Is Sovereign Default “Unnecessary, Undesirable and Unlikely” For All Advanced Economies?

- "We conclude there is no such thing as completely safe sovereign debt."
- "Sovereign default in the advanced economies is not a ‘can’t pay’ issue but a collective ‘won’t pay’ issue."
- "The cost-benefit analysis of sovereign default may favour default for the most highly indebted countries."
- "The political economy of fiscal burden sharing may demand that sovereign creditors share the pain with tax payers and beneficiaries of public spending."
- "Greece is the Euro Area member state most at risk of sovereign default."
- "Ireland may not be able to make whole both its sovereign debt holders and the unsecured creditors of its banks."

Should BTPs become the new benchmark for Europe?

- Overview: "Significant challenges remain for EMU but we see the issue as being contained. We do not think Europe should have a meaningful impact on global rates."
- "Extremely low Bund yields may be distorting valuations of risk premia in Europe. We look in more detail at how this has impacted the market."
- US Rates Strategy: "We speculate about the possibility of further monetary easing by the Fed: why they might do it, what would trigger it, its timing, the likely instruments used, and its size."
- Euro Rates Strategy: "We examine whether France’s current pricing is justified by expected fundamental improvements. We also build on and expand last week’s examination of curvature, including at the very long end."
- Global Inflation Strategy: "Shifting supply pressure, rich AsW valuations, and the historically tight level of breakeven inflation boxes all suggest switching out of BTPei into OATei."
- APAC Rates Strategy: "We have reached our entry target to buying 10yr Australia. We continue to recommend receiving 6-mth NZD OIS versus paying 6-mth AUD OIS with a target of 175bps and a stop of 140bps."
- JGB Rates Strategy: "We recommend a 7s30s swap flattener. We expect rates to decline in the second half of September, to rise only modestly, if at all, in October, and to decline in November. Further monetary easing could come in Q4."
- Flow Analysis: "There are further signs in last week’s flow data that the bears’ hibernation may almost be over. Within Europe demand seems to be swinging away from peripherals in general rather than from individual countries."

FX for surfing, FI for diving

- FI Strategizer: Stable policy rates and slowing growth momentum should prove beneficial for long-term yields, especially AAAs. The belly of the curve performed well in 3Q, but the 2/5-year spread still offers value for yield hunters. Spreads within the eurozone should stay volatile in 4Q.
- EU Portfolio Strategy: Over the next several quarters, we face a global fiscal policy tightening (reversed German reunification) which calls for a modest long duration, adding to the active deviation if 10Y Bunds rise by another 25bp. Country wise, we continue to favor BTPs within periphery. We also take a prudent stance on France.
- Money Market: Demand for liquidity at the ECB refinancing operations has stabilized in recent months, although at regional level we still observe high reliance on ECB funding. Full allotment should stay in place until 2Q11, contributing to smoothing the path of MM rates in EMU.
- Inflation: As we had pointed out last quarter, EMU BE proved a good opportunity in 3Q. Now we are back to more “average” and unattractive levels. In 4Q we expect inflation to remain subdued, recent ECB remarks on upside risks are the only factor that may provide further support.
- Supply Corner: 4Q will be the least liquid quarter of the year, with just EUR 82bn in redemptions and EUR 30bn in coupons. We expect gross supply in 4Q to be EUR 165-180bn, with risks skewed to the downside. Net supply should be EUR 80-95bn, up from EUR 25bn in 3Q.
- FX Strategizer: Global uncertainty is still on and investors will continue to frequently change their mind due to opposing and temporary short-term drivers. The FX market remains more interesting for big-wave surfers than for free-climbers.
- EUR: EUR-USD will reflect again global and local risk factors (US growth fears vs. EMU woes), staying mostly trendless throughout 2H11. More strength will occur in late 2011, when the ECB starts hiking rates.
- JPY: BoJ intervention managed to stem JPY appreciation, but USD-JPY reversal is unlikely to exceed 90-95 in the medium term. In turn, EUR-JPY should progressively pull back above 125 by the end of 2011.
- CHF: SNB sounded more dovish on growth and inflation, but this will not prevent EUR-CHF to slide again below 1.30 if risk aversion persists. The 2011 outlook still points to a consolidation back towards 1.35.
- GBP: Cable may suffer again and a rally above 1.60 can be penciled in only in late 2H11, when we now expect the BoE to start a rate hike cycle. EUR-GBP should again remain mostly stuck within the 0.80-0.85 band.
- Commodity Currencies: The recent rally of the three dollars should be reverted if risk aversion escalates. More AUD, NZD and CAD strength should occur in 2011 in case of a relaxation of the global picture.
- Nordics: More EUR-SEK and EUR-NOK weakness is in the pipeline, but more attacks & retreats can be expected along their appreciation path.
- FX Special: Risk aversion has clearly enhanced the role of safe-haven currencies, but our dedicated special demonstrates that the yen tends to outperform the CHF and the greenback in this role.

China water: Flowing strongly

- Pressing water shortages raise awareness of conservation• "Severe drought in southern Chinese provinces has threatened rice crops and reservoirs."• "Macau and Zhuhai rely on the Xijiang River in Guangdong, and they experience salt tides."
- 12th Five-Year Plan to lend further support to the sector
• "Continued focus on water conservation: bodes well for tariff hikes and privatisation, in our view."• "Investment of RMB700bn during 2011-15F (up from RMB330bn during 2006-10) in wastewater treatment industry is forecast by the Ministry of Construction."• "Opportunities in recycling water: target to recycle 10% of wastewater emission in urban area by 2015F, representing a CAGR of 24% from 2009."
- Tariff hikes should come in steeper and more widely
• "Avg water tariffs in 36 major cities grew by 8%, from RMB1.7/m3 in Jun 2009 to RMB1.84/m3 in Jun 2010"• "Chinese water tariffs only account for 0.8% of disposable household income."
- Wastewater treatment: maturing, but growth will be sustained
• "As the market matures, capacity growth should slow to 8% pa from 2010F, compared with 11-16% in 2006-08, by assuming a wastewater treatment ratio of 90% by end-2015F."• "But we are not close to over-capacity, given third- and fourth-tier cities and counties are still showing wastewater treatment ratios of 30-50%, compared with 73% in urban areas in 2009 and 80%-95% in OECD countries."
- Tap water supply remains a privatisation story
• "Management ability in M&A execution and track record are key success factors."
- Waste-to-energy is the next attraction
• "Industry is still in its infancy, though proper legislation should open up opportunities."
• "WTE should outshine other waste treatment projects in terms of capacity growth, at 17% CAGR versus 10% in overall waste treatment, given it has higher environmental standards and energy efficiency but accounts for less than 20% of China’s residential waste currently being treated, compared with 80% from landfill sites."
- Defensive against rising commodity prices and inflation
- Risks: intensifying competition, rising interest costs
- Our stock-picking criteria and preferences
• "Search for company-specific strengths to identify outperformers in the sector — solid track records and rich catalysts for growth in 2010-11F, followed by quality management, undemanding valuations, and healthy balance sheets."
• "Preferences for quality players: Guangdong Inv’t (270 HK, BUY), China Everbright Int’l (257 HK, BUY)."
• "Risks/rewards opportunities: Beijing Enterprises Water (371 HK, BUY), China Water Affairs (855 HK, BUY), Sound Global (SGL SP, BUY)."
• "NEUTRAL on Hyflux (HYF SP) due to financial risks as overhangs."
• "Avoid Tianjin Capital Environmental (1065 HK, REDUCE)."

The forgotten financiers

- "The Basel Committee has agreed on stricter capital requirements for banks. It argues that the impact on the economy via bank lending should be limited. But banks account for only 22% of credit in the US and 44% in the eurozone. Since the behaviour of the remaining lenders is not well understood it is premature to conclude that the regulatory changes will result in greater stability in the financial system."

JPY intervention starts as we expected

- JPY intervention starts as we expected "The MOF intervened unilaterally in the forex market on 15 September by selling JPY, likely triggered by the government’s motivation to defend the 80 line. Although the intervention was unilateral, we think it was probably unsterilized (i.e., that the BOJ is unlikely to try to mop up the liquidity created). Judging by reports that MOF sold some ¥2.0trn of JPY on 15 September, we estimate that by the time its intervention is finished they would have sold ¥10–20trn. Although we estimate that USD/JPY could rebound to 85–87 in the near term, forex market trends are largely determined by USD weakness against all major currencies, which reflects the poor fundamentals of the US economy. We are therefore maintaining our forecast for USD/JPY at 82.5 by end-2010 and 80.0 by end-March 2011."
- Impact of JPY intervention on the rest of Asia "In our view, Japanese FX intervention (first since March 2004) marginally weakens the short USD/Asia story. Asian central banks may view Japan's intervention as an additional reason to resist local FX appreciation, despite global political pressure to move (namely on China). However, we do not believe the Asia ex-Japan authorities can argue on the same fundamental basis as Japan given the large divergences in broad economic performance, exports, equity markets and FX valuation. In this respect, we think that the impact of JPY intervention could be important, but not decisively for Asian FX. This may, for example, support reducing our short USD/CNY trade. However, we do not think that it markedly alters the core story (see FX Insights: China Visit Notes, 1 September 2010). Likewise, it reduces our conviction on our short EUR/KRW trade (See FX Insights: Recommend marginally adding a short EUR/KRW trade, 6 September 2010)."
- JPY - Why JPY appreciation had accelerated despite an increase in Japanese outward investment
"In August, USD/JPY dipped below 84, its lowest level in 15 years, as JPY continued to strengthen. However, the MOF's latest International Transactions in Securities report revealed that Japanese net outward portfolio investment increased to roughly ¥5trn in the same month. We see three likely reasons for the apparent contradiction between an increase in outward portfolio investment and observed acceleration of JPY appreciation: (1) transactions not involving forex transactions, (2) purchases of short-term Japanese bonds by a number of foreign government investment institutions, and (3) currency hedging by Japanese institutions and companies. What appeared at first sight to have been large-scale Japanese outward investment in August turned out not to be powerful enough to reverse the downtrend in USD/JPY in August."
- GBP: Further recovery in store "This week, we released the second in our series of Strategic Currency Views, which presents a comprehensive analysis of the key factors influencing the outlooks for currencies. Here we summarise our findings for sterling. For the outlook in its entirety, please see The UK pound: Further recovery in store, 14 September 2010."
- RBNZ signals slow path to a lower “neutral” rate: Receive NZD IRS 5fwd 5yr "The Reserve Bank of New Zealand (RBNZ) kept its policy rate unchanged at 3.0% today, which was widely expected, but the policy statement and subsequent comments by Governor Alan Bollard were more dovish than expected. The RBNZ is signaling both a slow path to a “neutral” policy rate, and that the level of that “neutral” rate has declined. We recommend maintaining long duration positions in the NZD IRS curve, but see the NZD IRS 5fwd 5yr as currently offering a more attractive opportunity than the front end of the curve. For investors concerned about liquidity risk in terms of the IRS curve beyond 5 years, we also see value in receiving the NZD IRS 2fwd 2yr."
- EMFX Portfolio Update: Enter ILS 1v2 steepener, a proxy 1y1y payer "Israel is one of the few emerging market countries whose unemployment rate has reached pre-crisis levels. Increasing inflation expectations and housing prices all suggest that the ILS front end is very vulnerable to the upcoming inflation releases. In addition, the 1v2 slope appears cheap by around 20bp on a number of metrics. To establish our view in a low-carry way we are putting USD10k to the 1v2 steepener. We also continue to recommend USD/ILS shorts, based on the higher probability of a faster pace of rates hikes."
- EMFX Portfolio Update: Fading RUB's temporary MXN disease "We recommend buying a RUB basket – selling 3m USD/RUB and EUR/RUB (entry 34.75, stop 35.25, target 33.65) – based on our explanations of recent underperformance and our identification of various changing dynamics. Inflation should provide a catalyst for the rouble as the trend caused by the negative food price shock appears to have reversed, partly due to the lagged effects of monetary and fiscal loosening during 2009. In the NDF space we see rate differentials on the rise after a period of contraction since Q4 2009, which would have turned off yield-hungry investors. Furthermore, REER overvaluation retracement, a declining external debt repayment schedule, relative equity market underperformance and upsides from any oil price increment are all supportive of the trade."
- FX Quant Insights: Pump up the volume "Volume data are often used in other asset classes (such as equities) to act as a further input into technical trading rules. In FX, they tend to be used less, largely because of the scarcity of volume data. The idea of using volume data is that they can be used to confirm technical moves. If there is a significant technical break higher and volume does not spike, we would conjecture that the move is relatively shallow. Conversely, a spike in volume would be supportive of the price action. Our focus is on combining on balance volume (OBV) with more traditional technical-based momentum style trading rules. In particular, we look at breakout style rules on OBV. Our volume-based basket has annualised returns of 3.9% and an information ratio of 0.66 since 2002."

Nikkei Average rebound to test July high of 9,800 or June high of 10,250

- Japanese equity market—expecting rebound to continue in near term; move off bottom should be clear after Oct–Nov: On 1 September, the Nikkei Average fell to 8,796 and the TOPIX nearly dipped below 800, but they did not drop any further and have since started to rebound slightly. We think the indices did not fall as far as they might have because investor pessimism had already peaked, as suggested by the TSE’s short-selling ratio exceeding 30% on 1 and 2 September. We think the indices have likely entered a near-term rebound given that they have broken out of the diagonal triangle pattern on the chart that has been in place since April. If the yen appreciation that has impeded any market rally enters a more pronounced lull, we could see Japanese equities stage something of a rebound toward the rally highs of 14 July (9,807 for the Nikkei Average, 874 for the TOPIX) or 21 June (10,251 and 904). On the other hand, the wave count suggests that we are in a consolidation phase ahead of the next rally, and thus the market could remain in a broadly defined holding pattern until Oct–Nov. Only after this do we think it will become clear that equities have moved off their bottom.
- US equities—likely to trade in tight range until Oct–Nov: US equities have been regaining ground since 27 August. The three main indices have broken through the resistance line connecting 26 April and 9 August highs, and are now within sight of those same 9 August rally highs (10,719 for the DJIA, 1,129 for the S&P 500, 2,309 for the NASDAQ composite). A normal correction pattern based on wave count would point to the rebound from 27 August running out of steam, but if the three main indices regain their 9 August rally highs, it would add weight to the possibility that the correction phase ended with July lows (9,614 for the DJIA, 1,010 for the S&P 500, 2,061 for NASDAQ). Having said that, we make no major change to our view that US equities are likely to trade in a tight range until Oct–Nov, when the next four-month cyclical bottom is expected. Only after this do we think it will become clear that equities have moved off their bottom.
- Bond market—Japanese long-term interest rates heading for major bottom, followed by rebound; US long-term interest rates also heading for rebound off bottom: So long as the yield on newly issued 10-year JGBs does not fall sharply lower than the 25-day moving average (currently 1.02%), we think it will be fair to conclude that the yield of 0.895% on 25 August marked a major bottom. We think it is more likely to transition into an upward phase if it clearly breaks through resistance at the 1.15–1.19% level that has acted as a support line since 2004. We also think the yield on US 10-year T-Notes reached a bottom of 2.416% on 25 August. We expect yields to target the October 2009 low of 3.104%.
- Forex market—USD/JPY near to nine-month cyclical bottom, yen appreciation versus dollar in final phase; EUR/USD may have embarked on renewed upleg: USD/JPY is eyeing a drop below 83, but the chart suggests that the latest phase of yen appreciation versus the dollar may have entered its final phase. The nine-month cyclical bottom from the November 2009 low is approaching and technical indicators also suggest that the USD/JPY bottom is near. The diagonal triangle on the chart traced by the downtrend since May is now clearly visible, and we think the yen could be about to depreciate. In our view, USD/JPY could rebound to around 90 if large volumes of long yen speculative positions are unwound. The correction in EUR/USD from early August appears to have run its course and the rate may have already embarked on a renewed upleg.
- Commodity market—WTI crude oil prices could drop out of triangular holding pattern; COMEX gold futures could push on further from all-time high: WTI crude oil futures (front-month) have  oved into a triangular holding pattern, but wave count suggests that they are likely to fall south out of this pattern. If they were to fall below the key technical juncture of around $70–71, this could lead to further declines. Having reached an all-time high, we think COMEX gold futures (front-month) could push on toward $1,369/troy oz.

U.S. / Japan Comparisons Again: More than One Route to Perdition

- "Aspects of the U.S. outlook have become more reminiscent of post-bubble Japan than during other (merely) cyclically weak periods. However, structural and behavioral differences from Japan remain very significant, just as before."
- "In the U.S., a reality of disinflation has won over simplistic “hyper-inflation” forecasts. The risks of insufficient demand and deflation aren’t entirely negligible. For housing assets, the U.S. banking and GSE sectors seem poised to hold and work off bad debt gradually rather than purge it quickly. Fiscal intervention has been repetitive and insufficient to permanently change growth expectations, all ostensible similarities to Japan."
- "Monetary policy in the U.S. has been strikingly different than post-bubble Japan, particularly in the early aftermath of the Lehman event. However, it seems possible that inertia and misunderstanding keeps monetary policy in the U.S. from a truly aggressive track, even if warranted."
- "Even optimal monetary policy can’t generate higher living standards over the long run. But it can avoid lasting deflation (a spiral higher in the purchasing power of currency). The long-run monetary policy track in the U.S. has been and is likely to be more inflationary than Japan’s, as chronic currency strength in Japan and mild U.S. dollar depreciation also suggest."
- "Private sector behavioral differences remain vast. The U.S. labor market and capex are far more cyclical than in Japan, and suggest an early and lasting bottom. Even amid structural growth slowdowns in both economies, we believe cyclical differences will be notable. In effect, the U.S. is more prone to “boom and bust” than slow and lasting stagnation."

Inflation is sleeping

- Overview: Inflation is sleeping
- Focus 1: United States: A new context for monetary policy "The deterioration in economic data has changed the monetary policy situation. Now, the debate is over another easing of monetary policy and the most appropriate way of achieving it. During his speech at the Jackson Hold symposium, Ben Bernanke claimed the Federal Open Market Committee (FOMC) was prepared to act if prospects were to deteriorate further, thus indicating an accommodative bias. Expanding the Federal Reserve’s balance sheet via the purchase of Treasuries seems to be the preferred solution to make monetary policy more accommodative. Even though the FOMC seems to be divided, the camp that is more in favour of further intervention, led by Ben Bernanke, seems to be in a position to impose its views. Ongoing job creations in the private sector in August limit incentives to act as of September. In the months ahead, however, the slowdown in growth (estimated at a trend of 1.5% in the second half of this year, i.e. well below FOMC projections) and the fact that private sector job creations are likely to be insufficient to reduce unemployment might convince the FOMC to adopt a new programme of purchasing Treasuries."
- Focus 2: Basel III: Capital requirements not without impact "On 12 September, the Basel Committee unveiled the new capital ratios under the so-called Basel III prudential reforms plus the timetable for their application. The new regulatory thresholds are equivalent to at least a tripling of capital requirements between Basel II and Basel III due to the redefinition of both the numerator and the denominator. However, the recapitalisation efforts accomplished since the financial crisis and a relatively stretched-out timetable for application will allow most major European banks to comply with the new requirements without substantial capital increases. Even so, implied market demands could lead to the deadlines being brought forward. A number of elements of the reforms (additional capital buffer for systemically-important banks, definition of the long-term liquidity ratio) are yet to be defined and the economic impact based on the known elements should therefore be considered only partial."

Yield Attractions/Job Application

UK — Yield Attractions
- The 3Cs — "Conundrums, crossovers and cults. The centre of debate in financial markets. Suggests value in equity, especially in yield compared to other assets."
- Yield strategies — "We look for companies which offer income and growth. Next, Unilever and BP feature. UK “Big Guns” look attractive in absolute terms."
Pan-European — Job Application
- Mega-traps — "European mega-caps have underperformed for 10 years. Long time. Applying for post of President of European Mega Inc. to drive value creation strategies."
- Mega-shrink — "No flow to European equities from capital allocators. Headwind for mega-caps. Need to generate own excitement (growth) or shrink equity to perform."

Inflation remains a concern in the UK

- "Last week’s data was mixed, but, overall, pointed to a modest US economic recovery. Therefore, no major new announcements are expected at tomorrow’s FOMC statement (p.2, p.3 & p.4)."
- "This week’s focus is on the FOMC statement tomorrow and durable goods orders on Friday, and on the euro zone PMIs on Thursday and the German Ifo index on Friday (p.2, p.3 & p.4)."
- "The Chart of the Week shows the CPI inflation rate and public attitudes to current inflation in the UK. Inflation is of little concerns for the major Western central banks at present, especially not for the countries that are confronted with a modest recovery. However, there is an exception, and that is the Bank of England (BoE). CPI inflation in the UK has been more than 1% higher than its 2% target for 6 consecutive months in August. According to the BoE, too high inflation is due to temporary factors, such as the past depreciation of sterling, higher oil prices and the restoration of the VAT rate. However, a VAT hike and higher food prices might imply that CPI inflation will remain above the 2% target until the end of next year at least. In addition, the chart shows that, in line with actual inflation developments, consumers’ perceptions of the current rate of inflation (according to the BoE/GfK NOP survey) have been rising since late 2009, and also 1-year inflation expectations have increased to the highest level since 2008 (when oil prices rose sharply). Interestingly, inflation perceptions increased when inflation picked-up, but have declined far more modestly when inflation rates fell. As such, the BoE does not only face weak economic growth, but also adverse developments on the inflation front. Therefore, the BoE will have to act very cautious if it does not want to put its credibility as an inflation fighter further at stake."

No near-term rate hike from the CNB

- Market movers ahead: A couple of strong Polish releases are due next week "Next week’s calendar is very light. The most interesting items on the agenda are likely to be a number of Polish economic releases due on Tuesday and Friday, which should all show positive signs for the Polish economy. Polish core inflation should confirm the fact that inflationary pressure is still not an issue in Poland. We expect core inflation to remain unchanged at 1.2% y/y in August. On Friday we expect data on Polish retail sales to come out on the positive side, increasing to 4.5% y/y in August compared with 3.9% y/y in July. Also due on Thursday is the rate decision in the Czech Republic and minutes from the latest monetary policy meeting in Poland."
- Fixed income outlook: CNB rate decision "On Thursday next week the Czech central bank (CNB) has its rate setting meeting. We do not expect this to be a major event as we expect the CNB to keep its key policy rate unchanged at an historical low of 0.75%. Overall, we expect the CNB to maintain a rather neutral tone, as we do not see any changes to Czech monetary policy for some time."
- FX outlook: EUR/USD should set the tone "As the calendar does not hold many potential market movers we do not expect much activity on the EMEA FX markets in the coming week. The key driver could be a further move up in EUR/USD, which will be positive for the euro-sensitive CEE currencies."
- Scorecard-based trade of the week: buy ILS/ZAR "For the fifth week in a row, the highest-scoring currency in our EMEA FX Scorecard is the Israeli shekel, while the lowest-scoring is the South African rand. Therefore, we continue to recommend buying ILS/ZAR, based on our EMEA FX Scorecard."

OECD countries are about to change over to even more expansionary monetary policies: What will be the consequences and how effective will they be?

- "The United States, the euro zone and Japan are faced with less positive economic situations than what the governments expected:
• renewed slump in growth in the United States due to labour market and property market problems, ongoing deleveraging and balance sheet adjustments;
• prospects for slower growth in the euro zone due to the weakening of global trade, the rise in savings, the profitability problems in several countries, the reduction in fiscal deficits and deindustrialisation;
• risks on growth in Japan, since it is still linked to exports and since the yen continues to appreciate."
- "Fiscal policies cannot be made more expansionary, so governments and central banks will use monetary policies once again: additional stimulus from banking liquidity, reinforcement of quantitative easing and credit easing, etc."
- "We believe these monetary policies, which will be even more expansionary, are:
ineffective because liquidity is already extremely abundant and credit demand is declining; and because the real problem is not of a monetary nature: it is the distortion of income sharing at the expense of wage earners and, in Europe the United States, the balance sheet adjustment;
• dangerous, by making it even more likely that speculative bubbles will reappear in the future."

Basel III rules on minimum capital ratios announced

- "The release of the Basel III rules on new minimum capital requirements was the dominating news in the credit market this week. The rules were slightly less tough than was stated in press reports last week and consequently financial spreads performed well. Of particular interest to the subordinated debt market is the transition rules concerning bank capital. Essentially, extension risk has been reduced for hybrids – especially those with step-up coupon features – and on the back of this we saw a massive rally in the Tier 1 market. The rally was partly halted after the market became aware of certain possibilities for some issuers to make calls of outstanding bonds by 2013 in case these bonds no longer qualify as regulatory capital. This was particularly the case for highcoupon bonds trading above par. For a further description of the new rules, see below."
- "On the back of the confusion on whether to call or not to call hybrids and at what date, it seems that Abbey (owned by Banco Santander) is not calling an outstanding UT2. We think that ongoing uncertainty over how to design subordinated debt instruments such that they comply with Basel III requirements will make issuance limited in the short term. Against this background, it is perhaps not surprising that some banks opt not to call outstanding sub debt, as the ability to substitute it is uncertain. Therefore, in our view it is possible that more banks will follow in the footsteps of Santander (which is one of the major market players, after all), especially on UT2 instruments where there is no amortisation of capital after the first call date."

USD: relief bounce on FOMC?

- USD: relief bounce on FOMC? "Intervention by the BoJ and a surprisingly brutal reaction to SNB forecast revisions caused trends to shift in G10 currency markets over the past week and threaten to compound volatility over the coming days as the FOMC meets to discuss monetary policy and in the UK the Sep MPC meeting minutes are published. The USD may be in a win/win position going into the FOMC. If the Fed are downbeat, the USD may benefit from a risk sell off, while if they are more positive, it may benefit from a back up in US yields as QE2 fears are put on the back burner. With the EUR suddenly back in favour and central bank intervention forcing investors to trim long JPY and CHF strategies, predicting flows under a ‘risk off’ scenario is not straightforward. Even though correlations with risk have rebounded, we are alert to retracements in EUR crosses as talk of debt restructuring flares up in the periphery and risk reversals signal a possible counter trend move."
- "The BoJ intervened to weaken the yen through alleged unsterilised sales of JPY (tbc next week). The yen jumped in response from a low of 82.88 to the end-of-week highs in the region of 85.80 to the dollar. Despite strengthening against JPY, USD weakened against GBP and EUR as speculation persisted regarding QE2 amidst a slew of weak macro UK numbers. It was a strong week for GBP as it strengthened vs all G10 currencies from oversold levels. The EUR too rallied against G10 currencies except GBP, with concerns over Ireland causing a wobble on Friday. The SNB kept the policy rate unchanged but downward revisions for 2011/12 CPI sparked aggressive unwinding of long CHF positions causing EUR/CHF to spike 300pips before eventually settling below 1.32."
- "It was another week of soft indicators for the UK economy with a weak RICS survey and a surprise decline in August retail sales. CPI inflation surprised on the upside as it stayed unchanged at 3.1%. Amidst elevated inflation levels, MPC minutes next week are much anticipated but may not bring much clarity on the outlook for monetary policy. On the other hand, data in the US somewhat alleviated double-dip fears with rising retail sales and inventories, surveys showing stable confidence (though Michigan survey down) and declining initial claims to 450k. Core annual CPI fell below 1% in August to 0.9%, causing disinflationary worries to resurface. Euro zone industrial production was flat on the month and the ZEW survey showed declining economic sentiment."
- "A turbulent week for government bonds dominated by mixed 2020 and 2030 gilt auctions ended with yields closing at the lower end of the range. The front end and belly of the curve outperformed the long end, resulting in a steeper 2y/10y curve (through 240bp for gilts) and 10y/30y (103bp). The 2y/10y swap curve held steady in a range around 182bp pivot. 5y swaps climbed 7bp to 2.24%, retracing from an earlier 2.31% high. A busier than usual week of late for corporates brought sterling issuance from Bank Nederlandse Gemeenten (£200 mln 2015), EDF (£1.0bln 2050) and Co-op Bank (£400mln 2017)."

Japan: After Two Weeks of Political Shows

- MoF eventually intervened — "The MoF intervened in the FX markets after PM Kan's victory in the DPJ presidential election sent the yen higher. However, the FX intervention seems unlikely to change the recent trend in the FX markets for a long time. If Fed takes additional easing measures in months to come, downward pressures on Yen/USD will likely overwhelm the FX intervention."
- Impasse in economic policies unlikely to unravel — "Debates about imminent economic issues did not deepen during the DPJ election campaign and the basic thrust of economic policies likely will remain largely the same under new Kan Administration. Most importantly, the political decision-making will likely be dysfunctional as the ruling coalition falls short of the absolute majority in the Upper House of Parliament."
- We expect the economy to manage to maintain an uptrend — "We now expect real GDP growth of +3.2% in 2010 and +1.6% in 2011. The general trend of the Japanese economy is for slower growth as several factors which have driven activities since last year are waning: exports are decelerating, an
economic boost by the inventory cycle has run its course and reactionary moves after policy-driven strength are becoming evident. But a renewed recession is unlikely, in our view."

Hungary and Greece: What is the best strategy, that of the bad pupil (Hungary) or that of the star pupil (Greece)?

- "Greece is rapidly reducing its fiscal deficit, both via a cut in government expenditure and a tax hike, reforming its pension system and accepting a decline in activity and employment. As a result, it is receiving substantial international financing."
- "Conversely, the new Hungarian government prefers to maintain an unchanged fiscal deficit and tax financial institutions, but has decided to reduce household taxes to boost consumption and tax on earnings to boost competitiveness. However, it does not meet the conditions for receiving help from the IMF."
- "In the case of Greece (the star pupil), the major risk is the size of the shortfall in activity, which may be such that it will jeopardise the recovery in public finances in the future."
- "In the case of Hungary (the bad pupil), the major risk is financial market distrust, which would weaken the currency (the forint), while most of the debt is denominated in foreign currencies."
- "What is the most serious risk, and what is the market perception? Currently, the financial markets clearly prefer Hungary’s strategy to that of Greece. However, both countries have to stabilise their domestic savings at a higher level, which requires a reduction in the fiscal deficit."
- "Nevertheless, Hungary risks an exogenous shock in the event of a rise in risk aversion and a weakening of the forint. It is therefore under the threat of an uncontrollable event."

The main problem of the global economy is the shortfall in consumption

- "Almost all regions of the world are currently suffering from the shortfall in household consumption:
• in the United States and Europe because of the imbalance of the balance sheets of households (excess indebtedness relative to wealth) and the distortion of income sharing at the expense of wage earners;
• in Japan, due to the constant distortion of income sharing in favour of companies;
• in China, because of the insufficient share of wages in GDP;
• also in Asian emerging countries other than China, India and oilproducing countries, but not in Latin America or Central Europe."
- "The shortfall in consumption is weakening global growth, since there is a savings glut. Furthermore, it is making the global economy more cyclical and more erratic. The reason is that the weight of the most volatile demand components (investment in construction, corporate investment) is too high."
- "Fiscal deficits cannot be a permanent remedy, but a rise in the share of wages in GDP can be a remedy in many countries."

Does the deterioration in the situation of public finances make banks more risky, or does the deterioration in the situation of banks make public debts more risky?

- "It is possible to have two interpretations of the relationship between sovereign risk and banking risk:
(1) If a country’s public finances deteriorate, the government will not be able to bail out the banks  especially major banks) since there will not be any budgetary resources to do so; the banking risk is therefore increased by the lack of a possibility of a bail out. This implies a causality heading from sovereign risk to banking risk.
(2) If a country’s banks struggle, investors believe that the government will have to bail them out; this increases the expected fiscal deficit. There is then a causality heading from banking risk towards sovereign risk."
- "To discriminate between these two hypotheses, we look at the causal links between sovereign CDS and bank CDS. We find that bank CDS are correlated, with a lag, to sovereign CDS in most cases: most often, sovereign risk causes the banking risk."