FIXED INCOME STRATEGY WEEKLY WEEKLY ANALYSIS 25 MAY /// #

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1 FIXED INCOME STRATEGY WEEKLY WEEKLY ANALYSIS 25 MAY /// # Volatility spurt in Spanish, Italian spreads Document intended for professional clients Key Points FOMC: status quo under conditions in June Euro area: growth extends into 2Q Long bias on Bunds, 2s10s flattening Hold on to peripheral exposure despite Spain s political risk The euro area bond market resumed rising last week. The benchmark 10y yield hovers about 0.55% after a further move down in the wake of the outcome of local elections in Spain. Greek political risk as payments to the IMF near in June ( 1.5bn total) contributed to increased volatility in peripheral sovereign markets. Above 130bps, spreads on Italy and Spain bonds are within 10bps of their 2015 highs on 10y maturities. Asset allocators have kept reducing their exposure to the asset class. As concerns inflation linkers, breakeven inflation rates have diminished of late. Conversely demand for US TIPS remain sustained due to attractive valuations (190bps on 10y breakevens) whist core inflation is stable at 1.8%yoy in April. Most spreads remain almost unaffected by sovereign volatility as is the case for equity indices. In the US, the T-Note keep trading under the 2.20% mark as the yield curve resumes flattening. Stable 2y note yields contrast with a broad-based strength in the US dollar. The euro dipped to $1.09 and the Japanese yen weakened to 123. FOMC awaits confirmation of activity pickup The minutes from the April 29 FOMC were released last week. Then, many FOMC participants anticipated that data available by mid-june would not support raising interest rates although they did not rule out tightening. A few members nevertheless considered that incoming data would show sufficient improvement to warrant policy firming. Market forecasts differ significantly from our reading of the minutes. The most likely scenario priced in rate market instruments assumes that policy firming starts in December. Looking at futures and option prices on the effective Fed Funds rate, the implied probability of a June hike is zero. The chance of a July hike is less than 5% according to asset prices. As concerns the economic backdrop, residential construction is picking up. Housing starts have bounced from the 1Q15 low in keeping with the level of building permits. The NAHB homebuilder confidence gauge stood at 54 in May. Demand for credit for house purchase has increased since the start of the second quarter. Durable goods orders (up 1%mom in April exdefence and aircraft) turned out to be betterthan-expected and point to higher business capital spending in 2Q15. Furthermore, an inflation ex-energy and food was stable at 1.8%yoy in April. In sum, these data releases paint a brighter growth picture between April and June after a sharp contraction in the first quarter. The employment report and national surveys for the month of May could result in a more balanced debate regarding a rate hike at the upcoming FOMC in June. Euro area growth consolidating in 2Q15 Growth seen in the three months to March is extending into 2Q15. The composite PMI survey stands at 53.4 in May modestly down from 53.9 a month ago. France s activity growth is at last catching up with Germany s stronger momentum. Furthermore, the details of German s GDP in 1Q15 (+0.3%qoq) were reassuring as concerns the outlook for the rest of the year. Domestic demand ex-inventories (+0.9%qoq) has been the main growth driver. Equipment investment and construction spending have recorded strong growth. Deleveraging of the private sector may not be over in the euro area, but the credit channel

2 has been restored. Monetary data due out this week may confirm the recovery in lending which is crucial for the economy. Bond market outlook The outcome of Spanish local elections which favoured far-left parties accelerated to drop in bond yields towards our estimated fair value estimate (0.54%) to the detriment of peripheral bonds. On technical analysis grounds, further gains remain uncertain. That said, high weekly lows compared with the previous two weeks entail a positive signal. A weekly close above would put the market in a bullish context with price targets of and These elements argue for a bullish bias and curve flattening. The 2s10s spreads stands at 78bps. Significant buying continues to take place in German bond markets focusing however on the 10- year maturity point at the expense of longerdated bonds. Pension funds and banks have in turn been payers of long swap rates. For this reason, we keep a neutral stance on 10s30s in the short run. Conversely, breakeven inflation rates have suffered from the rally in nominal bonds despite evidence of growth and a lower euro. In the United States, 10y note yields have fluctuated in a 10bp narrow range around 2.20%. On our estimates, fair value is about 2.32% slightly higher than current market levels. According to positioning surveys, final US investors have increased their short exposure in UST markets. From a nonresident investor point of view, dollar strength and Greek political risks in the euro area are a boon for US bonds contributing to curve flattening. Demand for TIPS was solid in the wake of the US April CPI release thanks to hedge fund buying (and selling UST futures). We recommend a bearish bias in US markets. Volatility on Spain bonds Local elections in Spain have fanned uncertainty as regards contagion risks from the Greek political risks. Speculative accounts have rapidly sold BTP futures igniting spread widening on Italian bonds. The asset class is still being sold by cross-asset managers. That being said, 1-3y ETFs have seen inflows in keeping with the spreads curve steepening trend. Selling was most evident in the 5-10y segment. Hedge funds and asset managers added fuel to the sell-off movement on BTPs and Bonos towards the end of last week. In terms of strategies, short-term volatility does not jeopardize the outlook for sovereign bonds in our opinion. We keep our overexposure in Italian and Spanish debt market. The spread on 10y Bonos is now 130bps close to 2015 highs (138bps). Italian bond have been penalized by selling pressure in derivative markets as Spain s spreads widen. We however take some profits on 2y Portuguese bonds while maintaining a long stance in longer-term maturity bonds. In core debt markets, stability in yield premiums justify holding on to our current positions. That being said, we lighten our holdings of 2y DSLs due to rich valuations. Belgium and France are our favourite core bets. Spreads are with 30-40bps on 10 years maturities and beyond. In credit space, stability continues to prevail. In the euro area, IG spreads stand at 97bps over German bunds. Covered bond premiums are about 33bps whilst agency debt trade near 42bps. Some German agency bonds trade through the German government benchmark. We expect credit to outperform. The asset calls also attract investment flows on the other side of the Atlantic. US high yield (CDX HY within 340bps) enjoys inflows amid stable oil prices over the past few weeks. Investors have also bought leveraged loans back after a prolonged period of net outflows.

3 Main Market indicators Selected s Government Bonds 27-May-15-1wk (bps) -1m (bps) Ytd (bps) EUR Bunds 2y % EUR Bunds 10y 0.52 % EUR Bunds 30y 1.16 % EUR Bunds 2s10s 75 bps USD Treasuries 2y 0.65 % USD Treasuries 10y 2.15 % USD Treasuries 30y 2.91 % USD Treasuries 2s10s 150 bps GBP Gilt 10y 1.88 % JPY JGB 10y 0.39 % Sovereign Spreads (10y) 27-May-15-1wk (bps) -1m (bps) Ytd (bps) France 31 bps Belgium 32 bps Italy 138 bps Spain 133 bps Portugal 200 bps Inflation Break-evens (10y) 27-May-15-1wk (bps) -1m (bps) Ytd (bps) EUR OATi 136 bps USD TIPS 184 bps GBP Gilt Index-Linked 266 bps Swap Spreads (10y) 27-May-15-1wk (bps) -1m (bps) Ytd (bps) EUR Swap Spread 36 bps USD Swap Spread 8 bps EUR Credit Indices (BarCap) 27-May-15-1wk (bps) -1m (bps) Ytd (bps) EUR Corporate Credit OAS 97 bps EUR Financials OAS 104 bps EUR Agencies OAS 42 bps EUR Securitized - Covered OAS 33 bps EUR Pan-European High Yield OAS 347 bps Currencies 27-May-15-1wk (%) -1m (%) Ytd (%) EUR/USD $ GBP/USD $ USD/JPY Source: Bloomberg, Natixis Asset Management

4 Government Bonds Cross-Currency Spreads EUR Bunds 10y = / +1 EUR Bunds 2s10s = / -1 EUR Bunds 10s30s = USD Treasuries 10y = / -1 USD Treasuries 2s10s = USD Treasuries 10s30s = USD Treasuries - EUR Bunds (10y) = USD Treasuries - GBP Gilts (2y) +1 Sovereign Spreads - All Maturities Other Bond Markets France vs. German Bunds +1 Netherlands vs. German Bunds +1 Belgium vs. German Bunds +1 Spain vs. German Bunds +1 Italy vs. German Bunds +1 EUR Index-Linked Bonds (Breakeven View) = / +1 EUR Corporate Credit +1 EUR Agencies (vs. Swap Curve) +1 EUR Securitized - Covered (vs. Swap Curve) +1 EUR Pan-European High Yield +1 Positions on a scale of "-2" to "+2", "=" stands for neutral +1 is long ( -1 is short) spread or duration or steepening Source: Natixis Asset Management

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