EU Deflation

EU Deflation Stress Test
August 5, 2014
HICP -4%

Scenario 1: Hard Landing
• HICP falls to -4% as a result of a combination of external shocks
• Monetary policy is kept constant, with no additional financing through
REPOs, and the benchmark interest is left at 0.25%
• Resulting in a Eurozone recession, soon after dragging other EU
economies down with it
• EURCHF floor is assumed to be in place

t814776 [printed: März 8, 2013 8:48 AM] [saved: März 8, 2013 8:50 AM] P:My DocumentsTemp Daten05_SPOCStakeholder BoardST_Mgt_UpdatesWM_Stress_Brown_Bag_2013-03-08.ppt
GDP, Equities, FX, Commodities
2
(25)
(20)
(15)
(10)
(5)
0
Gold (USD/t.
oz)
Silver
(USD/t. oz)
Oil
(USD/barrel)
Copper
(USD/lb)
Steel
(USD/lb)
5 day 10 day 1 month
GDP1 Components
Consumption Investment Government Exports Imports
Weighting1 56.9 18 23.1 44.9 -42.9
Percentage Change 0.87 0.85 1.15 1.05 1.05
Percentage Change x Weight 49.503 15.3 26.565 47.145 -45.045
Percentage Change to GDP (%) -6.532
(40)
(35)
(30)
(25)
(20)
(15)
(10)
(5)
0
EU USA JAPAN EM CHINA AUSTRALIA
(4)
(2)
0
2
4
6
8
Euro GBP CHF JPY RMB
% change against USD
Equities2 FX3
Commodities4

Yield Curves, Credit Spreads
TED Spread Movements7
0
50
100
150
200
250
300
350
400
450
CDX IG CDX HY iTraxx Main iTraxx XO iTraxx Japan
(300)
(200)
(100)
0
100
200
300
400
500
Japan USA Switzerland UK Germany GIPSI
Short end (1yr)
0
20
40
60
80
100
120
140
USD EUR CHF GBP JPY
Short end (1m) Long end (1yr)
0 50 100 150 200 250 300
USD
CHF
GBP
JPY
Long end (bp) Short end (bp)
CDS Spreads8
Libor5
Government Yield Curves6

Scenario 2: Soft Landing
• HICP falls to -4% as a result of a combination of external shocks
• ECB implements quantitative easing (€1.5tn) straight away, embarking
on a large-scale asset purchase program resulting in a depreciation of the
Euro. It also lowers the benchmark interest rate to 0.10%
• Governments with debt less than 100% of GDP implement fiscal policy
• We assume that precious metal prices fall in response to the
strengthening of the dollar
• EURCHF floor is assumed to be in place

GDP, Equities, FX Commodities
5
(16)
(14)
(12)
(10)
(8)
(6)
(4)
(2)
0
Gold (USD/t.
oz)
Silver
(USD/t. oz)
Oil
(USD/barrel)
Copper
(USD/lb)
Steel
(USD/lb)
GDP9 Components
Consumption Investment Government Exports Imports
Weighting9 56.9 18 23.1 44.9 -42.9
Percentage Change 0.9 0.89 1.1 1.1 1.07
Percentage Change x Weight 51.21 16.02 25.41 49.39 -45.903
Percentage Change to GDP (%) -3.873
(30)
(25)
(20)
(15)
(10)
(5)
0
EU USA JAPAN EM CHINA AUSTRALIA
(20)
(15)
(10)
(5)
0
5
10
Euro GBP CHF JPY RMB
% change against USD
Equities10 FX11
Commodities12

Yield Curves, Credit Spreads
0
50
100
150
200
250
300
CDX IG CDX HY iTraxx Main iTraxx XO iTraxx Japan
(150)
(100)
(50)
0
50
100
150
200
250
300
Japan USA Switzerland UK Germany GIPSI
Short end (1yr) Long end (10yr)
0
10
20
30
40
50
60
70
80
90
100
USD EUR CHF GBP JPY
Short end (1m) Long end (1yr)
0 50 100 150 200
USD
CHF
GBP
JPY
Long end (bp) Short end (bp)
Libor13 TED Spread Movements14
Government Yield Curves15 CDS Spreads16

Data & Reasoning:
7
GDP1
Consumption -13%
• Consumer spending falls, saving encouraged, rising unemployment
Investment -15%
• Real value of debt rises, credit dries up, business confidence low
Government Spending 15%
• Rises without the presence of monetary policy, however many countries have high debt to GDP ratios.
Exports 5%
• Euro depreciation leads to export rise
Imports 5%
• Imports rise 5% as proportion of GDP due to cost rises through weakening of Euro.
Weightings1 – (CIA World Factbook, 2012)

Data & Reasoning (Cont.)
8
http://www.bbc.co.uk/news/business-15748696
5 day 10 day 1 month Comment
EU -15 -20 -35
• ASE fell 12% previously
• Nikkei 225 fell as low as 30%
• Interconnection of EU, resulting in
exposure of debt and fact that ALL
suffer.
USA -7 -13 -20
• 3rd largest of EU's import sources
• Financial exposure to EU high
• Hit by high copper, steel and gold
production.
• EU is key for trade.
• Low oil exports
JAPAN -3 -6 -10
• 6th largest EU import source
• Hit on steel exports
• 3rd largest oil importer
• Moderate debt exposure to EU
• Low financial exposure
• Could do well in the longer term
from German decline as the both
specialise in manufactured goods.
EM (Brazil, Argentina, Mexico,
Russia, India) -4 -15 -25
• Russia suffer as it is a main oil and
steel exporter and is the second
largest source of EU imports.
• Mexico and Brazil moderate oil
exporters.
• 53% Latin American investment
from EU and 35% trade into Brazil.
EU is Brazil main trade partner (EC)
• 19% Argentinian trade to EU (EC).
• Delayed equity decline as most hits
are due to commodity prices falling.
CHINA -6 -14 -23
• Largest EU import source
• 50% China exports pass through
'Western network' (UBS Neo)
• Largest steel, silver and gold
producer.
AUSTRALIA -2 -8 -15
• Copper exporter and gold producer.
• 20% exports to China
• Mining country
• Delayed shock to equities as
Australia is dragged down by China,
not EU.
Equities2
http://ec.europa.eu/index_en.htm

9
% change against USD Comment
Euro -3
• Euro depreciates initially due to falling prices. This effect
is lessened by the slight increase in exports, leading to
an overall fall in the Euro of 3%.
GBP -2
• Depreciates less than the Euro as initially GBP is viewed
as a safe haven within the EU.
CHF -3 • CHF depreciates with the euro as the peg remains.
JPY 7
• JPY appreciate against USD as US is a main EU trade
partner as well as being exposed to a lot of EU debt.
RMB 0 • Remnimbi stays the same as the USD as it is pegged.
FX3
Commodities4
Gold (USD/t. oz) -3 -5 -10
• Gold performs best when inflation is high, dollar is
weak and there are elevated levels of financial stress
Silver (USD/t. oz) -5 -10 -14
• Silver more volatile than gold, more widely used in
industry = larger fall.
Oil (USD/barrel) -10 -16 • EU makes up 14.9% global oil demand
Copper (USD/lb) -15 -22
• EU makes 20% global copper – demand from
emerging market economies also weakening = larger
falls
Steel (USD/lb) -8 -14
• EU makes up 9.2% global steel demand - demand
from emerging market economies also weakening
(steel very widely used in industry = large fall also)

Libor5
Ted Spread Movements7
Short end (bp) Long end (bp)
USD 72 250
CHF 31 20
GBP 100 140
JPY 23 25
Libor Yields Short end (1m) Long end (1yr) Comment
USD 65bp 50bp • USA has high bank exposure to the EU.
EUR 120bp 110bp • Sovereign default risks in European countries make interbank
lending riskier.
CHF 30bp 20bp • Safe bank lending
GBP 90bp 70bp • GB has high bank exposure to EU.
JPY 20bp 15bp • Japan has low bank exposure to EU.

http://www.six-swiss-exchange.com/services/yield_curves_en.html
Current Govt. Yields
(05/08/2014)
Short end
(1yr)
Long end (10yr)
Japan 0.054% 0.51%
USA 0.10% 2.5%
Switzerland 0.05% 0.52%
UK 0.43% 2.55%
Germany 0.04% 1.148%
0
0.1
0.2
0.3
0.4
0
0.5
1
1.5
2
Short end Long end
Resulting yields following deflation
Govt. Yield Curves6
Govt. Yields Short end (1yr) Long end (10yr) Comment
Japan -3bp -10bp • Safe haven – Both short and long end yields. Should have lowest yields due to
low risk and low exposure.
USA -7bp -200bp • Relatively low yields in short end. Expect investors to flock to 10 year bonds
due to safety and high yield.
Switzerland -1bp 0bp • Higher exposure to EU than US or Japan, already low yields mean there will
not be much movement.
UK -10bp -70bp • Initially UK seen as a safe haven in Europe so yields fall.
Germany 0bp -30bp • Germany, as another usually 'safe' EU country will also see yield falls initially,
however UK Gilts with their higher yields will be preferred.
Gre, Ire, Portugal Esp, It 400bp 350bp • Deflation leads to real value of debt rising. These weak European countries
become riskier investments.

CDX IG 50 • In response to falling US equity market these rates rise also.
CDX HY 150 • The above problem is accentuated for high yield bonds.
iTraxx Main 130
• As European equities deteriorate and there is no monetary policy allowing companies access to
capital, the risk of default rises.
iTraxx XO 420 • The above problem is accentuated for high yield bonds.
iTraxx Japan 20 • Japanese companies are less exposed to EU than USA – 2011, 10% S&P 500 sales in Europe.
CDS Spreads8 – nb: Figures based around UBS Eurozone crisis LAS. Gauged that at the long end, this scenario sees higher yield rises as deflation is a long
term problem – real value of debt rising over time. In the short end, yield rises aren't as severe, as the euro crisis is more of an initial shock.
GDP9
Consumption -10%
• Less of a shock to consumption as QE and lowered interest rates encourages spending.
Investment -11%
• QE injects capital, easing flow of credit and allowing investment.
Government Spending 10%
• Less rise in government expenditure as, with the implementation of expansionary monetary policy,
countries with high debt to GDP avoid spending.
Exports 10%
• Extreme currency depreciation leads to further rise in exports.
• However exports less sophisticated than Japan's (proxy).
Imports 7%
• More significant cost increase for imports due to the Euro depreciation leads to their rise.
Weightings9 – (CIA World Factbook, 2012)

Equities10
EU -8 -13 -25
• Monetary policy intervention will curb the
trend in falling equities as bank lending and
consumer spending is encouraged.
USA -4 -9 -14
• American equities supported by EU
monetary policy expansion.
JAPAN -2 -4 -6
EM (Brazil, Argentina, Mexico,
Russia, India) -2 -10 -15
• Effect on emerging markets is still delayed
however as demand for commodities does
not fall as much in this scenario, EM
equities do not suffer as much.
CHINA -3 -5 -14
AUSTRALIA -2 -5 -10
• Delayed effect again, however as China
does not suffer as much, neither does
Australia.
http://www.bbc.co.uk/news/business-15748696
FX11
% change against USD Comment
Euro -17
• The implementation of QE leads to a heavy depreciation
of the Euro.
GBP -10
• GBP depreciates slower as it is viewed as a safe haven
within the EU initially.
CHF -17 • CHF pegged to Euro
JPY 5 • Yen appreciates due to its safe haven status.
RMB 0 • RMB fixed to USD.

14
Comment - All commodity price falls curbed by monetary policy expansion
as demand fall from industrial use is less severe.
Gold (USD/t. oz) -3 -4 -8
Silver (USD/t. oz) -5 -6 -12
Oil (USD/barrel) -8 -12
Copper (USD/lb) -12 -15
Steel (USD/lb) -7 -11
Commodities12
Libor13
Ted Spread Movements14
Short end (bp) Long end (bp)
USD 45 150
CHF 25 17
GBP 90 155
JPY 21 21
Short end (1m) Long end (1yr) Comment – for all, long end rises less as monetary policy and
eases lending, lowering the risk of default in the near future.
USD 40bp 20bp
EUR 90bp 60bp
CHF 25bp 15bp
GBP 75bp 50bp
JPY 20bp 15bp

0
0.1
0.2
0.3
0
0.5
1
1.5
2
Current Govt. Yields Short end
(1yr)
Long end (10yr)
Japan 0.054% 0.51%
USA 0.10% 2.5%
Switzerland 0.05% 0.52%
UK 0.43% 2.55%
Germany 0.04% 1.148%
http://www.six-swiss-exchange.com/services/yield_curves_en.html
Short end Long end
Resulting yields following deflation
Govt. Yield Curves15
Govt. Yields Short end (1yr) Long end (10yr) Comment – Reduced scenario 2 by scale factor 2/3.
Japan -1bp -6bp • All safe havens see a lower fall in yields as investing in Europe is not as risky
due to monetary policy.
USA -5bp -130bp • There is still a significant fall in the long end for US bonds as a result of their
higher yield and safety.
Switzerland 0bp -2bp • Both short and long end yields for Switzerland are already low.
UK -15bp -105bp • More significant fall for UK Gilts as risk is reduced by monetary policy,
investors are also attracted to high yields initially. QE pushes long end down
for all EU.
Germany 0bp -45bp • Short end bunds are low yielding already. Larger fall in this scenario in the
long end due to monetary policy.
Gre, Ire, Esp, It, Portugal 260bp 230bp • Less significant rise in yields due to ECB action. Not much difference between
long end and short end rise as deflationary spiral is long term.

CDX IG 35
CDX HY 100
iTraxx Main 80
iTraxx XO 280
iTraxx Japan 13
• Scenario 2 is scaled to 2/3 of scenario 1.
• Monetary policy ensures that companies have adequate access to capital, lowering risk.
• Japan is again considered a safe haven, with companies having low exposure to EU, therefore insignificant rise.
CDS Spreads16

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