192395 bb a4 the path to qexit qr lr

The Path to QExit

Fixed Income Focus

Fixed Income Focus

The Path to QExit

Marketing Communication

Group Economics Macro & Financial Markets Research

DISCLAIMER: This report has not been prepared in accordance with the legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead. This report is marketing communication a nd not investment research and is intended for professional and eligible clients only.

3 June 2015  The next big thing is QExit The ECB’s asset purchase programmes have been a major force in financial markets over the last year. The next big question for investors is how long will QE continue, or to put it another way, when will it end? In this note we assess the timing of the ECB’s exit from QE – or QExit – given our view of the macro outlook and the central bank’s reaction function. We also look at the impact on fixed income markets.  ECB to dismiss tapering fears in coming months We think the ECB will be unwavering in its commitment to continue QE this year. We have only just seen signs of a more convincing recovery, while (core) inflation remains low and below target. In addition, we think the ECB will want to fight against any early tightening of financial conditions, as it could nip the economic recovery in the bud.  Early next year the tone could change However, as we move into next year, the ECB’s tone could change. By then we would have seen several quarters of better growth, while bank loans will also have expanded. Core inflation will have shown some signs of turning the corner, while inflation expectations will rise. The ECB’s confidence that it will meet its inflation goal over the medium term should be stronger. It will be clearer that September 2016 is very likely the end point for QE. The March 2016 policy meeting could be a watershed.  Bund sell off probably a false start Given that the ECB will re-enforce its commitment to QE, we think the recent rise in Bund yields is unlikely to last. Indeed, with acute scarcity of AAA bonds likely to re-assert itself, core bond yields will likely fall back. At the same time, we expect to see flatter curves (2s5s and 2s10s in particular). In addition, further risk spread compression, especially in non-financial credits and peripheral sovereigns is likely and the euro should decline further. Finally, Länder bonds could benefit from being included in the ECB’s eligible universe.  Positioning for the QExit When expectations of the ECB’s exit from QE take hold from the turn of next year, we would expect a sharp rise in core government bond yields and curves to steepen, mirroring the taper tantrum in the US. It would make sense to then be short core government bonds, covered bonds, SSAs as well as short duration. Meanwhile, the US experience suggests that credit spreads will actually tighten, likely helped by the improved economic growth outlook. Overweighting credit in the belly of the curve could provide some relative protection. As QExit expectations rise, we think the euro will rebound.

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Fixed Income Focus: The path to QExit – 3 June 2015

About the authors Nick Kounis (Head Macro & Financial Markets Research) Nick is responsible for research on the global economy, central banks, fixed income and FX strategy. He is widely quoted on the ECB’s monetary policy and eurozone economy. Nick was previously Chief European Economist at Fortis, and advised on economic policy at HM Treasury in the UK. Joost Beaumont (Senior Fixed Income Strategist - Covered Bonds) Joost is a well-known analyst of euro-denominated covered bonds, with a particular expertise on the Dutch market. He previously held positions as Senior European Economist at ABN AMRO and Fortis and spent nearly seven years as a policy advisor at the central bank of the Netherlands Antilles.

Kim Liu (Senior Fixed Income Strategist - Rates) Kim is an experienced specialist in the Sovereign, Supranational and Agency bond markets as well as swaps. He previously worked as a government bond trader at ABN AMRO. Kim has also worked for the DSTA (Dutch State Treasury Agency), which is part of the Dutch ministry of Finance.

Aline Schuiling (Senior European Economist) Aline covers the eurozone economy, focusing on the cycle as well as the comparative fundamentals of the member states. Her recent thematic notes include an analysis of the state of structural reforms in different countries. She is also an ECB specialist. Aline has a vast experience as a market economist, working for several banks.

Hyung-Ja de Zeeuw (Senior Fixed Income Strategist – Corporate Bonds) Hyung covers EUR IG non-financials with an expertise in European utilities. She provides market analyses from a broad perspective and shares her views on sector developments. Hyung previously worked as a Fixed Income Portfolio manager Credits and as an Originator in the Debt Capital Markets.

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Fixed Income Focus: The path to QExit – 3 June 2015

Conviction views Government bonds

National agency bonds

Covered Bonds

QE The recent sell-off in government bonds is a false start. We expect yields to decrease as scarcity of core government bonds will kick in.

We make a case for the inclusion of Länder bonds to decrease scarcity of German government bonds. Government bond curves are now steeper than before QE was announced. Flattening in 2s5s is supported by ongoing ECB buying. Peripheral country spreads have widened on Grexit concerns. We believe that in the end an agreement will be reached and are therefore supportive of peripheral country spreads.

Underweight bonds issued by national agencies and European institutions. Bonds issued by the so called national agencies and European insitutions and which are eligible for QE purchases have outperformed significantly.

These bonds are trading flat or very expensive to their respective government bonds. We are cautious to set up bullish trades in these names.

Overweight periphery and non-CBPP3 eligible paper. Potential for tightening is the largest in the periphery, reflecting higher spread levels, as (semi) core covered bonds are already relatively expensive. Spreads of non-CBPP3 eligible paper (e.g. Canada and Australia) also offer potential to perform, as they are trading with a pickup versus the (semi) core.

QExit We expect yields on government bonds to rise and curves to steepen. Impact on short maturing bonds will be less than on long end maturing bonds as excess liquidity will remain and as the ECB will keep its policy rates unchanged.

Government bonds will likely underperform vs swaps. Performance in peripheral spreads is backed by improved economic sentiment and search for yield.

Underweight bonds issued by national agencies and European institutions. The national agency and European insitution bonds which have outperformed sovereign bonds during QE are likely to underperform once the ECB will stop buying these bonds. We are therefore not supportive of these names.

Underweight peripheral covered bonds, as we think they will be hit hardest. Not only did these bonds benefit the most from CBPP3, but we also expect relatively more supply from the periphery than from the (semi) core. (Semi) core paper will remain relatively scarce, limiting its widening potential. Non-CBPP3 paper will end up in between, as it will be less attractive as a substitute for CBPP3 paper.

Credit Non-financial bonds Overweight non-financials. The purchase Overweight non-financials. Improving economic programme pushes investors into riskier assets conditions will trickle through to reported results of the spectrum resulting in spread compression at the company level. We prefer high beta BBB and flattening credit curves. We prefer the BBB rated segment. Only hold hybrids if volatility is not rated segment, hybrids and longer maturities. an issue. Name selection will become more important as event risk increases when the economy strengthens. Move out of the longer end and into the belly of the curve.

3 3 Fixed Fixed Income Income Focus: Focus: The The path path toto QExit QExit –3 – June 3 June 2015 2015

Euro Euro Interest Interest Rate Rate Forecasts Forecasts *denotes *denotes forecasts forecasts

Outright Outright Yield Yield Deposit Deposit facility facility Refi Refi Marginal Marginal lending lending Eonia Eonia 1m1m Euribor Euribor 3m3m Euribor Euribor 2y 2y Germany Germany 5y 5y Germany Germany 10y10y Germany Germany 30y30y Germany Germany 2y 2y IRSIRS 5y 5y IRSIRS 10y10y IRSIRS 30y30y IRSIRS

3m3m -0.20 -0.20 0.05 0.05 0.30 0.30 -0.05 -0.05 0.00 0.00 0.04 0.04 -0.23 -0.23 -0.10 -0.10 0.30 0.30 0.96 0.96 0.10 0.10 0.26 0.26 0.67 0.67 1.20 1.20

1m1m -0.20 -0.20 0.05 0.05 0.30 0.30 -0.08 -0.08 -0.03 -0.03 0.00 0.00 -0.26 -0.26 -0.10 -0.10 0.16 0.16 0.61 0.61 0.07 0.07 0.21 0.21 0.51 0.51 0.81 0.81

Now Now -0.20 -0.20 0.05 0.05 0.30 0.30 -0.14 -0.14 -0.05 -0.05 -0.01 -0.01 -0.23 -0.23 0.02 0.02 0.55 0.55 1.19 1.19 0.11 0.11 0.38 0.38 0.91 0.91 1.36 1.36

2015Q4* 2015Q4* -0.20 -0.20 0.05 0.05 0.30 0.30 -0.08 -0.08 -0.05 -0.05 0.00 0.00 -0.20 -0.20 0.00 0.00 0.50 0.50 1.10 1.10 0.10 0.10 0.30 0.30 0.80 0.80 1.20 1.20

2016Q1* 2016Q1* -0.20 -0.20 0.05 0.05 0.30 0.30 -0.08 -0.08 -0.05 -0.05 0.00 0.00 0.10 0.10 0.40 0.40 1.00 1.00 1.70 1.70 0.20 0.20 0.60 0.60 1.30 1.30 1.80 1.80

2016Q4* 2016Q4* -0.20 -0.20 0.05 0.05 0.30 0.30 -0.08 -0.08 0.05 0.05 0.10 0.10 0.20 0.20 0.60 0.60 1.40 1.40 2.20 2.20 0.30 0.30 0.80 0.80 1.60 1.60 2.30 2.30

Curve Curve Spreads Spreads Germany Germany 2s5s 2s5s Germany Germany 5s10s 5s10s Germany Germany 10s30s 10s30s 10y10y Bond Bond Swap Swap Spread Spread IRSIRS 2s5s 2s5s IRSIRS 5s10s 5s10s IRSIRS 10s30s 10s30s

3m3m 13 13 40 40 67 67 37 37 16 16 41 41 53 53

1m1m 16 16 26 26 45 45 35 35 15 15 29 29 30 30

Now Now 25 25 53 53 64 64 37 37 28 28 53 53 44 44

2015Q4* 2015Q4* 20 20 50 50 60 60 30 30

2016Q1* 2016Q1* 30 30 60 60 70 70 30 30

2016Q4* 2016Q4* 40 40 80 80 80 80 20 20

20 20 50 50 40 40

40 40 70 70 50 50

50 50 80 80 70 70

10y10y Government Government Bond Bond Yield Yield Spreads Spreads Finland Finland Netherlands Netherlands Austria Austria Belgium Belgium France France Ireland Ireland ItalyItaly Spain Spain Portugal Portugal Greece Greece

3m3m 2 2 5 5 8 8 24 24 28 28 58 58 105105 98 98 171171 894894

1m1m 6 6 15 15 12 12 27 27 26 26 56 56 129129 124124 182182 1256 1256

Now Now 6 6 20 20 14 14 31 31 30 30 71 71 135135 130130 193193 1121 1121

2015Q4* 2015Q4* 3 3 5 5 8 8 20 20 25 25 40 40 95 95 90 90 145145 900900

2016Q1* 2016Q1* 3 3 4 4 6 6 10 10 20 20 35 35 90 90 80 80 100100 750750

2016Q4* 2016Q4* 2 2 3 3 4 4 8 8 10 10 20 20 50 50 30 30 80 80 450450

Forecasts: Forecasts: ABNABN AMRO AMRO Group Group Economics Economics

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Fixed Income Focus: The path to QExit – 3 June 2015 Fixed Income Focus: The path to QExit – 3 June 2015

Introduction Introduction The ECB’s asset purchase programmes have been a major The ECB’s asset purchase programmes have been a major force in financial markets over the last year. QE had a long-run force in financial markets over the last year. QE had a long-run up, with a significant impact on asset prices as expectations up, with a significant impact on asset prices as expectations built that the central bank would finally take the road wellbuilt that the central bank would finally take the road welltrodden by other central banks. However, it has continued to trodden by other central banks. However, it has continued to have an impact on markets following both the announcement have an impact on markets following both the announcement and implementation. Government bond yields have seen a and implementation. Government bond yields have seen a long downward trend, though they have recently retraced long downward trend, though they have recently retraced some of their falls. some of their falls.

The next big question for investors is how long will QE The next big question for investors is how long will QE continue, or to put it another way, when will it end? In this note continue, or to put it another way, when will it end? In this note we assess the likely timing of the ECB’s exit from QE – or we assess the likely timing of the ECB’s exit from QE – or QExit – given our view of the macro outlook and the central QExit – given our view of the macro outlook and the central bank’s reaction function. We also look at the impact on fixed bank’s reaction function. We also look at the impact on fixed income markets. income markets.

Conditions necessary for QExit Conditions necessary for QExit The ECB has set out its framework for deciding how long QE The ECB has set out its framework for deciding how long QE will last. President Mario Draghi has stated that ‘purchases are will last. President Mario Draghi has stated that ‘purchases are intended to run until the end of September 2016 and, in any intended to run until the end of September 2016 and, in any case, until we see a sustained adjustment in the path of case, until we see a sustained adjustment in the path of inflation that is consistent with our aim of achieving inflation inflation that is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term’. rates below, but close to, 2% over the medium term’.

The ECB head clarified that the ECB would look through The ECB head clarified that the ECB would look through ‘transient’ effects on inflation, suggesting that an uptrend in ‘transient’ effects on inflation, suggesting that an uptrend in core inflation is a key element in assessing the success of the core inflation is a key element in assessing the success of the policy. Developments necessary to ensure this are ‘a further policy. Developments necessary to ensure this are ‘a further improvement in the economic outlook, a reduction in economic improvement in the economic outlook, a reduction in economic slack and a recovery in money and credit growth’. In addition, slack and a recovery in money and credit growth’. In addition, the ECB is looking for a ‘firm anchoring of inflation the ECB is looking for a ‘firm anchoring of inflation expectations’, suggesting these need to move back up to expectations’, suggesting these need to move back up to levels consistent with the price stability goal. levels consistent with the price stability goal.

The ECB’s inflation problem The ECB’s inflation problem HICP inflation, % yoy HICP inflation, % yoy

4 4 3 3 2 2 1 1 0 0 -1 -1 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 01 02 03Total 04 05 06 07Core 08 rate 09 10 11 12ECB 13target 14 15 Total Core rate ECB target

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

GDP growth to strengthen this year GDP growth to strengthen this year We expect GDP growth to step up a gear in the coming We expect GDP growth to step up a gear in the coming quarters. Net exports should benefit from the sharp quarters. Net exports should benefit from the sharp depreciation of the effective euro exchange rate since the depreciation of the effective euro exchange rate since the middle of last year, which was largely due to the anticipation middle of last year, which was largely due to the anticipation and implementation of the ECB’s QE policy. The effective euro and implementation of the ECB’s QE policy. The effective euro has fallen by more than 10% and we expect another has fallen by more than 10% and we expect another depreciation of around 5% during the rest of this year. depreciation of around 5% during the rest of this year.

Combined with a strengthening of the global economy after a Combined with a strengthening of the global economy after a weak Q1, this should result in eurozone exports accelerating. weak Q1, this should result in eurozone exports accelerating.

On top of this, domestic demand should gather momentum. To On top of this, domestic demand should gather momentum. To begin with, the drop in oil prices in the second half of last year begin with, the drop in oil prices in the second half of last year will continue to work its way through to domestic demand, will continue to work its way through to domestic demand, boosting GDP growth by around 1 percentage point on boosting GDP growth by around 1 percentage point on average during the year. average during the year.

Fall in the euro will lift net exports Fall in the euro will lift net exports Contribution to yoy GDP growth, %

% yoy % yoy

Contribution to yoy GDP growth, %

2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -0.5 -1.0 -1.0 -1.5 -1.5 -2.0 -2.0 98 98

00 02 04 00 02 04 Net exports (lhs) Net exports (lhs)

06 08 10 12 14 06 08 10 12 14 Euro trade-weighted (rhs, reversed) Euro trade-weighted (rhs, reversed)

-20 -20 -15 -15 -10 -10 -5 -5 0 0 5 5 10 10 15 15 20 20

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

Consumers getting a windfall from lower oil prices Consumers getting a windfall from lower oil prices Net gain from USD 50 drop in oil prices, % GDP Net 2.5gain from USD 50 drop in oil prices, % GDP

2.5 2.0 2.0

1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0

BE GR NL PT ES BE GR NL PT ES

FI FI

EZ DE AT EZ DE AT

IE IE

FR FR

IT IT

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

Moreover, financial conditions will continue to improve on the Moreover, financial conditions will continue to improve on the back of the ECB’s QE policy. This should also support private back of the ECB’s QE policy. This should also support private consumption and investment. Indeed, banks have eased consumption and investment. Indeed, banks have eased lending conditions and the bank credit channel is working lending conditions and the bank credit channel is working again, both in the core eurozone countries and in the again, both in the core eurozone countries and in the

5

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Fixed Income Focus: The path to QExit – 3 June 2015 Fixed Income Focus: The path to QExit – 3 June 2015

periphery. Furthermore, bank lending conditions for SMEs are periphery.

Furthermore, conditions SMEs are now easing faster than for bank largelending firms. Overall, we for expect now easing faster than for large firms. Overall, expect growth to strengthen to levels of around 0.6-0.7%we qoq in the growth to strengthen to levels of around 0.6-0.7% qoq in the second half of 2015, which is well above the potential rate of

second half of 2015, which is well above potential rate around 0.2-0.3%.

In 2016, quarterly growththe is expected to of around In 2016, settle at a0.2-0.3%. slightly lower rate quarterly of aroundgrowth 0.5%. is expected to settle at a slightly lower rate of around 0.5%.

Banks easing lending standards to companies Banks easing lending standards to companies % net tightening % net tightening

70 6070 Tighter 5060 Tighter 4050 3040 2030 1020 010 -10 0 Easier -20-10 Easier 03 04 05 06 07 08 09 10 11 12 13 14 15 -20 03 04 05 06 07 08 09 10 11 12 13 14 15 Large firms SMEs Large firms SMEs

Source: Thomson Reuters Datastream, ECB Bank Lending Survey Source: Thomson Reuters Datastream, ECB Bank Lending Survey

Bank loan rates to companies falling Bank loan rates to companies falling Loans up to EUR 1 million, % Loans up to EUR 1 million, %

7.0 7.0 6.0 6.0 5.0 5.0 4.0 4.0 3.0 3.0 2.0 03 04 05 06 07 08 09 10 11 12 13 14 15 2.0 03 04 05 06 07 08 09 10 11 12 13 14 15 Loans up to 1 year Loans 1-5 years Loans up to 1 year Loans 1-5 years

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

Core inflation will follow, but with a lag Core inflation will follow, but with We expect core inflation to remain lowainlag 2015, but to rise

We expectincore inflation to remain lowrates in 2015, but to may rise significantly 2016.

Economic growth of 1.5-2% significantly in 2016.

Economic growth rates of 1.5-2% may seem too moderate to trigger inflationary pressures on the

growth – signals that service sector inflation should start to rise growth signals service inflation later this–year, butthat much moresector significantly in should 2016. start to rise later this year, but much more significantly in 2016.

Closing of output gap should push up core inflation Closing of output gap should push up core inflation % 4 34 23 12 01 -10 -2-1 -3-2 -4-3 -5-4 -597 99 01 03 05 97 99 01 03 05 Output gap (lhs) Output gap (lhs)

%

07 07

09 11 13 15 17 09 11 13 15 17 Service price inflation (rhs) Service price inflation (rhs)

3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

The past fall in the euro should also push up core inflation next The past fall in theof euro shouldprice alsopressures push up core inflation next year.

Our indicator external – made up of year. Our indicator price pressures – made up–ofhas global prices dividedofbyexternal the euro effective exchange rate global prices divided by the euro effective exchange rate – has risen sharply over recent months due to the euro’s decline. risensuggests sharply over recent months due toInthe euro’s That import prices will follow. turn, coredecline. goods That suggests import prices will follow.

In turn, price inflation follows import price inflation with acore longgoods lag price inflation follows price inflation with a long lag (around one and a halfimport years). (around one and a half years).

Fall in the euro should push up import prices Fall in the euro should push up import prices % yoy 8 68

% yoy

46 24

15 10 510

02 -20

-4-2 -6-4

-606 06

20 20 15

05 0 -5

07 08 09 10 11 07 08 09 10 11 import prices ex. energy (lhs) import prices ex. energy (lhs)

-5 -10 -10 -15

12 13 14 15 -15 12 13 14 15 global prices/EER (rhs) global prices/EER (rhs)

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

seem too moderate to trigger on the surface.

However, trend growthinflationary has slowedpressures considerably in surface.

However, trend growth has slowed considerably in recent years. For instance, the OECD and European

Inflation expectations to increase Inflation expectations to increase Inflation expectations dropped sharply in the second half of

That means economic should fade over quarters, partlythat reflected in a slack significant decline in coming quarters, partly reflected in a significant decline in growth. unemployment, which should eventually impact wage

measures andAnchoring was a keythe reason that triggered the ECB tobased start its QE policy. expectations for inflation in to start its QE policy.

Anchoring the expectations for inflation in the medium to longer term is of vital importance to the ECB, as

recent years.

For instance, the growth OECD and European Commission estimate that trend is now around 1%.

Commission estimate that trend growth is now around 1%.

That means that economic slack should fade over coming

unemployment, which should eventually impact wage growth.

The figure below shows that changes in the output gap leads The figure below shows changes in the outputOur gap leads service sector inflation withthat a lag of around a year. service sector with–ausing lag ofour around a year. Ourfor projection of the inflation output gap own estimates projection of the output gap – using our own estimates for

Inflation dropped sharply in themarket secondand halfsurvey of 2014.

Thisexpectations was reflected in several financial 2014.

This was reflected in several financial market and survey based measures and was a key reason that triggered the ECB

the medium longer is ofsure vital that importance ECB, as its only policytotarget is term to make inflationto is the below, but its only policy target is to make sure that inflation is below, but close to 2% in the medium term. close to 2% in the medium term.

Fixed Income Focus: The path to QExit – 3 June 2015 Fixed Income Focus: The path to QExit – 3 June 2015

6 6

Since the start of this year, inflation expectations have started Since the start of this year, inflation expectations have started to recover. Although the announcement of the ECB’s QE policy to recover. Although the announcement of the ECB’s QE policy might have played some part, the rise in inflation expectations might have played some part, the rise in inflation expectations seems to be mainly due to oil prices rebounding (just as falling seems to be mainly due to oil prices rebounding (just as falling inflation expectations last year had coincided with the sharp inflation expectations last year had coincided with the sharp drop in oil prices) and headline inflation moving higher (from drop in oil prices) and headline inflation moving higher (from 0.6% yoy in January to 0.0% in April).

0.6% yoy in January to 0.0% in April).

Indeed, inflation expectations for the short to medium term Indeed, inflation expectations for the short to medium term tend to move closely in sync with current levels of inflation (see tend to move closely in sync with current levels of inflation (see graph below). As we expect the headline inflation rate to jump graph below). As we expect the headline inflation rate to jump higher around the end of this year on the back of higher foodhigher around the end of this year on the back of higher foodand energy price inflation, inflation expectations will probably and energy price inflation, inflation expectations will probably jump higher as well. Indeed, we expect the inflation jump higher as well. Indeed, we expect the inflation expectations to rise to levels closer to the ECB target around expectations to rise to levels closer to the ECB target around the end of this year. the end of this year.

Rising import prices to push up core inflation Rising import prices to push up core inflation % yoy % yoy

8 8 6 6 4 4 2

2 0 0 -2

-2 -4 -4 -6

-6 06 06

07 07

08 09 10 08 09 10 import prices (lhs) import prices (lhs)

11 11

12 13 14 15 12 13 14 15 core cpi ind goods (rhs) core cpi ind goods (rhs)

2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -0.5

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

Inflation expectations follow current inflation Inflation expectations follow current inflation% yoy % %

2.5 2.5 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -0.5 Jan-12 Jan-12 2y ahead 2y ahead

% yoy

3.0 3.0 2.5

2.5 2.0 2.0 1.5

1.5 1.0 1.0 0.5

0.5 0.0 0.0 -0.5 Jan-13 Jan-14 Jan-13 Jan-14 Medium-term to long-term Medium-term to long-term

-0.5 -1.0 -1.0

Jan-15 HICPJan-15 inflation (rhs) HICP inflation (rhs)

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Thomson Reuters Datastream, ABN AMRO Group Economics

In the medium term, leaving commodity prices and exchange In the medium term, leaving commodity prices and exchange rate effects aside, inflation is driven by wage increases. In turn, rate effects aside, inflation is driven by wage increases. In turn, wages are driven by the situation on the labour market. In wages are driven by the situation on the labour market. In short, eurozone inflation can only return to the ECB’s target if short, eurozone inflation can only return to the ECB’s target if

the economy grows at a pace sufficient to reduce slack and the economy grows at a pace sufficient to reduce slack and unemployment in particular. As mentioned earlier in this note, unemployment in particular. As mentioned earlier in this note, we judge that the outlook is encouraging as the economy we judge that the outlook is encouraging as the economy appears to be gaining momentum and unemployment has appears to be gaining momentum and unemployment has trended lower for some time, a development we expect to trended lower for some time, a development we expect to continue. continue.

ECB unlikely to waver this year ECB unlikely to waver this year The big question is how the ECB will respond to this base The big question is how the ECB will respond to this base scenario. We think that President Mario Draghi’s message will scenario. We think that President Mario Draghi’s message will be unwavering this year, starting with the June press be unwavering this year, starting with the June press conference following the Governing Council meeting. He will conference following the Governing Council meeting. He will state clearly that there will be no early tapering and that QE will state clearly that there will be no early tapering and that QE will be implemented in full. be implemented in full.

Mr. Draghi will have the evidence on his side. We have only Mr. Draghi will have the evidence on his side. We have only just seen signs of a more convincing recovery, while core just seen signs of a more convincing recovery, while core inflation remains low, below target and with no signs yet of inflation remains low, below target and with no signs yet of turning up. Inflation expectations have risen but remain at turning up. Inflation expectations have risen but remain at historically low levels. Moreover, the QE programme is only a historically low levels. Moreover, the QE programme is only a few months old. So, we think the ECB will want to fight against few months old. So, we think the ECB will want to fight against any early tightening of financial conditions due to higher bond any early tightening of financial conditions due to higher bond yields and a stronger euro, as it could nip the economic yields and a stronger euro, as it could nip the economic recovery in the bud. recovery in the bud.

Forecasters see less downside risk Forecasters see less downside risk Inflation 5 years ahead, probability distribution, %

Inflation 5 years ahead, probability distribution, %

35 35 30 30 25 25 20 20 15 15 10 10 11 12 13 11 12 13 Probability of inflation below target Probability of inflation below target

14 15 14 15 Probability of above target Probability of above target

Source: Thomson Reuters Datastream, ECB Professional Forecasters Source: Thomson Reuters Datastream, ECB Professional Forecasters

Another reason for the ECB not to consider an early tapering Another reason for the ECB not to consider an early tapering to their programme is the situation around Greece. So far, the to their programme is the situation around Greece. So far, the continued difficulties around the Greek situation have not led to continued difficulties around the Greek situation have not led to significant contagion to other peripheral bond markets. This is significant contagion to other peripheral bond markets. This is possibly partly because of the ECB’s asset purchase possibly partly because of the ECB’s asset purchase programme. The ECB would certainly not want to risk programme. The ECB would certainly not want to risk unsettling financial markets. unsettling financial markets.

Situation could change at the turn of the year Situation could change at the turn of the year However, as we move into next year, the ECB’s tone could However, as we move into next year, the ECB’s tone could change. By then we would have seen a number of quarters of change. By then we would have seen a number of quarters of

7 Fixed Income Focus: The path to QExit – 3 June 2015 7 7 Fixed Fixed Income Income Focus: Focus: The The path path toto QExit QExit –3 – June 3 June 2015 2015

better economic growth, while credit to the private sector will better better economic economic growth, growth, while while credit credit to to thethe private private sector sector willwill also have expanded. Core inflation will have shown some also also have have expanded. expanded.

Core Core inflation inflation willwill have have shown shown some some signs of turning the corner. Headline inflation will be much signs signs of of turning turning thethe corner. corner.

Headline Headline inflation inflation willwill bebe much much higher, while inflation expectations will have risen further. The higher, higher, while while inflation inflation expectations expectations willwill have have risen risen further. further.

The The Governing Council’s confidence that it will meet its inflation Governing Governing Council’s Council’s confidence confidence that that it will it will meet meet itsits inflation inflation target over the medium term should be stronger. Overall, it will target target over over thethe medium medium term term should should bebe stronger. stronger.

Overall, Overall, it will it will become clearer that September 2016 is very likely the end become become clearer clearer that that September September 2016 2016 is is very very likely likely thethe end end point for QE. point point forfor QE. QE.

ABN AMRO inflation forecast ABN ABN AMRO AMRO inflation inflation forecast forecast % yoy

The ECB could also decide to taper purchases rather than end The The ECB ECB could could also also decide decide to to taper taper purchases purchases rather rather than than end end the programme in one step in September 2016. In any case, thethe programme programme in in one one step step in in September September 2016.

2016.

In In any any case, case, we think Mr. Draghi could well signal that conditional on the wewe think think Mr.Mr. Draghi Draghi could could well well signal signal that that conditional conditional onon thethe data, QE will end later in the year. He will also likely data, data, QEQE willwill end end later later in in thethe year. year.

HeHe willwill also also likely likely emphasise that policy rates will remain at current levels far emphasise emphasise that that policy policy rates rates willwill remain remain at at current current levels levels farfar beyond that point. beyond beyond that that point. point.

% yoy % yoy

2.5 2.5 2.02.5 2.0 1.52.0 1.5 1.01.5 1.0 0.51.0

0.5 0.00.5 0.00.0 -0.5 -0.5 -0.5 -1.0

-1.0 -1.0 13 13 13

14 14 14

15 16 17 15 15 16 16 17 17 All items Core All All items items Core Core

18 18 18

Source: Thomson Reuters Datastream, ABN AMRO Group Economics Source: Source: Thomson Thomson Reuters Reuters Datastream, Datastream, ABN ABN AMRO AMRO Group Group Economics Economics

March 2016 ECB meeting could be a watershed March March 2016 2016 ECB ECB meeting meeting could could bebe a watershed a watershed The Governing Council meeting of March 2016 could be a The The Governing Governing Council Council meeting meeting of of March March 2016 2016 could could bebe a a pivotal one. The ECB will publish updated forecasts for growth pivotal pivotal one. one.

The The ECB ECB willwill publish publish updated updated forecasts forecasts forfor growth growth and inflation, but will also extend its forecasting horizon to and and inflation, inflation, butbut willwill also also extend extend itsits forecasting forecasting horizon horizon to to 2018. The central bank is currently projecting inflation roughly 2018.

2018.

The The central central bank bank is is currently currently projecting projecting inflation inflation roughly roughly on target in 2017 at 1.8%, assuming QE continues until onon target target in in 2017 2017 at at 1.8%, 1.8%, assuming assuming QEQE continues continues until until September 2016. Therefore, by then it could start showing September September 2016.

2016.

Therefore, Therefore, byby then then it could it could start start showing showing inflation around the goal in 2018 as well. inflation inflation around around thethe goal goal in in 2018 2018 asas well. well.

ECB projections in March 2015 ECB ECB projections projections in in March March 2015 2015 % %%

2.5 2.52.5 2.0 2.02.0 1.5 1.51.5 1.0 1.01.0 0.5 0.50.5 0.0 0.00.0

1.5 1.51.5

0.0 0.00.0 2015 2015 2015

1.9 1.91.9

2.1 2.12.1 1.5 1.51.5

2016 2016 2016 GDP HICP GDP GDP HICP HICP

financial markets had time to adjust to the idea. In May 2013, financial financial markets markets had had time time to to adjust adjust to to thethe idea. idea.

In In May May 2013, 2013, the previous Fed Chairman, Ben Bernanke, said in comments thethe previous previous Fed Fed Chairman, Chairman, Ben Ben Bernanke, Bernanke, said said in in comments comments to Congress ‘that if we see continued improvement, and we to to Congress Congress ‘that ‘that if we if we see see continued continued improvement, improvement, and and wewe have confidence that that is going to be sustained, in the next have have confidence confidence that that that that is is going going to to bebe sustained, sustained, in in thethe next next few meetings we could take a step down in our pace of few few meetings meetings wewe could could take take a step a step down down in in ourour pace pace of of purchases’. The tapering of purchases preceded in December purchases’. purchases’.

The The tapering tapering of of purchases purchases preceded preceded in in December December of that year, with a small reduction in the monthly pace of asset of of that that year, year, with with a small a small reduction reduction in in thethe monthly monthly pace pace of of asset asset purchases, and the programme was wound down completely purchases, purchases, and and thethe programme programme was was wound wound down down completely completely

by October 2014. byby October October 2014.

2014.

1.8 1.81.8

2017 2017 2017

Source: Thomson Reuters Datastream, ECB Source: Source: Thomson Thomson Reuters Reuters Datastream, Datastream, ECB ECB

Communicating the QExit Communicating Communicating the the QExit QExit In the US, when the FOMC judged that the point to wind down In In thethe US, US, when when thethe FOMC FOMC judged judged that that thethe point point to to wind wind down down QE was advancing, it started to change its tone, so that QEQE was was advancing, advancing, it started it started to to change change itsits tone, tone, soso that that

Key assumptions in our base case Key Key assumptions assumptions in in our our base base case case On balance, we think that the most likely scenario is that the OnOn balance, balance, wewe think think that that thethe most most likely likely scenario scenario is that is that thethe ECB will finish the purchasing programme it is committed to.

ECB ECB willwill finish finish thethe purchasing purchasing programme programme it is it committed is committed to.to.

There is, however, a chance that they will announce a gradual There There is,is, however, however, a chance a chance that that they they willwill announce announce a gradual a gradual tapering of the programme in the second half of next year. The tapering tapering of of thethe programme programme in in thethe second second half half of of next next year. year.

The The latter can only happen if the economy continues to grow above latter latter can can only only happen happen if the if the economy economy continues continues to to grow grow above above trend, inflation, inflation expectations and inflation forecasts trend, trend, inflation, inflation, inflation inflation expectations expectations and and inflation inflation forecasts forecasts move higher and the euro crisis does not re-escalate. move move higher higher and and thethe euro euro crisis crisis does does notnot re-escalate. re-escalate.

Two other key judgements are important. First of all, that there Two Two other other key key judgements judgements areare important. important.

First First of of all,all, that that there there will be a relatively benign resolution to the Greek crisis. willwill bebe a relatively a relatively benign benign resolution resolution to to thethe Greek Greek crisis. crisis.

Second, that the Fed will raise its key policy rates later this Second, Second, that that thethe Fed Fed willwill raise raise itsits key key policy policy rates rates later later this this year, which should assist the ECB in keeping downward year, year, which which should should assist assist thethe ECB ECB in in keeping keeping downward downward pressure on EUR/USD. If the Fed were to wait longer, this pressure pressure onon EUR/USD. EUR/USD. If the If the Fed Fed were were to to wait wait longer, longer, this this could put upward pressure on the euro, which would also could could putput upward upward pressure pressure onon thethe euro, euro, which which would would also also increase the possibility that the ECB needs to signal an increase increase thethe possibility possibility that that thethe ECB ECB needs needs to to signal signal anan extension of QE to keep the euro on a downward trend. extension extension of of QEQE to to keep keep thethe euro euro onon a downward a downward trend. trend.

Bond yields are expected to fall again Bond Bond yields yields areare expected expected to to fallfall again again So what does our base scenario mean for fixed income SoSo what what does does ourour base base scenario scenario mean mean forfor fixed fixed income income markets? The recent surge in government bond yields raises markets? markets?

The The recent recent surge surge in in government government bond bond yields yields raises raises the question whether eurozone QE is becoming a textbook thethe question question whether whether eurozone eurozone QEQE is is becoming becoming a textbook a textbook example and following the same development as US Treasury example example and and following following thethe same same development development asas USUS Treasury Treasury yields did under the Fed’s QE (see chart below). We do not yields yields diddid under under thethe Fed’s Fed’s QEQE (see (see chart chart below). below).

We We dodo notnot think so. We think the drivers of the sudden rise in yields are think think so.so.

We We think think thethe drivers drivers of of thethe sudden sudden rise rise in in yields yields areare mostly temporary in nature or are simply misplaced. mostly mostly temporary temporary in in nature nature or or areare simply simply misplaced. misplaced.

A big difference between the Fed’s QE programme and the A big A big difference difference between between thethe Fed’s Fed’s QEQE programme programme and and thethe ECB’s PSPP is that the US government was running large ECB’s ECB’s PSPP PSPP is is that that thethe USUS government government was was running running large large deficits when the Fed started buying bonds. Even after the deficits deficits when when thethe Fed Fed started started buying buying bonds. bonds.

Even Even after after thethe Fed’s purchases, net bond supply was positive. The situation Fed’s Fed’s purchases, purchases, netnet bond bond supply supply was was positive. positive.

The The situation situation in the eurozone is different. Germany, for example, is running in in thethe eurozone eurozone is is different. different.

Germany, Germany, forfor example, example, is running is running a modest budget surplus. So after the ECB’s purchases of a modest a modest budget budget surplus. surplus.

SoSo after after thethe ECB’s ECB’s purchases purchases of of Bunds, net supply is actually significantly negative. The recent Bunds, Bunds, netnet supply supply is is actually actually significantly significantly negative. negative.

The The recent recent

Fixed Income Focus: The path to QExit – 3 June 2015 Fixed Income Focus: The path to QExit – 3 June 2015

rise in eurozone yields came at a time in which net supply in rise in eurozone yields came at a time in which net supply in government bonds was temporarily positive. This therefore government bonds was temporarily positive. This therefore weighed on the market. However, if we look beyond and focus weighed on the market. However, if we look beyond and focus on the months to come, we calculate that net bond supply will on the months to come, we calculate that net bond supply will become significantly negative again. become significantly negative again.

Impact of US QE on 10y Treasury yields Impact of US QE on 10y Treasury yields 10y, % 10y, %

In EUR bn

180 180 120 120 60 60 0 0 -60 -60 -120 -120Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Net adjusted flow Issuance Redemptions Net adjusted flow Issuance Redemptions

Source: Bloomberg, ABN AMRO Group Economics Source: Bloomberg, ABN AMRO Group Economics

2015 Net flow in eurozone government debt 2015 Net flow in eurozone government debt

4 4 9 9 4 4 5 5 8 8 13 13 81 81 60 60 109 109 14 14

Purchases Purchases in 2015 in 2015 118 118 26 26 13 13 8 8 11 11 16 16 81 81 58 58 93 93 8 8

Adjusted Adjusted Net Flow Net Flow -114 -114 -18 -18 -9 -9 -3 -3 -4 -4 -3 -3 0 0 2 2 16 16 6 6

306 306

432 432

-126 -126

Country Country

Net supply* Net supply*

DE DE NL NL AT AT FI FI PT PT BE BE IT IT SP SP FR FR IR IR Total Total

Net flow % Net flow % Total market** Total market** -15 -15 -7 -7 -5 -5 -4 -4 -4 -4 -1 -1 0 0 0 0 1 1 6 6

*Includes issuance of fixed coupon bonds, linkers and FRNs *Includes issuance of fixed coupon bonds, linkers and FRNs **Includes 2-30y government bonds, net flow is corrected for supply **Includes 2-30y government bonds, net flow is corrected for supply Source: ABN AMRO Group Economics, Bloomberg, National DMOs Source: ABN AMRO Group Economics, Bloomberg, National DMOs

Dec Dec

Nov Nov

Oct Oct

Sept Sept

Aug Aug

Scarcity of AAA bonds will remain a key driver Scarcity of AAA bonds will remain a key driver QE purchases will decrease the availability of outstanding QE purchases will decrease the availability of outstanding bonds to other investors in the coming months. We calculate bonds to other investors in the coming months. We calculate that especially core bond markets will be severely impacted that especially core bond markets will be severely impacted (see table below). This will, in time, create acute scarcity, with (see table below). This will, in time, create acute scarcity, with the outstanding stock of AAA government bonds shrinking the outstanding stock of AAA government bonds shrinking significantly after ECB purchases. significantly after ECB purchases.

10 10 0 0 -10 -10 -20 -20 -30 -30

July July

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

In EUR bn

June June

14 14 10yr yield 10yr yield

May May

12 13 12 Tapering dry13run Tapering dry run

Apr Apr

10 11 10 11 QE periods QE periods

March March

09 09 Tapering Tapering

… especially in Summer and in December … especially in Summer and in December In EUR bn

Feb Feb

4.5 4.5 4.0 4.0 3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 1.0 08 08

ECB purchases will lead to Bund scarcity…

ECB purchases will lead to Bund scarcity…

In EUR bn

Jan Jan

8 8

Net adjusted flow Net adjusted flow

Source: Bloomberg, ABN AMRO Group Economics Source: Bloomberg, ABN AMRO Group Economics

Covered bond redemptions peak in June Covered bond redemptions peak in June Redemptions of euro benchmark covered bonds (EUR bn) Redemptions of euro benchmark covered bonds (EUR bn)

30 30 25 25 20 20 15 15 10 10 5 5 0 0

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

Source: Markit, Bloomberg, ABN AMRO Group Economics Source: Markit, Bloomberg, ABN AMRO Group Economics

The (expected) impact of scarcity will likely push yields lower in The (expected) impact of scarcity will likely push yields lower in coming months. Since the ECB will only buy bonds with yields coming months. Since the ECB will only buy bonds with yields higher than -20bps, we think that as yields decline, the selfhigher than -20bps, we think that as yields decline, the selfreinforcing QE circle of lower yields will emerge again. This reinforcing QE circle of lower yields will emerge again. This reflects that as yields fall the universe of eligible bonds will reflects that as yields fall the universe of eligible bonds will become smaller making scarcity more acute, and increasing become smaller making scarcity more acute, and increasing

9

9

Fixed Income Focus: The path to QExit – 3 June 2015 Fixed Income Focus: The path to QExit – 3 June 2015

the downward pressure on yields and so on. Over the summer, the downward pressure on yields and so on. Over the summer, net supply of government bonds after ECB purchases net supply of government bonds after ECB purchases becomes deeply negative again. becomes deeply negative again.

This also holds for the covered bonds, as June will be the peak This also holds for the covered bonds, as June will be the peak month in terms of redemptions, money that investors need to month in terms of redemptions, money that investors need to put to work again. Moreover, covered bond spreads should put to work again. Moreover, covered bond spreads should narrow again as this is the third consecutive year of negative narrow again as this is the third consecutive year of negative net supply. Meanwhile, in the case of agencies scarcity is even net supply. Meanwhile, in the case of agencies scarcity is even more acute than in the case of government bonds, which more acute than in the case of government bonds, which should see them outperform. should see them outperform.

Box 1: When scarcity kicks in, what will the ECB do?

Box 1: When scarcity kicks in, what will the ECB do?

ECB President Mario Draghi has mentioned on several ECB President Mario Draghi has mentioned on several occasions that the QE programme has a flexible set up and occasions that the QE programme has a flexible set up and that it can change over time. We judge that when scarcity kicks that it can change over time. We judge that when scarcity kicks in, the ECB will once again change the programme by in, the ECB will once again change the programme by increasing the universe of eligible bonds. increasing the universe of eligible bonds.

Alternative options to alleviate scarcity of government bonds Alternative options to alleviate scarcity of government bonds include the lowering of the forward guidance, detaching the include the lowering of the forward guidance, detaching the floor of –20bps, breaching the maximum amount held by floor of –20bps, breaching the maximum amount held by Collective Action Clause and abandoning the ECB capital key Collective Action Clause and abandoning the ECB capital key for the composition of its purchases. However, we think that an for the composition of its purchases. However, we think that an expansion of the universe would be the most plausible as other expansion of the universe would be the most plausible as other alternatives will be either politically not feasible or ineffective. alternatives will be either politically not feasible or ineffective.

The trump card: inclusion of Länder bonds The trump card: inclusion of Länder bonds The most effective way from a big picture perspective to The most effective way from a big picture perspective to alleviate scarcity of especially AAA bonds is to include German alleviate scarcity of especially AAA bonds is to include German Länder bonds.

Länder bonds.

If the ECB were to decide to add Länder bonds to its list, we If the ECB were to decide to add Länder bonds to its list, we calculate that it would alleviate scarcity of German bonds calculate that it would alleviate scarcity of German bonds significantly. However, we also come to the conclusion that significantly. However, we also come to the conclusion that scarcity of German government bonds will not be fully scarcity of German government bonds will not be fully eradicated. We think that including Länder bonds will at best eradicated. We think that including Länder bonds will at best bring scarcity of Bunds more into line with other core eurozone bring scarcity of Bunds more into line with other core eurozone government bond markets. Including this new asset class government bond markets. Including this new asset class would make sense, as it makes up for the largest sub would make sense, as it makes up for the largest sub sovereign market in the eurozone. Total outstanding Länder sovereign market in the eurozone. Total outstanding Länder bonds between 2 and 30 years, equate to around one third of bonds between 2 and 30 years, equate to around one third of the German government bond market. the German government bond market.

In addition, the credit quality of Länder bonds is high, which In addition, the credit quality of Länder bonds is high, which would be important for the Bundesbank. The strong credit would be important for the Bundesbank. The strong credit quality can be explained by the implicit guarantee of the quality can be explained by the implicit guarantee of the German Federal government, the equal footing of the German German Federal government, the equal footing of the German states with the Federal government and the solidarity principle states with the Federal government and the solidarity principle between German states. Although it makes sense from an between German states. Although it makes sense from an economic perspective to include Länder bonds, we do think economic perspective to include Länder bonds, we do think

that before Länder bonds can be included, some political that before Länder bonds can be included, some political obstacles will first need to be solved in the Governing Council. obstacles will first need to be solved in the Governing Council.

Inclusion of corporate bonds is unlikely but still an option Inclusion of corporate bonds is unlikely but still an option Another option to alleviate the tightness in the government Another option to alleviate the tightness in the government bond and SSA markets would be to include nonfinancial bond and SSA markets would be to include nonfinancial corporate bonds in the eligible universe. ECB Governing corporate bonds in the eligible universe. ECB Governing Council member Hansson said in an interview in April that the Council member Hansson said in an interview in April that the expansion of the list of eligible institutions was a “first stage” in expansion of the list of eligible institutions was a “first stage” in the discussion of what else could be included. He also said the discussion of what else could be included. He also said that in the “second stage” in the coming months, it will be that in the “second stage” in the coming months, it will be discussed if and how much corporate debt should be included. discussed if and how much corporate debt should be included.

The total pool of senior bonds of eurozone nonfinancial The total pool of senior bonds of eurozone nonfinancial investment grade issuers is EUR 500bn. investment grade issuers is EUR 500bn.

Still, there are some issues with corporate bonds. For Still, there are some issues with corporate bonds. For example, the ECB concluded earlier this year that the credit example, the ECB concluded earlier this year that the credit easing potential of corporate bond issues would be rather easing potential of corporate bond issues would be rather small, given the market size and the yield level at that time. small, given the market size and the yield level at that time.

However, the ECB did not exclude broadening its scope to However, the ECB did not exclude broadening its scope to corporate bonds in the future. Another issue is liquidity in the corporate bonds in the future. Another issue is liquidity in the secondary corporate bond market. The liquidity in the secondary corporate bond market. The liquidity in the secondary market for corporate bonds is already much lower secondary market for corporate bonds is already much lower than is the case in the government bond market or covered than is the case in the government bond market or covered bond market. bond market.

Ongoing QE supportive of 2s5s flatteners Ongoing QE supportive of 2s5s flatteners We judge that the ongoing QE purchases will push core We judge that the ongoing QE purchases will push core government bond yields down, although we do not think we will government bond yields down, although we do not think we will reach the lows seen earlier in the year. The downward move in reach the lows seen earlier in the year. The downward move in yields will mostly be accompanied by curve flattening, yields will mostly be accompanied by curve flattening, especially in 2s5s, which is much steeper than even before the especially in 2s5s, which is much steeper than even before the announcement of QE. We are also supportive of country announcement of QE. We are also supportive of country spreads, as we think that risk sentiment will improve further on spreads, as we think that risk sentiment will improve further on the back of improved economic momentum and the search for the back of improved economic momentum and the search for yield. As noted above, this assumes crucially that there will be yield. As noted above, this assumes crucially that there will be an agreement between Greece and its creditors. an agreement between Greece and its creditors.

Ongoing QE supportive of spreads Ongoing QE supportive of spreads We expect credit spreads to slowly grind tighter as the QE We expect credit spreads to slowly grind tighter as the QE programme progresses. A major driver of spreads will be programme progresses. A major driver of spreads will be supply. We expect that many issuers still want to make use of supply. We expect that many issuers still want to make use of the low yield environment as long as it lasts. If the primary the low yield environment as long as it lasts. If the primary market succeeds in controlling the volume of new deals to a market succeeds in controlling the volume of new deals to a digestible flow, it will be supportive for spreads and we will digestible flow, it will be supportive for spreads and we will revisit the levels seen earlier in the beginning of March. On the revisit the levels seen earlier in the beginning of March. On the other hand, if we return to the high volumes of February and other hand, if we return to the high volumes of February and March, the secondary market won’t be able to absorb the flow March, the secondary market won’t be able to absorb the flow and spreads will be pushed wider. and spreads will be pushed wider.

Fixed Income Focus: The path to QExit – 3 June 2015 Fixed Income Focus: The path to QExit – 3 June 2015

10 10

Credit resilient during Bund tantrum Credit resilient during Bund tantrum Index

% %

Index

90 90 80

0.8 0.8 0.7 0.7 0.6 0.6 0.5 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.1 0.1 0 0

80 70 70 60 60 50 50 40 40 30 30 20

201/1/15 1/1/15

1/2/15 1/3/15 1/2/15 1/3/15 iBoxx Non-financials (lha) iBoxx Non-financials (lha)

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

have estimated that negative net supply will amount to EUR have estimated thatcorrecting negative net supply will purchases amount to in EUR 17bn this year, but for the ECB’s the

1/4/15 1/5/15 1/4/15 1/5/15 10y Bund yield (rha) 10y Bund yield (rha)

Asw-spread iBoxx euro benchmark covered bond index (bps)

bonds largestbonds in theare periphery, higher in spread levels, is asthe covered already reflecting quite expensive the levels, as covered bonds are already quite expensive in the (semi) core countries. Spreads of non-CBPP3 eligible paper, (semi) countries. of covered non-CBPP3 eligible paper, such ascore Canadian andSpreads Australian bonds, are also such as Canadian Australian bonds, also expected to tightenand further, as theycovered are trading withare a pickup expected to tighten further, as they are trading with a pickup versus (semi) core covered bonds. versus (semi) core covered bonds.

Ongoing QE and – as a result – lower on core yields should put downward pressure thegovernment euro in the bond yields should put downward pressure on the in the coming months. At the same time, we expecteuro the Fed to hike

coming the same time, expect the to hike its policymonths. rates inAt September, whichwe should see a Fed stepping up its policy rates in September, which should see a stepping up of investor expectations for US short term interest rates. This

of investor expectations US short term interest This policy divergence shouldfor see the EUR/USD falling rates. significantly policy divergence should see the EUR/USD falling significantly further. further.

CBPP3 CBPP3

08 08

09 09

10 10

11 11

12 12

13 13

14 14

15 15

would taper its asset purchases (see graph below).

2.5 2.5

72 72

-89 -89

2010 2010

2011 2011

Bernanke taper speech Bernanke taper speech

2.0 2.0

67 67

-36 -36

2009 2009

Treasury rose significantly the previous Chairman,yields Ben Bernanke, raised after the possibility thatFed the Fed Chairman, Ben Bernanke, raised the possibility that the Fed would taper its asset purchases (see graph below).

3.0 3.0

in bps (asw-spread)

2008 2008

Looking how will the ECB’s QExit markets?further Againforward, we can draw on lessons from the impact US. US markets?

Again rose we can draw on lessons the US. Treasury yields significantly after thefrom previous FedUS

10y, %

Tightening of covered bond spreads Tightening of covered bond spreads in bps (asw-spread)

97 97

Lessons from the US taper ‘dry-run’ Lessons from the US taper ‘dry-run’ Looking further forward, how will the ECB’s QExit impact

Increase of yield after the taper speech Increase of yield after the taper speech 10y, %

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

150 150 100 100 50 50 0 0 -50 -50 -100 -100

We think that the potential for tightening of spreads of covered We think thatlargest the potential for tightening of spreads of spread covered bonds is the in the periphery, reflecting higher

Further euro weakness ahead Further weakness ahead Ongoingeuro QE and – as a result – lower core government bond

Covered bonds also resilient during Bund tantrum Covered bonds also resilient during Bund tantrum Asw-spread iBoxx euro benchmark covered bond index (bps) 250 250 200 200 150 150 100 100 50 50 0 0 -50 -50 07 07

17bn thismarket, year, but for the ECB’s purchases primary thiscorrecting amount might rise to EUR 50bn. in the primary market, this amount might rise to EUR 50bn.

2012 2012

-65 -65

2013 2013

-33 -33

2014 2014

-16 -16

2015 2015

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

Spreads of covered bonds are also expected to continue to Spreads of covered bonds are also to continue to tighten, albeit to a lesser extent thanexpected in previous years. The

tighten, to aaround lesser EUR extent than in aprevious years.

The ECB hasalbeit bought 11-12bn month of covered ECB has bought around EUR 11-12bn a month of covered bonds since the start of the year and although we still expect

bonds sincetothe start of the year andthe although we still expect purchases slow somewhat during remainder of the year, purchases to slow somewhat during the remainder of the CBPP3 will result in paper becoming increasingly scarce. year, We CBPP3 will result in paper becoming increasingly scarce. We

1.5 May-13 1.5 May-13

Jun-13 Jun-13

Jul-13 Aug-13 Jul-13 Aug-13 10y Treasury 10y Treasury

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

Sep-13 Sep-13

11 Fixed Income Focus: The path to QExit – 3 June 2015 11 Fixed Income Focus: The path to QExit – 3 June 2015

Steepening of Treasury 5s10s after tapering Steepening of Treasury 5s10s after tapering in bps in bps

140 140 120 120 100 100 80 80 60 60 40 40 20 20 08 09 10 11 12 13 14 08 09 10 11 12 13 14 QE Tapering dry run Tapering US 5s/10s (lhs) QE Tapering dry run Tapering US 5s/10s (lhs)

Impact of dry-run on risky assets Impact of dry-run on risky assets in % in %

3 3 2 2 1 1 0 0 -1 -1 -2 -2 -3 -3

1 US HY credit US IG credit 1 Dow US IG US HY credit S&P 500credit Jones S&P Dow Jones US 10y500 Treasury (% pt.)

US 10y Treasury (% pt.)

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

During this period which we refer to as the tapering dry run, the During this period which we refer to as the tapering dry run, the Treasury curve steepened (see graph above for 5s10s).

Treasury curve steepened (see graph above for 5s10s).

Steepeners and short duration on QExit…

Steepeners and short duration on QExit…

When expectations of the ECB’s exit from QE take hold at the When expectations of the ECB’s exit from QE take hold at the turn of next year, we would expect a sharp rise in government turn of next year, we would expect a sharp rise in government bond yields and curves to steepen, mirroring the taper tantrum bond yields and curves to steepen, mirroring the taper tantrum in the US. Upward yield movements of shorter maturing bonds in the US. Upward yield movements of shorter maturing bonds will be compressed by the ongoing availability of excess will be compressed by the ongoing availability of excess money market liquidity. We also think that the ECB will keep its money market liquidity. We also think that the ECB will keep its monetary policy rates unchanged for the foreseeable future, monetary policy rates unchanged for the foreseeable future, which will also dampen the impact on short end government which will also dampen the impact on short end government bonds. In such an environment, short duration and steepening bonds. In such an environment, short duration and steepening trades would likely make sense. trades would likely make sense.

During the tapering dry run, US credit spreads were resilient.

During the tapering dry run, US credit spreads were resilient.

Although they widened initially, they started to tighten again Although they widened initially, they started to tighten again before long. Indeed, despite the increased volatility in the before long. Indeed, despite the increased volatility in the credit market, spreads on balance tightened (see graphs below credit market, spreads on balance tightened (see graphs below and above on the right). Equity markets also performed well. and above on the right). Equity markets also performed well.

The resilience of risky assets could reflect that Fed tapering The resilience of risky assets could reflect that Fed tapering was also seen as a sign of confidence in the economic outlook, was also seen as a sign of confidence in the economic outlook, which may have led investors to ratchet up their growth which may have led investors to ratchet up their growth expectations. expectations.

Impact of dry-run on US non-financial spreads Impact of dry-run on US non-financial spreads Bps (asw-spread) Bps (asw-spread)

180 180 170 170 160 160 150 150 140 140 130 130 120 120 May-13 May-13

Jun-13 Jun-13

Jul-13 Jul-13

Source: Thomson Reuters Datastream Source: Thomson Reuters Datastream

Aug-13 Aug-13

…and tighter swap and peripheral spreads… …and tighter swap and peripheral spreads…

In the run up to QE, we have also observed a strong In the run up to QE, we have also observed a strong performance of cash government bonds vs swaps. We expect performance of cash government bonds vs swaps. We expect this ASW move to reverse as yields on government bonds are this ASW move to reverse as yields on government bonds are likely to rise. With regards to country spreads, we remain likely to rise. With regards to country spreads, we remain largely supportive, especially for peripheral spreads. Spreads largely supportive, especially for peripheral spreads. Spreads of core government bonds are already trading at very tight of core government bonds are already trading at very tight levels, almost as close to pre-crisis levels. Therefore we do not levels, almost as close to pre-crisis levels. Therefore we do not see much value in these spreads. The relative value see much value in these spreads. The relative value perspective in peripheral spreads is better, especially as perspective in peripheral spreads is better, especially as spreads on the back of a possible Grexit have spreads on the back of a possible Grexit have underperformed. We expect that as expectations about the underperformed. We expect that as expectations about the economic outlook improve and a Greek exit will be avoided economic outlook improve and a Greek exit will be avoided investors will search for yield and that peripheral spreads will investors will search for yield and that peripheral spreads will benefit from this. Of course a lot depends on levels when QExit benefit from this. Of course a lot depends on levels when QExit expectations start to build. expectations start to build. …as well as credits …as well as credits Meanwhile, the US experience suggests that credit spreads Meanwhile, the US experience suggests that credit spreads could actually tighten, also likely helped by the improved could actually tighten, also likely helped by the improved economic growth outlook. Overweighting credit in the belly of economic growth outlook. Overweighting credit in the belly of the curve could provide some relative protection. By the time the curve could provide some relative protection. By the time the QExit is announced, companies will report better results on the QExit is announced, companies will report better results on the back of improving economic conditions. Growth prospects the back of improving economic conditions. Growth prospects

12 12

Fixed Income Focus: The path to QExit – 3 June 2015 Fixed Income Focus: The path to QExit – 3 June 2015

will improve and balance sheets will strengthen further. We will improve andtobalance further. expect spreads tighten sheets during will this strengthen phase of the cycle.We We

expect spreadsourselves to tightenoverweight during this credit, phase in of particular the cycle. in We would position high would position ourselves overweight credit, in particular in beta BBB rated segment and hybrids category if volatility ishigh not beta BBB However, rated segment hybrids category volatility isas not an issue. nameand selection will be moreif important an issue. selection more important event riskHowever, rises. We name also expect thatwill thebe steepening of the as

event curve risk rises.

We also expectout thatofthe theinto Bund will move investors thesteepening longer endof and Bund curve will move investors out of the longer end and into the belly of the curve. the belly of the curve.

Agencies could underperform…

Agencies could (national underperform…

In sub sovereign agency) names we are very

In sub sovereign are very selective.

Names(national which areagency) eligible names for QE we buying have selective. Names which arebonds eligible forhave QE buying outperformed government and been orhave are in

outperformed government bonds and have been or are in some cases trading flat to their comparable government some cases trading flat to their comparable government bonds. We do not think that these names will continue to trade bonds. do not think that bond thesecurves nameswhen will continue as closeWe to the government QExit to trade as close to the government bond curves when QExit approached.. approached..

…as could covered bonds, especially peripherals …as bonds, especially peripherals In thecould event covered of a QExit, we think that peripheral covered bonds In of a QExit, we think that peripheral covered bonds willthe beevent hit hardest.

Not only did these bonds benefit the most will hit hardest.

Not of only did these bonds benefit frombeCBPP3 (in terms spread tightening), but we the alsomost from CBPP3 (in terms of spread tightening), but we also expect relatively more supply from the periphery than from the expect relatively more supply from the periphery than from the (semi) core. This is based on the fact that peripheral banks (semi) core.

This is large basedamounts on the fact that banks borrowed relatively from theperipheral ECB (in the borrowed relatively large amounts from the ECB (in the LTROs), which they are unable to match in the TLTRO

LTROs), which areperipheral unable to match in the TLTRO operations.

As athey result, banks will have a funding operations.

As a result, peripheral banks will have a funding gap. We think they will partially fill this gap by issuing more

gap.

We bonds, think they will partially fill this gap by issuing morefor covered as this has become increasingly attractive covered bonds, as this has become increasingly attractive for peripheral banks. Brightening economic prospects could work

peripheral banks.

Brightening economic prospects could work in the opposite direction, keeping investors in the periphery in the opposite direction, keeping investors in the periphery and dampening the spread widening. and dampening the spread widening.

In the (semi) core, we expect spreads of covered bonds to In the (semi) core, we than expect spreads of covered to widen more modestly in the periphery.

Bondsbonds from the

widen modestly than in thethe periphery.

Bondsinfrom the (semi) more core were hit less during taper dry-run the US. (semi) coretheir werespreads hit lesshave during the tapermore dry-run in the US. Moreover, tightened moderately than

Moreover, their counterparts spreads haveduring tightened more than their peripheral QE in the moderately eurozone, which their peripheral counterparts during QE in the eurozone, which also limits the widening potential. Furthermore, we expect

also limits the widening potential.

Furthermore, we expect supply by banks in (semi) core countries to remain suppressed supply in (semi) core countries to is remain as theyby willbanks increasingly use TLTROs. This likely suppressed to replace as they will increasingly use TLTROs. This is likely to Overall, replace some other types of funding, such as covered bonds. some other types of funding, such as covered bonds.

Overall, this will increase scarcity of (semi) core paper, which will this will increase scarcity of (semi)incore paper, core which dampen the widening of spreads the (semi) aswill well. dampen the widening of spreads in the (semi) core as well.

Euro to revive on QExit Euro toas revive QExit Finally, QExiton expectations rise, we think the euro exchange Finally, as QExit expectations exchange rate will rebound. By that point,rise, the we Fedthink rate the hikeeuro cycle will be rate willpriced rebound.

By that point, the Fed rateyields hike cycle willas be largely in, while eurozone core bond will rise largely priced in, while eurozone core bond yields will rise as investors factor in the end of asset purchases. This means the investors factor in the end of asset purchases. This means the

bond yield spread between the US and Germany would narrow bond spread between US and Germany would narrow again,yield which is usually eurothe supportive. again, which is usually euro supportive.

13 Fixed Income Focus: The path to QExit – 3 June 2015 13 Fixed Income Focus: The path to QExit – 3 June 2015

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