Euro Fixed Income. June Michael Krautzberger, Managing Director, Head of Euro Fixed Income FOR PROFESSIONAL INTERMEDIARIES ONLY

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1 Euro Fixed Income Michael Krautzberger, Managing Director, Head of Euro Fixed Income June 2011 FOR PROFESSIONAL INTERMEDIARIES ONLY

2 Numerous significant headlines in 2011 so far, but Financial markets have held up remarkably well in the first quarter despite political revolutions and economic weakness 2011 headlines Globally: Capital controls Increasing central bank rates Food and energy price increases Q returns US: 1Q GDP weakness Government shutdown saga European ratings crises: Ireland Portugal Greece Middle East / North Africa revolutions Syria Libya Egypt Bahrain Japan: Earthquake Tsunami Nuclear disaster Supply disruptions US Treasuries (bps) Commodities (%) Currencies (%) Fixed Income (%) Equities (%) 2-year 0.23 Oil 14.3 USD -4.0 IG Credit 0.9 S&P year 0.27 Gold 0.8 GBP 2.7 High Yield 3.9 FTSE year 0.18 Corn 9.5 Euro 5.8 CMBS 2.1 Euro Stoxx year 0.17 Cotton 49.2 Yen -2.4 Source: Bloomberg Emerging markets 1.6 Nikkei

3 Euro Area Ranks Well in International Comparison If the euro area could be seen as a single fiscal area, its debt and deficit metrics would compare favourably with Japan, the US and the UK However, the euro area is not currently one single fiscal area and internal imbalances have built up over the last decade as excessive consumption in peripheral markets was financed by excessive saving in core Europe Peripheral countries ran up twin deficits and their domestic economies lost competitiveness within the Euro area and internationally and as growth slowed over the financial crises, the public sector took up the slack Lasting damage was done to potential growth & banks balance sheets when the real estate bubbles burst in Spain and Ireland and the construction sectors collapsed General Government Deficit & Debt (% GDP) OECD Medium-term Fiscal Sustainability Scenario* Japan OECD US Euro area UK % of GDP United States Japan United Kingdom Euro area % of GDP Gross Financial Liabilities (RHS) 2007 Deficit 2011 Deficit 2017 Deficit 2007 Debt, RHS 2011 Debt, RHS 2017 Debt, RHS Source: OECD & EC Source: OECD * 6 years of consolidation (6pp of GDP from 2012) 3

Central Bank real rates are negative Global Central Bank rates are very low relative to inflation rates 8 6 ECB Real Rate Fed Real Rate BoE Real Rate PBOC 7d Real Rate 4

4 Central Bank real rates are negative Global Central Bank rates are very low relative to inflation rates 8 6 ECB Real Rate Fed Real Rate BoE Real Rate PBOC 7d Real Rate Source: BlackRock For use with institutional and professional investors only proprietary and confidential 4

5 Where Next? European Solution - Extend & Pretend Further downward rating migration likely in the periphery Numerous peripheral downgrades to date as ratings converge to market perceptions/valuations Further downwards rating migration likely in the near term as agencies continue to digest the credit implications of the ESM & in the medium term as the full costs of the financial crisis become known & additional fiscal consolidation gets harder to achieve politically & dampens growth prospects Portugal, Greece, & Ireland were downgraded by S&P on the back of the credit implications of accessing the ESM e.g. the likelihood of private sector involvement & subordination of private sector creditors There is limited scope for upgrades if economic growth is better than expected &/or governments manage to achieve deficit & debt targets faster than expected Country Moody s S&P Fitch Austria Aaa Belgium Aa1 AA+ AA+ Finland Aaa France Aaa Germany Aaa Greece B1 Review for Downgrade B BB+ Ireland Baa3 BBB+ BBB+ Review for Downgrade Italy Aa2 A+ AA- Netherlands Aaa Portugal A3 BBB- BBB- Review for Downgrade Spain Aa2 AA AA+ UK Aaa 5

6 It has been a rocky ride in Europe over the last 8 months German 2y Bund Yield (%) Peripheral Spreads over Germany % Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Percent Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Source: Bloomberg to May 2011 Portugal Ireland Volatility in peripheral markets, mounting inflationary pressures and a rapid change in central bank direction and rhetoric caused a sharp back up in government yields moving into The correlation between credit and peripheral sovereigns has been high During the six month period from 30/09/2010 to 31/03/2011, passive benchmark investors witnessed negative returns with the Euro Aggregate Benchmark returning -3.61% and the Euro Aggregate 1-3 Year Benchmark returning -0.22% 6

7 German yields distorted by safe haven flows During Q4 2010, relative to the outlook for economic growth, German yields were far too low and had benefitted from the safe haven bid. Coming into 2011, duration moved to a more neutral stance and traded tactically Industrial Production vs. German and Spanish Yields Mar-05 Nov-05 Jul-06 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Spain 2y (lhs) Germany 2y (lhs) Short European duration Spain Ind. Prod. YoY (4 per. mov. avg.) Germany Ind. Prod. YoY (4 per. mov. avg.) 7

8 2-year Spanish and Italian yields are unchanged since the start of 2011 however not the same can be said about Germany Yield % /01/11 10/01/11 17/01/11 24/01/11 31/01/11 07/02/11 14/02/11 21/02/11 28/02/11 07/03/11 14/03/11 21/03/11 28/03/11 04/04/11 11/04/11 18/04/11 25/04/11 02/05/11 09/05/11 16/05/11 23/05/11 30/05/11 06/06/11 Germany 2yr Italy 2yr Spain 2yr Source: Bloomberg

9 Inflation short term risks are clearly to the upside The difficulty of calculating the output gap is well documented. ECB member Stark has said inflation arguments based on the size of the output gap are flawed. Pressures stem from non-domestic factors. - Globalisation is now reversing and we are importing inflation from developing economies Input prices:- Food:- - Weather related supply shocks are keeping prices high - However structural demand has increased as China continues to grow - The recent increase in raw food prices does not appear to have fully fed into HICP yet 9

10 ECB watch: Where Next? The ECB is priced for slightly more than one additional hike in 2011 However they continue to provide liquidity to the banking sector Jean Claude Trichet, 3 rd March Our message for all price setters is that they have to take into account that the ECB will not permit second-round effects to emerge from the stronger commodity prices...."what we can do is clearly to avoid that" commodity shocks will have second round consequences. Expected EONIA rates at the December ECB meeting Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 10

11 Yield Curve: Focus on country differentials The Italian and Spanish yield curves have steepened considerably over the last months. Portugal, on the verge of below investment grade status has an inverted yield curve. Italy and Spain offer relative value opportunities Yield % Yield % yr 3yr 5yr 7yr 10yr 15yr 30yr 4 Italy (LHS) Spain (LHS) Germany (LHS) Portugal (RHS) Source: Bloomberg Data available to 2 th June

12 Relative Value opportunities on mid-tier periphery resilience Italian CDS is back to the levels seen before the Greek debacle Yield % bps Jan-10 Mar-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Mar-11 May-11 0 Italy 5yr yield (LHS) Italy CDS (RHS) Source: Bloomberg. 12

13 Flatness in the Euro Money Market Despite talks of stimulus withdrawal, outstanding flatness offers compelling risk/return trade-off September 2012 contract - March 2012 contract Closed position bps Opened position 5 0 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Source: Bloomberg. 13

14 Credit: Focus on Security Selection Likes : Dislikes + Avoids Apr-07 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 BlackRock Credit Analysis: Likes / Dislikes + Avoids Source: Bloomberg Data available to 5 th May 2011

15 Credit: Euro Covered vs. Senior Banking OAS Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 EUR Covered vs. Senior Banking OAS EUR Covered EUR Banking Senior

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PRESENTATION BY JACOB A. FRENKEL AT THE FORUM: INTELLIGENCE ON THE WORLD, EUROPE, AND ITALY. Villa d'este, Cernobbio - September 7, 8 and 9, 2012

PRESENTATION BY JACOB A. FRENKEL AT THE FORUM: INTELLIGENCE ON THE WORLD, EUROPE, AND ITALY Villa d'este, Cernobbio - September 7, 8 and 9, 1 Working paper, September 1. Kindly authorized by the Author.