Global Strategy Flash Weekly Cross Asset Views Deutsche Bank Markets Research

Deutsche Bank
Markets Research
United States
18 November 2014
Dominic Konstam
Global Strategy Flash
Research Analyst
(+1) 212 250-9753
[email protected]
Weekly Cross Asset Views
Joseph LaVorgna
Trade recommendations
US Treasury futures: We are bearish on FV and longer calendar rolls.
USD: Buy contingent 6M3Y OTM payers subject to knock-out criteria.
USD: Buy contingent 1Y3Y OTM payers subject to knock-out criteria.
U.S. Economics
We expect a one-tenth decline in headline CPI in October, in effect lowering
the year-on-year growth to 1.5% based on further decline in energy prices.
However, we expect services inflation to accelerate in the near term as the
unemployment rate approaches the NAIRU.
U.S. Rates
We remain broadly neutral on the market at current levels. Nonetheless we
see a number of themes that are more likely to produce a re-test of recent lows
in yield than they are to produce a breakout to higher levels.
Japan Rates
We see the risk of a repeat strong performance of the incumbent government
in the next elections, which could trigger a further rise in equities and USD/JPY
and put upward pressure on JGB rates.
Modestly bullish on long-end spreads. Good value in 2-year agencies,
expecting 1.04% 12M total return with unchanged yields.
Chief US Economist
(+1) 212 250-7329
[email protected]
Makoto Yamashita, CMA
(+81) 3 5156-6622
[email protected]
Francis Yared
(+44) 020 754-54017
[email protected]
Steve Abrahams
Research Analyst
(+1) 212 250-3125
[email protected]
David Bianco
(+1 ) 212 250-8169
[email protected]
U.S. Credit
The low point in HY defaults in this credit cycle is likely already behind us.
We remain overweight MBS against rates on expectations of a flatter curve,
good carry and demand outpacing supply.
U.S. Equities
The dollar’s broadening strength vs. EUR, GBP, Yen, and the rapidity of oil’s
price plunge has put our previous S&P 4Q EPS estimate of $30.50 out of reach.
We now expect $30 for 4Q and ~$117.50 for full-year 2014
Deutsche Bank Securities Inc.
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
U.S. Economics
The latest inflation readings are especially important given that the FOMC
acknowledged recent declines in market-based measures of inflation
expectations in the October meeting statement. In our view, above-trend
growth will continue to put downward pressure on the unemployment rate and
eventually upward pressure on inflation, in particular for service sector prices.
Since the latter are the dominant driver of measures of core consumer inflation
at around 75%, the trend in service prices will ultimately dictate the broader
trend in core inflation. This may be one reason why the October meeting
statement indicated that the Fed continues to see the likelihood of inflation
running persistently below 2% as having diminished somewhat since earlier in
the year.
Goods disinflation is abating, while service prices are on the rise. The current
12-month rate of change in the consumer price index (CPI) is 1.7%—the same
rate as the core CPI. Energy prices will likely continue to weigh on headline CPI
in the near term and we expect a one-tenth decline in October, which would
have the effect of lowering the year-over-year growth rate of headline CPI
inflation to 1.5%. However, core prices are expected to rise +0.2%, raising the
year-over-year growth rate a tenth to 1.8%. It is core inflation that matters
most for monetary policymakers, given the inherent volatility in food and
energy prices. Moreover, it is the core personal consumption expenditures
(PCE) deflator that policymakers are watching most closely.
Core CPI goods prices have been declining year-over-year since April 2013,
and this has weighed on overall core inflation. However, core service prices
have shown no such weakness—they have consistently been growing at well
above 2% for the past three years. The weakness in goods prices has been the
direct result of a significant deceleration in non-petroleum import prices—
particularly imports from China. Essentially, the slowdown in global growth
outside of the US lowered the demand, and therefore, the price of globally
traded goods. While modest disinflation in the goods sector may continue in
the near term, this is not the case for services, where the price of labor is the
dominant input into the production process. The unemployment rate has fallen
significantly over the past year, declining 140 basis points (bps) to 5.8% at
present, and is on track to fall within the Fed’s estimate of full employment by
the second half of next year. The FOMC’s central tendency forecast pegs the
non-accelerating inflation rate of unemployment (NAIRU) somewhere within
the range of 5.2% to 5.5%. As shown in the accompanying chart, as the
unemployment rate approaches (and then moves below) the NAIRU, both
wage pressures and service prices tend to accelerate. While the increase in
wages to this point in the business cycle has been relatively modest, a
tightening labor market will put upward pressure on labor costs. In turn,
service prices, which have been consistently running above 2%, are likely to
accelerate. Given that services (75%) have roughly three times the weight in
measures of core inflation compared to goods (25%), it would take an
unusually large decline in the latter to prevent core inflation from trending
higher. This is highly unlikely given our above-trend growth forecast for the US
Page 2
Deutsche Bank Securities Inc.
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
Core services inflation tends to accelerate as the economy reaches full
Source: Deutsche Bank
Joseph Lavorgna and Carl Riccadonna
(+1) 212 250-7329/0186
[email protected],[email protected]
Deutsche Bank Securities Inc.
Page 3
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
U.S. Rates
While we are broadly neutral with most of our favored valuation metrics where
they “should” be, we still think there are a variety of themes that are more
likely to resolve toward a re-test of 2% in 10s rather than a break to higher
yields over the next few months.
We think changes in Treasury issuance, and the inclusion of Treasury supply
formerly spoken for by Fed purchases in major indices, will produce index
extension and force indexed investors to buy simply to remain at constant
levels relative to benchmark. For example, we think real money needs to buy
$225 billion in 10y equivalents just to maintain their current underweight
On the real growth front, the issue hasn’t changed much during 2014 in that
GDP remains disappointing (2-3 percent tendency) with an overreliance on
labor input rather than productivity. Low productivity makes profits vulnerable
to negative price shocks as well as a negative demand shock.
Inflation of course remains undesirably low or falling across major
industrialized economies. Ironically, the tendency of headline inflation to
“cause” or lead core inflation could create a natural brake to not only inflation
but also rate hikes. If expectations of higher rates strengthen the dollar, the
stronger dollar puts downward pressure on commodities and most notably
energy, falling food and energy put downward pressure on headline inflation
that “leaks” into core, then in the end the tightening cycle could be far shorter
than historical experience.
We think the ECB was able to agree that balance sheet growth is desirable, but
we remain skeptical that it is unanimous on how to bring that about. We
remain concerned that markets will force the issue if the ECB does not clarify
how it will grow its balance sheet in the reasonably near future.
Trade Recommendations
Buy $100mn 6M3Y 25bp OTM payers (1.78% strike) subject to KO if 3s >
ATMF (1.53%) in the first 3M, offer 8c, a 77% discount to vanilla at 35c.
Buy $100mn 1Y3Y 25bp OTM payers (2.16% strike) subject to KO if 3s >
ATMF (1.91%) in the first 6M, offer 22c, a 67% discount to vanilla at 68c.
December Treasury futures roll recommendations
Relatively neutral
Relative value
Short the calendar
Relative value
Short the calendar
The 2.25s of 7/2021 CTD is rich
Short the calendar
The 10s-US-30s spread looks tight
Short the calendar
Relative value
Source: Deutsche Bank
Dominic Konstam and team
(+1) 212 250-9763
[email protected]
Page 4
Deutsche Bank Securities Inc.
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
Japan Rates
Yen bond market tested a rebound led by the superlong sector as the BoJ
boosted its purchases of JGBs with residual maturities of over 25y by JPY40bn
to JPY160bn. The trend of yen depreciation and a rise in stocks continues, but
the market was led by supply/demand. The BoJ appears to be mechanically
adjusting the amount of its purchases to extend the average maturity of
purchases to 7-10 years. Domestic investors seem to be bullish despite the
weak 20y auction on Tuesday.
The Abe administration declared its intent to postpone the consumption tax
hike scheduled for October 2015 and then dissolve the lower house for a
general election before the end of this year in the hope of reaffirming its
mandate. This expectation has already triggered a significant rally in equities
and further depreciation of the yen. The general consensus is that Prime
Minister Shinzo Abe will remain in office with the ruling Liberal Democratic
Party (LDP) maintaining a clear majority. JGBs might ordinarily be sold off on
economically positive news and concerns over a weakening yen and a
worsening fiscal outlook, but few market participants expect interest rates to
rise significantly while the BOJ remains such a big buyer of bonds. That said, if
the LDP is able to match its 2012 election showing, the implied endorsement
of the Abe government's course of action could trigger further rises in equities
and USD/JPY. Few observers expect a repeat of the LDP's 2012 landslide
victory at this juncture, but we are reluctant to rule out another very strong
performance given that opposition parties are now much less popular than
they were two years ago.
Makoto Yamashita
(+81) 35156 6622
[email protected]
Given the uncertainty regarding the futures of Fannie and Freddie, we are
slightly bullish on long-end spreads. Our best guess is that the two housing
GSEs will muddle along in their current form while continuing to benefit from
the implicit government backing in exchange for remitting quarterly dividends
to U.S. Treasury. While opposing camps on the reform issue both agree that
conservatorship is not the permanent solution, neither side is incentivized
enough to push for things to move along faster.
An orderly wind-down of the GSEs by the government should be positive for
spreads. Currently, 85% of FNMA and FHLMC long-term debt mature before
2020, which we believe will be the earliest reasonable termination date for any
potential GSE bill to be enacted. With under $100 billion outstanding that
matures after 2020, and even less after factoring in callables which may be
redeemed early, the remaining amount should be manageable for the
government to take steps to preserve their credit ratings.
We see good value for investors in the two-year sector. Spread volatility is
lowest in this part of the curve, and the breakeven spread-to-spread volatility
ratio remains more attractive relative to other sectors and its own history. The
rolldown is also quite substantial: on an unchanged yield curve investors can
expect a total return of 1.04% in one year’s time.
The Federal Home Loan Banks priced $3 billion new two-year Global on Friday.
Demand for this note was especially strong from central banks, which bought
31% compared to their past average of 21% for new issue 2yr Globals. The
new issue brings YTD FHLBanks Global issuance to $13.5 billion, a 12.5%
Deutsche Bank Securities Inc.
Page 5
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
increase from last year and the highest since 2011. FHLBanks’ next and final
issuance slot for 2014 is December 1.
Steven Zeng
(+1) 212 250 9373
[email protected]
U.S. Credit
Our current assessment of this most recent episode of spread widening is that
we came close to crossing the line into the next credit cycle, but probably have
not actually done so. With corporate balance sheets already carrying a
significant weight of leverage, and many indicators of aggressive issuance
reaching their 2007-cycle peaks, we are probably closer to the next credit cycle
than consensus continues to believe. Credit quality metrics are probably 7080% on their way to reaching their limit, and what stands between us and the
next default cycle is (1) an external shock of a somewhat higher intensity than
what we experienced in October; and (2) a shift in monetary policy. Thus, as
we move into early 2015 and approach a point of a liftoff in the fed funds rate,
these preconditions for the next credit cycle will continue to evolve and take us
closer to the point where it turns. The shock we have experienced so far in the
last few months, coupled with pressures on the fundamentals of the weakest
energy issuers we discussed last week, is probably sufficient to conclude that
the low point in defaults in this credit cycle is already behind us. Having seen
default rates bottoming at 1.7% on the issuer basis and 1.9% in face amounts
earlier this year, we are likely to see them trending towards 3.5% in 2015. Part
of this gradual increase would be attributable to low-quality energy names,
whereas other candidates could come from other somewhat stressed sectors
such as media, gaming, and retail. Overall, this base-case is still compatible
with a view that the current credit cycle could go on for a little longer, perhaps
the next year or so, before it finally reaches its tipping point. Historical
evidence provides us with additional comfort to say so, as each of the past
three credit cycles saw a modest increase in defaults to 3-4% in 1988, 1996,
and 2006, all happening before the turning points discussed in detail above.
Oleg Melentyev and Daniel Sorid
(+1) 212 250-6779/1407
[email protected], [email protected]
Revisiting relative value
The dramatic moves in the rates market last month ultimately left us back
where we started but not without first shaking up valuations in different parts
of the mortgage market and leaving some relative value opportunities. The
shift in the Fed from net buying to reinvestment and the redoubling of the BoJ
QE offensive also brings new potential demand dynamics to the market. All of
it comes back to core positioning, where most still stands but a couple of new
things look worth adding. For more detail on these positions, please see ‘The
Outlook in MBS and Securitized Products’ from November 12, 2014.
Remain overweight MBS against rates on expectations of a flatter curve,
good carry and demand outpacing supply
Get long lower-coupon 15-year TBA against 30-year TBA on the strength of
supply technicals, better hedge-adjusted carry and continued bank
Page 6
Deutsche Bank Securities Inc.
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
Hold higher coupon TBA 30-year 4.5%s and 5.0%s on hedge-adjusted
carry, but be cautious about position exposure to special dollar rolls
To reduce exposure to a break in special dollar roll, consider adding call
protection in 4.5%s rather than 5.0%s as the former looks undervalued
after October pay-up volatility, the latter slightly overvalued
Consider holding the 4.5%s in structure as a front PAC for additional yield
and more convex total returns, while the 5.0% appears better in pool form
For extension or call protection stories look to 3.5%s where seasoning,
loan balance and high-LTV stories all appear undervalued
The MBS market lost its one guaranteed net buyer when the Fed officially
ended QE3 at the October FOMC. However, the Fed bought only $5 billion net
last month, against an early estimate of $16 billion of net supply. And still the
basis ground tighter—suggesting continued support from private capital.
Indeed, according to the latest Fed H.8 release, US banks alone in October
added $14 billion. Our early estimate for November net supply is a surprisingly
robust $20 billion, which would put us ahead of our $30 billion projection for
all of the fourth quarter—though December production has run flat to negative
in two of the last three years.
There is potentially some risk of a net supply upside surprise, of course. As
noted in ‘Short the prepayment option’ from The Outlook on October 22, the
MBA reported a marked improvement in origination margins in the second
quarter—and suggested the low margins of prior quarters may have reflected
the costs of complying with new underwriting rules out of the CFPB. Those
costs may now be behind us, possibly making it a bit easier for banks to lend.
However, despite FHFA Chair Watt’s recent emphasis on improving access to
credit, it seems that tangible progress still needs to be made before lenders’
fears of GSE put-backs are sufficiently assuaged to meaningfully reduce credit
overlays. Just ask Ben Bernanke how hard it still is to get a mortgage. Winter
seasonals and tight credit should keep demand ahead of supply through the
next few months at least.
Steve Abrahams and Ian Carow
(+1) 212 250-3125/9370
[email protected], [email protected]
U.S. Equities
We cut our S&P 4Q EPS estimate from $30.50 to $30, 2014E EPS ~$117.50
The dollar’s broadening strength vs. EUR, GBP, Yen, and the rapidity of oil’s
price plunge has put our previous S&P 4Q EPS estimate of $30.50 out of reach.
We now expect $30 for 4Q and ~$117.50 for full-year 2014. We maintain our
2015E S&P EPS of $123, which is nearly 5% growth. Our 2015E EPS assumes
a small rebound in oil prices to an $80-85/bbl average and that the climb in
dollar slows, such that EUR/USD stays above 1.20 in 2015. We expect
investors to pay above-average multiples for below-average EPS growth given
persistently low interest rates. However, we think striking the right balance in
this uncomfortable math brings more volatility in the coming months and year.
David Bianco and Priya Hariani
(+1) 212 250-8169/2766
[email protected], [email protected]
Deutsche Bank Securities Inc.
Page 7
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
Appendix 1
Important Disclosures
Additional information available upon request
For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this
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Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition,
the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation
or view in this report. Dominic Konstam
Page 8
Deutsche Bank Securities Inc.
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
(a) Regulatory Disclosures
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consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the
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(e) Risks to Fixed Income Positions
Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise
to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash
flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a
Deutsche Bank Securities Inc.
Page 9
18 November 2014
Global Strategy Flash: Weekly Cross Asset Views
loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the
loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse
macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation
(including changes in assets holding limits for different types of investors), changes in tax policies, currency
convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and
settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed
income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to
FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the
index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended
to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon
rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is
also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be
received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options
in addition to the risks related to rates movements.
Page 10
Deutsche Bank Securities Inc.
David Folkerts-Landau
Group Chief Economist
Member of the Group Executive Committee
Raj Hindocha
Global Chief Operating Officer
Michael Spencer
Regional Head
Asia Pacific Research
Marcel Cassard
Global Head
FICC Research & Global Macro Economics
Ralf Hoffmann
Regional Head
Deutsche Bank Research, Germany
Richard Smith and Steve Pollard
Co-Global Heads
Equity Research
Andreas Neubauer
Regional Head
Equity Research, Germany
Steve Pollard
Regional Head
Americas Research
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