Investment Symposium March A2: Deflation and Extreme Inflation - Severity, Timing, and Risk Management. Moderator Allan Levin

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1 Investment Symposium March 2010 A2: Deflation and Extreme Inflation - Severity, Timing, and Risk Management Riddhi Barman Gang Hu Torsten Slok Moderator Allan Levin

2 Society of Actuaries Investment Symposium March 2010 Hedging Inflation in Today s Market Tools, techniques and strategies Riddhi Barman Deutsche Bank Volatility of Inflation has Returned Historical Year-on-year Change in US CPI Forecasted Year-on-year Change in US CPI 5% 4% 5% 4% Actual Range of Predictions 3% 3% 2% 2% 1% 1% 0% -1% Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 0% -1% May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11-2% -2% Source: Bloomberg Source: Bloomberg, Philadelphia Federal Reserve Extreme moves from central banks in 2009 combined with uncertainty of their exit strategy has fuelled volatility of future inflation While short term forecasts of US inflation are somewhat benign, there remains significant divergence of views over the long term implications of the Fed s QE program 2 1

3 Are equities a good hedge for inflation? As a portfolio manager, one is primarily concerned about hedging against unexpected inflation Equity returns are NEGATIVELY correlated to inflation shocks Equity performance suffers further as the magnitude of the inflation shock increases S&P 500 vs Inflation 3 What about Commodities / Property / Fixed Income? Commodities (S&P GSCI) vs Inflation Property (FHFA Series) vs Inflation Short 10y Treasuries vs Inflation Commodities do provide reasonably strong correlation to inflation Volatility of returns creates some difficulty in choosing a hedge ratio Positive correlation, however weaker than commodities Additional considerations should be taken to take into account any illiquidity of individual property holdings Positive correlation, similar strength to commodities Hedging ratios are constant under different inflation scenarios 4 2

4 Using Nominal Rates Instruments to Hedge Inflation Short Nominal Treasuries Nominal Rate Swaps and Options Pros Treasury market is extremely liquid Large, deep, and liquid market Other considerations Short 10y treasuries exhibit historical correlation of ~50% with unexpected inflation Repo Basis Risk Daily compounding effects in ETFs Easy to customize payoffs and tenor Negative carry of pay fixed swaps in steep curve environment High volatility levels and exposure to skew Basis Risk NB - Deutsche Bank does not provide accounting advice. The determination of the proper application of US GAAP to an actual transaction is the sole responsibility of the financial statement preparer in consultation with its external accountants. 5 Using Inflation Linked Instruments Inflation Protected Treasuries (TIPS) CPI Swaps and Options CPI Linked Notes Pros Payoff profile is tied directly to inflation (CPI) Large, deep and liquid market Ability to get up to 30y of inflation exposure YoY and Zero Coupon (Cumulative) formats Hedging with swaps allows risk mitigation decision to be independent of asset allocation decision Options provide increased flexibility to buy tail risk protection in limited downside format Ability to customize CPI-linked payouts without ISDA/CSA requirements Can be structured to address FAS 133 MTM considerations Other considerations Effect of inflation on payoff profile is mainly reflected at maturity Requires allocation of capital to low absolute yields EITF Good liquidity in swaps - Limited but steadily improving liquidity in options Typically exposed to MTM accounting in the absence of CPI linked liabilities Liquidity can vary depending on issuer Requires ISDA / CSA NB - Deutsche Bank does not provide accounting advice. The determination of the proper application of US GAAP to an actual transaction is the sole responsibility of the financial statement preparer in consultation with its external accountants. 6 3

Commodities & Inflation Hedging Hedging Unexpected Inflation Energy and food are a significant component of Headline Inflation Different commodity sectors react very differently to the macro events

5 Commodities & Inflation Hedging Hedging Unexpected Inflation Energy and food are a significant component of Headline Inflation Different commodity sectors react very differently to the macro events that drive inflation Invest efficiently and diversify in commodities markets by using indices (DBLCI - OY) Commodities (S&P GSCI) vs Inflation 12% 110% Une expected Inflation 8% 4% 0% -4% -8% YoY Unexpected Inflation 90% 70% 50% 30% 10% -10% -30% SCI TR Index Returns S&P GS Correlation Energy 82.8% Industrial Metals 36.6% Precious Metals 46.8% Agricultural 53.7% Source: Blloomberg -12% S&P GSCI Energy TR Index Source: Blloomberg -50% -70% -16% -90% Energy returns measured by the S&P GSCI Energy TR Index SM Industrial Metals returns measured by the S&P GSCI Industrial Metals TR Index SM Precious Metals returns measured by the S&P GSCI Precious Metals TR Index SM Agricultural returns measured by the S&P GSCI Agricultural TR Index SM 7 Property Indices A developing market Market is developing synthetic exposure to Residential / Commercial Real Estate Structures are now becoming available on Indices such as Case-Shiller Composite-10 (Residential) and NCREIF (Commercial) As real estate tends to be an illiquid asset class that usually requires a longer investment horizon, property derivatives provide a shorter-dated alternative Property vs Inflation Return on Real Estate Index Fixed Amount CLIENT 8 4

6 Other opportunities in inflation markets (1) Inflation volatility Markets Inflation volatility markets have overcome challenging liquidity considerations of 2008 and the most of 2009 As liquidity has steadily improved, the market has drawn increasing investor attention and participation Common strategies Buying floors for Deflation protection Buying caps for inflation protection Selling Covered Calls for income enhancement Why investors should care Developing nature of market can create dislocations Discrepancies across cash and derivative markets Discrepancies across regions (EUR vs US) relative to fundamentals 9 Other opportunities in inflation markets (2) 10y Deflation Floors Can cumulative inflation over the next 10yrs be negative? The cash market attributes next to no value to the implicit floor in 10y TIPS The derivative market attributes significant value to the same floor Unique opportunity for TIPS holders to monetize floors they are implicitly long Historical Distribution of Cumulative 10y Deflation 25% 10y Cumulative Inflation since the Great Depression Historical Distribution The cash market attributes no value to 10y floors 2.5% 20% 15% 10% 2.3% 2.1% 1.9% 1.7% Apr-2013 BE (floor OTM 2.5%) Apr-2014 BE (floor OTM 2.5%) Unlike the 5Y sector, TIPS breakevens in the 10Y sector are perfectly aligned despite different levels of OTM floors 5% 0% -10% to 0% 0% to 10% 10% to 20% 20% to 30% 30% to 40% 40% to 50% 50% to 60% 60% to 70% 70% to 80% 80% to 90% 90% to 100% 100% to 110% 110% to 120% 120% to 130% 130% to 140% 140% to 150% 1.5% 1.3% 1.1% 0.9% 0.7% M o reo ver, we find so me relative The Apr-2013 and Apr-2014 BEs cheapness of the most recent clearly trade at a substantial 10Y TIPS in spite of deflation premium because of their 2.5% floor closer to the money OTM deflation floor (around 2.4% for the new 01/20s) Term structure of TIPS breakevens 1y 2y 3y 4y 5y 6y 7y 8y 9y 10y 10 5

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8 Investing on Inflation Protection Gang Hu Senior Vice President PIMCO 0 Overview Investment Environment New Normal Investment Framework A word of Caution 1 1

9 New Normal What is New Normal? De-leveraging De-globalization li Re-regulation Market Impact Lower Potential Growth Lower NAIRU Sovereigns Risk Tail Currency Risk/Inflation Risk 2 Investment Framework Timing Tools and Instruments Market Developments 3 2

10 Investment Timing When there is NO inflation Timing for Secular Investment Asset/Liability Management Asset Allocation Weightings Secular Investment Preference Timing for Cyclical Investment Cyclical Investment Tools Cyclical overwight/underweight on Inflation 4 Investment Tools Global Inflation Linked Bonds Commodities Equity/Real Estate Inflation Caps/Floors Inflation Swaps or Tips BEI Higher Rate Protections 5 3

11 Market Developments (I) As of December 31, 2009 Growth of Global ILB Market* The global ILB market is large and growing 1,600 1,400 1,200 $1.2T $1.2T $1.0T $1.4T $ Billi ons 1, $813 $ $ $360 $268 $274 $207$247 $ Breakdown of Global ILB Market* ($ Billion) Diversity across developed country issuers presents relative value opportunities U.S. $ % Australia $11 0.7% Canada $43 3.0% France $ % Greece** $18 1.2% Germany $43 2.9% Italy $ % Sweden U.K. $33 $327 SOURCE: Components of Barclays World Government Inflation-Linked All Maturities Bond Index. 2.3% 22.8% * Excludes Inflation-Linked Bonds expiring in less than one year. ** Greece falls out of the index in 2010 Refer to Appendix for additional index and risk information. 6 ILB_review_25 Japan $69 4.7% Market Developments (II) Market Inflows Commodity Flows(MM) GLD Flows (MM) 7 4

12 Market Developments (III) Inflation Swaps Total Inter-dealer Broker Market Volume (MM) A Word of Caution The cost of tail hedging The structure of tail hedging Careful on crowded trades what if everyone is wrong The story of Gold 9 5

13 Outlook for US Inflation March 2010 Torsten Slok, Ph.D. Director, Global l Economics 60 Wall Street New York, New York Tel: Torsten.Slok@db.com Deutsche Bank AG/London All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 106/05/2009 Outline - Summary of outlook - Housing - Banking Sectors facing headwinds - Consumers - Fiscal policy Policy - Exit strategy/inflation response - Investment implications+greece 1 1

14 Likely to see a snapback in cyclical parts of GDP % y/y Cyclical components of GDP Durable goods and structures* % y/y Other components of GDP** *Consumer durables, res. Investment, bus. Equip., structures, change in inventories **Government and consumer services and nondurables, net exports -25 Cyclical components here include consumer durables, BFI, residential investment & chg. in pvt. inventories Source: BEA, DB Global Markets Research 2 Housing 3 2

15 Home foreclosures have soared % Homes in foreclosure (ls) Foreclosure started (per qtr, ls) Numbers of housing units in foreclosure (rs) mln Source: MBA, Datastream, DB Global Markets Research Banking 5 3

16 Senior Loan Officer Survey leads lending by 6 quarters % y/y 25 Banks C&I lending (ls) FRB Sr. officers survey: banks tightening C&I -15 loans to large firms (rs, inverted axis, 6 qtr lead) Source: FRB, DB Global Markets Research % Consumers 7 4

17 The permanent income hypothesis breaks down when households are credit constrained % Fed Survey: Banks' willingness to lend (ls) 2-qtr %chg, AR Real Consumer spending (rs) Source: FRB, BEA, DB Global Markets Research 8 Jobless claims sending a strong signal Thous. 4 wk % 700 MA Initial claims (ls) 12 Unemployment rate (rs) Source: BLS, DOL, DB Global Markets Research 9 2 5

18 Fiscal 10 Fiscal stimulus should boost GDP growth until 2010H2 % 3 Fiscal impact on the level of GDP and on the GDP growth rate % Growth rate Impact on GDP level (in %) Significant lift to GDP growth in 2009H2 and 2010H Q2 2009Q4 2010Q2 2010Q4 2011Q2 2011Q4-1 Source: Haver, DB Global Markets Research 11 6

19 Bottom line on inflation outlook 12 Core inflation is driven by four factors Unemployment Inflation expectations The big question is how flat the Phillips curve is Core inflation Oil price Import prices/ Exchange rate Source: DB Global Markets Research 13 7

Inflation risk rapidly disappearing yoy% Consumer prices yoy% 6 4 Core (ex food and energy) Headline 6 4 2 2 0 Fed's comfortzone 0-2 1996 1998 2000 2002 2004 2006 2008 2010 Source: BLS,DB Global

20 Inflation risk rapidly disappearing yoy% Consumer prices yoy% 6 4 Core (ex food and energy) Headline Fed's comfortzone Source: BLS,DB Global Markets Research Torsten Slok, Ph.D. Director, Global Economics Deutsche Bank Securities, Inc. Torsten Slok joined Deutsche Bank Securities in the fall of 2005 and is a senior member of the Global l Research Team. Prior to joining the firm, Mr. Slok worked at the OECD in Paris in the Money and Finance Division and the Structural Policy Analysis Division. Before joining the OECD he worked for four years at the IMF in the Division responsible for writing the World Economic Outlook and the Division responsible for China, Hong Kong, and Mongolia. Mr. Slok studied at University of Copenhagen and Princeton University. He has published numerous journal articles and reviews on economics and policy analysis

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The Fed s experience with forward

The Fed s experience with forward guidance and asset purchases December 2014 Torsten Slok, Ph.D. Chief International Economist Managing Director 60 Wall Street New York, New York 10005 Tel: 212 250 2155