio cap forQRMs of 75% on rate and term refinance loans and70% for cash-out refinance loans.

In Chart 2, we show the % of UPB that has LTVs

greater than 75% by coupon and vintage, using themore liberal standard of 75% for rate-term refis

Chart 1: 30+ Day Delinquencies for 30Y FG byCoupon and Vintage

4 4.5 5 5.5 6 6.5

2010 0.2 0.3 1 1.9 0.2

2009 0.3 0.7 1.4 3.2 4.6 5.5

2008 2 3.1 4.6 6.6 8.2

2007 19.3 3 4.4 5.6 7.8 10.9

2006 0.8 2.4 4.2 5.4 6.9 8.7

2005 2.4 2.3 3.7 5.1 7.2 9.8

2004 2.4 1.9 2.9 4.3 5.7 8.7

2003 1.9 1.5 2.1 3 5 7.6

2002 4.5 2 2.7 3.9 5.9

2001 5.1 3.8 2.6 3.6 5.8

Source: Freddie Mac, BNP Paribas

Chart 2: %UPB for Current LTV > 75% for 30YFGs by Coupon and Vintage

4 4.5 5 5.5 6 6.5

2010 9% 13% 69% 81% 51%

2009 2% 7% 46% 62% 78% 82%

2008 100% 57% 81% 88% 91% 96%

2007 64% 93% 95% 91% 92% 97%

2006 100% 82% 76% 85% 85% 91%

2005 20% 2% 22% 40% 63% 76%

2004 1% 2% 4% 4% 12%

2003 0% 0% 0% 2% 3%

2002 1% 0% 0% 0%

2001 0% 0%


Chart 3: % UPB with 2nd

Liens for 30Y FGs byCoupon and Vintage

4 4.5 5 5.5 6 6.5

2010 15 15 21 23 10

2009 16 16 13 11 3 2

2008 20 15 10 6 3

2007 21 17 18 20 16 8

2006 19 20 12 17 17 14

2005 12 1 2 2 4 3

2004 13 2 1 0 0 0

2003 0 0 0 0 0

2002 0 1 0 0 0

2001 4 3 0 0


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rather than the 70% for cash-out refis. Note thatcash-out refis may dominate at higher mortgagerates while rate term refis dominate at lowermortgage rates. So while these rules would tend tocurb callability in a rally, they could also worsenextension in a sell-off, supporting up in coupon onboth accounts.

Alternatively, in lieu of a higher level of or lesserflexibility on risk retention, standards may be morerelaxed: If the mortgage transaction is a purchasetransaction or rate and term refinancing, thecombined LTV ratio of the mortgage transactioncould not exceed 90% (with no restriction on theexistence of a subordinate lien at closing of a

purchase transaction)

3) 2nd

liens:

QRM standards would prohibit 2nd liens forpurchases and also for refinances where the existingloan doesnt have a 2

ndlien. Those refinances

currently with 2nd

liens would be subject to the CLTVrequirements above.

If the mortgage transaction is to purchase a one-to-four family property, no other recorded or perfectedliens on the one-to-four family property can, to thecreditors knowledge, exist at the time of the closingof the mortgage transaction. The proposal would notprohibit the existence of junior liens in connectionwith the refinancing of an existing loan secured by anowner-occupied one-to-four family property, providedthat the combined LTV ratio at closing of themortgage transaction does not exceed certainthresholds established by the proposed rules.

In Chart 1, we looked at loans with current LTVgreater than 75%, but the LTV was not the combinedLTV but just the LTV of the 1

stlien. In Chart 3, we

show that the persistence of 2nd

liens is lower as wego down in coupon but the incidence is of a muchsmaller magnitude that the LTV limitation itselfexhibited in Chart 1.

4) DTI (debt-to-income) ratio:

The rule proposes a front-end ratio limit of 28% anda back-end ratio limit of 36%, which are consistentwith the overall conservative nature of the QRMstandards.

In lieu of a higher level of or lesser flexibility on riskretention, DTI standards may be relaxed as well: Aborrowers maximum front-end DTI ratio could beincreased to (1) 33%, if payments under themortgage could not increase by more than 20% overthe life of the mortgage; or (2) 28%, if paymentsunder the mortgage could increase by more than20% over the life of the mortgage; (e) A borrowers

maximum back-end DTI ratio would be increasedto (1) 41%, if

Chart 4: % UPB for DTI > 36% for 30Y FGs byCoupon and Vintage

4 4.5 5 5.5 6 6.5

2010 6% 9% 34% 47% 24%

2009 1% 3% 22% 56% 68% 66%

2008 100% 29% 68% 81% 85% 79%

2007 80% 70% 68% 64% 77% 77%

2006 100% 72% 70% 76% 73% 74%

2005 48% 3% 8% 9% 27% 31%

2004 39% 11% 3% 1% 0% 2%

2003 0% 0% 0% 0% 0%

2002 15% 1% 1% 0%

2001 1% 0% 1%


payments under the mortgage could not increase bymore than 20% over the life of the mortgage; or (2)38%, if payments under the mortgage could increaseby more than 20% over the life of the mortgage;

5) ARMs:

In order for a mortgage that allows the annual rate ofinterest to increase after the closing of the mortgagetransaction to be a QRM, the terms of the mortgagemust provide that any such increase may not exceed:(a) two% (200 basis points) in any twelve monthperiod and (b) six% (600 basis points) over the life ofthe mortgage transaction.

6) Maturity limited to 30 years:

In addition, consistent with the QM requirementunder section 129C(b)(2) of TILA, the maturity dateof a QRM, at the closing of the mortgage transaction,must not exceed 30 years.

7) No credit for mortgage insurance:

While this insurance protects creditors from losseswhen borrowers default, the Agencies have notidentified studies or historical loan performance dataadequately demonstrating that mortgages with such

credit enhancements are less likely to default thanother mortgages, after adequately controlling for loanunderwriting or other factors known to influencecredit performance, especially considering theimportant role of LTV ratios in predicting default.Therefore, the Agencies are not proposing to includeany criteria regarding mortgage guarantee insuranceor other types of insurance or credit enhancementsat this time. The Agencies note that mortgageguarantee insurance is a form of credit enhancementaccepted by the Enterprises for mortgages withhigher LTV ratios that allows such mortgages to besecuritized through mortgage-backed securities

guaranteed by the Enterprises.

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As we discussed last week, we think that the supplyfrom the Treasury is easily absorbable by otherinvestors particularly given the sharp decline in Fedpaydowns and capital raised by REITs. We had firstshifted to a wings (4s, 5.5s and 6s) vs belly (4.5s and5s) coupon stack allocation to pick up positiveconvexity as we had rallied in mid-March. We keptthat allocation with Treasury sales, but dropped the5.5% short, shifting to neutral on that coupon.However, given that we have convincingly sold off

from the lows in rates, we shift back to up in couponon attractive carry, and the prospect of tightening inlending standards. Note that even if the agency MBSexemption remains, the GSE reform bill had talkedabout an 80% LTV restriction, and the possibility of acompromise on the agency MBS exemption in theform of tighter GSE underwriting is possible. Notethat in addition to refinancing, purchases would alsobe curtailed by these requirements.

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Patrick Jacq 31 March 2011


EUR: Curve Reaction to ECB Rate Hike

The decision of the ECB to raise the refi rateto 1.25% next week is largely priced in already.

However, such a decision will still trigger amarket reaction. And the impact

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