London february 2017

The shape of yield curve to come... risk
free
Cristiana Corno– Strategist
Capital Markets – Trading – Banca IMI
6th
-7th
February 2017

2
Aknowledgments
I would be happy to end the year with
more Europe rather than less.
Title of the presentation is stolen from H.G. Wells sci fiction «The shape of
things to come», published in 1933, which speculates about future events
from 1933 to 2106. In the book, a World state is established as the
solution to humanity’s problem.
First edition. Source web

3
Europe challenge in 2017: geopolitics
“The time for petty politics is past; the next century will bring the struggle for
the domination of the world”. Nietzsche, Beyond good and bad.
«Caosland:» a map of the powers and wars surrounding Europe. Source LIMESonline
The problems we are
experiencing “locally”
are probably global
problems’ derivatives:
1.Resource scarcity
2.Population growth
& immigration
3.Climate change
4.Wealth
redistribution
5.Democracy crisis
6.Automation

4
Europe challenge in 2017: Western society answer
The natural answer of the Western society to fear and uncertainty has been
to find refuge (we are all refugees) in the past. «Back to the past» is,
probably, the common denominator of:
Trump election
Brexit
«No» win at Italian referendum
Hungarian referendum on immigration
Austrian presidential race
Le Pen in France
Anti-European sentiment
Currently «Fearful» society is not priced in a «Fearless» market (chart).
Low fear in the market
Strike of a 3-m collar on SPX: the put strike you
can buy by selling a 10% OTM call, the lower the
index the more ATM the strike. Source Bloomberg.

5
Europe challenge in 2017: no Past in the Future
Source: Eurostat
 Extrapolating the current trend in population growth and economic
activity (GDP), Europe's importance in the world will decrease
further and the same will happen to each individual Western
country.
World population growth and distribution
0
10
20
30
40
50
60
70
IMF Adv Econ GDP
IMF Emerging & Developing Asia GDP
IMF Emerging Market & Developing GDP
Share on World GDP: Advanced and Emerging
Economies
Source: IMF, Bloomberg data

6
Europe challenge in 2017: How to «Handle» Brexit
 UK finds itself in a weak negotiating position: out of the EU into
the US?
Source: web
0
2
4
6
8
10
12
14
16
18
20
IMF UK GDP IMF Germany GDP IMF Euro area GDP
Share on World GDP: UK, Germany and Euro Area
Source: IMF, Bloomberg data

7
Europe challenge in 2017: politics «European spring»?
 Election with anti-European movements being «legitimate» by
Trump success and Brexit.
 60° Anniversary of the Treaty of Rome (25th March 2017).
 Start of stage 2 of the Five President’s report with Spring White
Paper (30th June 2017).
The roadmap of the Five Presidents’ Report. Source European Commission

8
Europe challenge in 2017: ongoing work on growth
convergence and stability
According to EC for the finalization of EMU we should see:
I. The completion of Banking Union with the European Deposit
Insurance Scheme in tandem with risk reduction in the banking-
government nexus via diversification of home-bias;
II. Further work on Capital Market Union (venture capital, integration
in funding, securitization);
III. A positive fiscal stance for Europe, meaning:
 Use of fiscal space where possible (Germany, Netherlands) in
line with European strategic objectives or infrastructure, digital
economy (FISCAL POLICY MUST BE NON-RICARDIAN to be
effective);
 Use of fiscal spending to reduce debt, where no space is
available (to LIMIT MORAL HAZARD implicit in QE cheap
financing).

9
Europe challenge in 2017: ongoing work on growth
convergence and stability
IV. The European pillar of social right: promotion of human capital,
work mobility in Europe, investment on training and new skills
(interesting proposal to consider COST OF TRAINING AS AN
INVESTMENT and not as current expenditure, R&D similarity)
0
5
10
15
20
25
Greece
Spain
Cyprus
Italy
Portugal
Latvia
France
Slovakia
Finland
Lithuania
Belgium
Slovenia
Ireland
Estonia
Luxembourg
Austria
Netherlands
Malta
Germany
Last Unemployment rate average (since 2000)
Addressing unemployment dispersion And quality: adult illiteracy as % of total adults
Source: Bloomberg Source: OECD

10
Europe challenge in 2017: “stability without safe asset?“*
From a market perspective the completion of the EMU lacks of a
common European safe asset. This missing tool is both a product
and an amplifier of the EU ecomomic divergence.
* «The ECB's Monetary Policy: stability without a safe asset?» Silke Tober, May16
Banking
Union
Reduce home bias via diversified
low risk asset
Capital
Market Union
Flow stability, less fragmentation,
european rather than national safe
asset
Fiscal policy
Financed via a Non-Ricardian asset
or low debt asset (otherwise it
increases precautionary savings to
pay future taxes)

11
The yield curve to come
1 2016 Experimental policy
2 Possible developments in 2017: European safe asset?
3 Markets

12
A journey into negative rates
 Negative policy rates, QE and vanishing inflation have taken bond
yield into deep negative territory with massive curve flattening,
hitting financial system stability and profitability.
 Negative rates have spread quickly and worldwide, taking 37% of
G7 bonds into negative territory (July16).
Correlation between curve slope and
financial stock performance
0%
5%
10%
15%
20%
25%
30%
35%
40%
0
1
2
3
4
5
6
7
8
9
10
Trillions
Outstanding Amount (value) Outstanding Amount (%)
Amount of G7 bonds trading at negative
rates: absolute and %
Source: Bloomberg

13
And back: BOJ amendment «Yield Curve Control»
In Sep16, BOJ has introduced QQE with yield curve control, thereby
targeting the policy rate and the 10y JGB yield (implicitly the curve
slope). The 10y target is a «soft» target.
 If credible, the YCC should allow control with limited buying.
BOJ could address in this way both the need for steeper curve
and for tapering (according to IMF*, BOJ will have to taper, starting
2017-2018).
*IMF paper, ”Portfolio rebalancing in Japan: constraints and implications for QE”
Central Banks balance sheet (% of GDP) Central Banks holding of government bonds

14
Yield curve control versus QE
Positive
 If credible ,YCC allows
results with lower
quantities and market
distortion
 It supports fiscal stimulus
keeping long term rates low
 It could be more effective in
reducing the correlation with
other rate markets
Negative
 It generates greater
uncertainty about the
evolution of the central
bank’s balance sheet, with
potential consequences in
term of credit risk and loss in
case of adverse market
move;
 It could be interpreted as
being fiscal dominance
Framework is not applicable to Euro-zone due to lack of a common asset:
multiple curves. Multiple equilibria.
Yield curve control targets a price, while QE targets a quantity.

15
BOJ buying in Yield curve control
To manage the YCC, BOJ has not increased the size of buying, but
the portfolio composition, adding duration in the 5y-10y bucket.
The curve has steepened (3010y) more in govies than cash,
maintaining low correlation with Developed rate markets (helping
currency depreciation).
-10.00%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
2 5 10 20 30 >30
7.00
7.50
8.00
8.50
9.00
9.50
10.00
10.50
11.00
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
3,500,000
buy oct buy nov buy dec buy jan
2 5 10 20 30 >30 AVG duration
Deviation of BOJ portfolio versus market
neutrality in post Sep16 buying
BOJ buying from September 2016: duration
increase
Source: BOJ, Bloomberg

16
«Yield Curve Control» impact on market
Currently BOJ holds nearly 40% of outstanding JGB, 50% at end
2017 (under current QE pace), mainly in the short end (chart left
below).
The asset swap curve on the Japanese market has steepened a lot,
with significative cheapening of the cash long end, not matched by an
equal move in cross-currency swaps (chart on the right).
BOJ holding on single securities as percentage
of amount outstanding
30y JGB asset swap and cross currency swaps
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00% One quarter left of
QE, then what?
-70
-60
-50
-40
-30
-20
-10
0
-0.15
-0.1
-0.05
0
0.05
0.1
.JGB30ASW JYBS30 cross cur

17
«Yield Curve Control» impact on volatility
With the YCC volatility on rates has decreased strongly along bucket
and expiries, but since October is increasing mainly in the long end.
Payer swaption on 10y cheap hedge on QE fatigue (6m expiry)
Volatility started to increase in the long end
(after Oct16)
Swaption volatility curve: we like a payer
swaption on QE fatigue
-10.00
-5.00
0.00
5.00
10.00
15.00
20.00
1y 2y 3y 5y 7y 10y 15y 30y
1m 3m 6m 1y 2y
0
10
20
30
40
50
60
1y 2y 3y 5y 7y 10y 15y 30y
1m 3m 6m 1y 2y

18
«Yield Curve Control» impact on other markets
The cheapening of the JGB long end is making the German long end
looking rich, also taking in account cross currency basis (chart on the
left) and explains marginally France underperformance, together with
political risk (chart on the right).
30y JGB asset swapped in Eur versus Bund
level (proxy)
France asset swap versus JGB asset swap in
Eur (proxy)
-60
-40
-20
0
20
40
60
80
.JGBEU U Index
.DBR30ASW U Index
.JGBEU U Index - .DBR30ASW U Index
0
10
20
30
40
50
60
70
80
.OAT30A U Index .JGBEU U Index

19
Interesting trends in asset swap
Two trends are emerging:
 Divergence between Bund and JGB (wider in xccy);
 Convergence between US and UK (smaller in xccy).
Possible trades: Dbr cash steepener versus swap in 3010y or
versus France 3010y flattener
Asset swap spread behavior in different markets
Source: ECB, Bloomberg; IMI calculations

20
ECB amendments: negative repo and PSPP change
ECB has amended the negative rate policy alleviating bank hit, via:
 Negative repo rate
 Steeper curve: allowing buying below the Depo rate, ECB has both:
 increased the pool of eligible assets while reducing market
distortion;
 and steepened the curve.
0
2
4
6
8
10
12
Billions
33%
40%
50%
Source: BOJ, Bloomberg
-
1
2
3
4
5
6
7
8
Billions
Change in eligible pool with cap raised 40%-50%
for non-Cac securities
Change in eligible pool with Depo limit removal:
less distortions

21
Current Buba Govies portfolio
Under our calculation, Buba has 15 months (13 plus gross supply) left, at
current QE pace. Eventual cap rise on non-CAC issue would increase
remaining time by 3 and 9 months (40% and 50%), but in 12 months it
will nearly hit the 33% issuer limit.
 The duration of the government portfolio should gradually decrease from
10.3 to 8;
 Main buying should be concentrated on 3y-4y area in barbell with long
end.
Available bonds to buy (IMI calculations) Richness and cheapness on the curve, errors of
Z-spread fit using duration and convexity
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
Billions
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00

22
Yield curve to come
2 Possible themes in 2017: European safe asset?
3 Markets

23
Europe challenge in 2017: safe asset
Modern developed economy have 2 stability anchors: price
stability and safe government bonds as store of value.
Safe assets are characterized by liquidity and low default
For safe assets to exist, public finances need to be sustanaible
With the increase of government debt, the “normal” for the safe
industry has become AA/A rather than AAA
«The supply of safe assets and fiscal policy», L. Schuknecht CFS working paper.
Debt to GDP ratio in G7: back to 1945 levels S&P projection of long term sovereign
distribution (no policy change)

24
Europe challenge in 2017: safe asset industry
According to academics*, safe assets production follows a Laffer
Curve; up to a certain debt level (B), the production of safe assets
increases linearly with debt. After that point, debt is still safe enough
and the weighted safe assets increases (D), but at some point all the
debt becomes unsafe (E).
The position of the Laffer curve depends both on the specific country
and on the economic circumstances.
Enhanced QE: QE profit to European Fund for debt reduction.
Safe assets production and debt QE could induce more debt production due to
increased safe-asset demand: explains BUBA
* «The supply of safe assets and fiscal policy», L. Schuknecht CFS working paper.
QE moral
hazard: cheap
financing
taken as
permanent

25
Europe challenge in 2017: European rather than
national safe asset
As opposed to US, UK and Japan, the Euro-Zone has price
stability, better ratios, but no safe asset.
Member States have different default probabilities and do «gravitate»
around a national safe asset which has become the anchor for the
whole system (Bund).
Default probabilities extracted by
government market (02-02-17)
Rating change for Euro members since
2000
Source: Bloomberg; IMI calculations
The Sun

26
Europe challenge in 2017: «European» rather than
«national» safe asset
This evolution has reinforced the economic divergences intra Europe,
by fragmenting further the financial system*:
altering the cost of credit intra Europe;
reducing the ability to diversify;
creating destabilizing capital outflows, alternatively, in search for
yield or for safeness.
At current stage, Eurobonds are politically (joint liabilities and
Treaty changes) and, probably, economically unfeasible (they
could end up being credit negative).
Using some Financial Engineering two schemes have been
proposed.
Currently, the European Systemic Risk board has started to study the
options with a Task force on the subject.
* “Addressing the safety trilemma: A safe sovereign asset for the eurozone”, Ad van Riet, Oct16

27
Europe challenge in 2017: financial engineering
Nasbies or National safe bond (Bundesbank*, July 2016)
Each national bond is issued in 2 tranches (Senior and Junior), with
defined loss distribution. In the simplest way, assuming a division
30%/70%, any traditional bond can be decomposed in:
 30% Senior tranche with loss for recovery value <30%;
 70% Junior tranche containing all the loss up to a recovery
value >= 30%.
The created tranches would be very similar between countries,
trading on perceived differences in recovery value.
The tranching would increase AAA assets from ca 1.9tr
(Germany & Netherlands) to 3.6tr, or almost 50% of the European
Gov. Debt (7.5tr).
We can simplify saying that the Junior loss bear the «default risk»,
the Senior tranche the «recovery risk».
* Bundesbank monthly

28
The Senior Tranche could be used:
 to reduce the home bias of the banks portfolios (regulatory
reasons);
 for QE, to increase the pool of eligible assets and to create an
almost risk free yield curve, eventually allowing yield curve
targeting;
 with a guarantee by ESM they could become fungible and
represent a light start for an European bond market. In this case,
the joint guarantees on the senior tranches would make any other
«national» asset trade at positive spread.
The tranching would not change each country liabilities'
structure. The tranches could trade separate or together (in analogy
with the stripped market) and they could also be used to build new
structures (junior coupon and senior bulk).
An eventual restructuring process would not be complicate.

29
Example: Bond price and tranches depending on recovery value
0
20
40
60
80
100
120
100 90 80 70 60 50 40 30 20 10 0
junior senior bond
We have
created a
new, more
«convex»
P&L profile
Senior and Junior BTP
(Autumn 2017)Source: Bloomberg; IMI calculations

30
Esbies or European safe bond (Brunnemeier, 2016) are more
complicated. They entail pooling and tranching a portfolio of
government bonds (capital keys weighted). The authors estimate that
with a 30% junior tranche is possible to get to AAA expected loss
exploiting the correlation and diversification of the assets.
The amount of safe assets (AAA tranche) would equal 5.8 tr.
The Senior tranche would be granted preferential treatment .
I find this solution too complex, DIFFICULT TO PRICE and long “tail risk”
(high correlation). Also due to the pooling, an eventual restructuring would
be complex.

31
Yield curve to come
2 Possible themes in 2017: European safe asset?
3 Markets

32
Inflation temporarly up
 We have been expecting higher EU broad inflation on higher
commodities/oil/food prices. The core component is still well
behaved and seems explained by monetary factors (MFI loan to non
financial growth rate).
 Our simulation puts a 2% hit on average in 2017 in All Items and
1.2-1.3% on Core to retrace towards 2018.
All Items YoY long term trend fit explained by
monetary factor: needs ECB support
Euro All Items YoY simulation
Source: Bloomberg; IMI calculations Source: Bloomberg; IMI calculations

33
Inflation and real rates diverging
 There is small risk premium in the inflation swap market, but we do
not like to be long at current levels. The Citi inflation surprise is at
2011 highs.
 We like to pay real rates to express a bearish position (rich
linkers). We highlight the divergence between real rates and
inflation.
Inflation and real rates diverging 10y
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
eu 10y inflation eu 10y real

34
Peripherals risk
 Difficult to be constructive, for the moment.
 Portugal-Germany spread is the variable which explains better the
move in zeta-spread complex in European market (PCA): a preview
of tapering? Since Apr16, the CB has been buying supranational.
 The only way, we would try to go long is via a cross-trade long
peripherals (Italy) and long volatility on EuroStoxx 50.
 Corporates and financials have lagged the move in sovereign risk
0
5
10
15
20
25
30
35
PARPUB33/407/05/21
PGB4.4506/15/18
PGB4.806/15/20
PGB2.210/17/22
PGB5.6502/15/24
PGB27/807/21/26
PGB37/802/15/30
PGB4.102/15/45
ESM07/810/15/19
EFSF11/201/22/20
EFSF13/410/29/20
EFSF0.101/19/21
EFSF13/806/07/21
EFSF21/409/05/22
EFSF011/17/22
EFSF17/805/23/23
EFSF21/802/19/24
EFSF13/406/27/24
ESM109/23/25
EFSF0.405/31/26
EFSF37/803/30/32
EFSF309/04/34
EFSF33/804/03/37
EFSF2.3507/29/44
ESM13/410/20/45
BTP-Bund spread and stocks volatitlity Possible portfolio of BOP QE related buying

35
Directional rates: bearish but with hedge
 We would keep a duration short, hedged with cheap protection
on equity. There seems to be a lot of good news priced in the US
equity market, in what has been called the «TRUMP SQUARED»
effect (by Shiller).
 Looking at term premia in rates market, Euro rates are much richer
than US, but given political situation, we would not play the spread.
 We suggest a long in OIL volatility as a good hedge for
geopolitical risk.

36
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Conflicts of interest
Banca IMI S.p.A. and the other companies belonging to Intesa Sanpaolo Banking Group (jointly, the "Intesa Sanpaolo Group") provide all services in
the lending and securities industry, carrying out in particular – through its companies in possession of the necessary authorizations, where required –
investment banking, corporate finance and finance and investment activities – through merchant banking activities and proprietary trading - financial
advisory, investment research and financial analysis or other forms of general recommendation regarding transactions on financial instruments,
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37
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London february 2017

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