27 September 2012 Fixed Income Research http://www.credit-suisse.com/researchandanalytics

US Interest Rate Strategy Weekly

Interest Rate Strategy Strategy: Don’t Fade This Fed Research Analysts  Treasury yields might temporarily move higher due to a likely near-term comeback Michael Chang for risk assets, but we look for yields to fall over time. We would look to use a +1 212 325 1962 michael.chang.2@credit-suisse.com bear-steepening move at the beginning of the quarter to re-engage the market from the long side. Ira Jersey +1 212 325 4674  The front-end of the curve – twos and threes – should hold firm into the release of [email protected] the FOMC minutes next week as the market awaits hints on the prospects for an eventual IOER cut. Carl Lantz +1 212 538 5081  We expect a recommitted Fed to eventually deliver still lower yields via even larger [email protected] LSAPs and stronger rate guidance. An extension of the current $45B purchase William Marshall pace in governments, without the offsetting short-end sales, would be the baseline +1 212 325 5584 expectation. However, the ongoing weak tone to the data suggest a bias towards an [email protected] even higher purchase amount with a possible overweight in bonds. George Oomman Market Insight: Fears of negative bill rates in January overblown 212 325 7361 [email protected]  FDIC emergency coverage of non-interest-bearing accounts is likely to be extended; Carlos Pro regardless, money market funds have already moved out of such deposits. +1 212 538 1863 [email protected]  The termination of the Fed’ s “Twist” operation is well telegraphed, and the stock of front-end Treasuries sold will remain part of floating supply. Scott Sherman +1 212 325 3586  The most tangible risk is a full-on “fiscal cliff,” but we see the risk as very unlikely. [email protected]  We think that Agency callables have some additional value relative to long mortgages against the backdrop of the latest round of Fed asset purchases. Trade Idea: Long 5y5y vs. 10y10y inflation swaps  A cross-market PCA decomposition suggests that TIPS spent the past 10 days mainly catching up with other markets in the risk-off move. We view the “catch-up” sell-off nearly done.  We recommend going long 5y5y versus 10y10y inflation swaps expecting the intermediate sector of the inflation curve to be better supported than the long end. Trade Idea: Favor Selling 2-year Forward 9-year Final Maturity Cap/Floor Straddles Against 2y7y Swaption Straddles  The vol spread between the 2-year forward 9-year final maturity (2x9) cap/floor straddle and the 2y7y swaption straddle appears to be too wide after adjusting for the steepness of the vol surface.  We favor selling 2x9 ATM cap/floor straddles and buying 2y7y ATM swaption straddles at flat vega and look to profit from a tightening in the 2x9 wedge. Technical Analysis  The S&P 500 has found a near-term cap at multi-year channel resistance at 1267, but we look for better support at 1400/1395 to maintain the uptrend.

ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION™ Client-Driven Solutions, Insights, and Access

27 September 2012

Trade Update 3

Strategy 6

Market Insight 10

Trade Idea 16

Trade Idea 16

Technical Analysis 19

Economics Events Calendar 23

Databank 24

US Interest Rate Strategy Weekly 2 27 September 2012

Trade Update YTD Total P&L: $7,129,815 Total P&L weekly change: $602,814 Current Trade Recommendations P&L change on Target/ Stop-out Trade Start Date Last Mark P&L ($) week ($) ($) Long 5y5y vs 10y10y inflation swaps 27-Sep-12 27-Sep-12 0 0 250k/ (175k) Sell 2x9 Cap/Floor Straddle vs. 2y7y Swaption Straddles 27-Sep-12 27-Sep-12 0 0 200k/ (150k) 3yr Swap spread Widener vs FRA/OIS IMM3 25-Sep-12 25-Sep-12 0 0 250k/ (175k) Sell 5s on 3s5sUSZ2 fly 20-Sep-12 26-Sep-12 110,493 110,493 250k/ (150k) 3yr fwd 5s10s15s fly 20-Sep-12 26-Sep-12 -15,853 -15,853 200k/ (175k) Receive 1y basis swap 6s3s vs. 1y basis swap 3s1s basis 11-Sep-12 26-Sep-12 40,000 35,000 160k/ (80k) 6m fwd 7s30s Conditional Bull Steepener 7-Sep-12 26-Sep-12 35,349 -87,548 250k / (175k) Long FNMA 0.625 10/14s vs. FNMA 0.375 3/15s on ASW 6-Sep-12 26-Sep-12 69,287 28,458 150k/ (80k) 1x2x1 EDZ2 put fly 14-Aug-12 26-Sep-12 -47,500 25,000 200k/ (100k) 2y2y, 4y1y, 2y3y vol triangle 9-Aug-12 26-Sep-12 -68,610 -64,416 200k / (175k) 1y fwd 3s5s10s receiver fly 19-Jul-12 26-Sep-12 57,848 43,966 250k / (175k) 1x2x1 EDM3 put fly 2-Jul-12 26-Sep-12 -25,000 30,000 250k / (175k) Sell 6m10y payers and buy 1y5y payers 14-Jun-12 26-Sep-12 112,435 125,747 250k / (250k) ED11-13-15 Fly Widener 6-Jun-12 26-Sep-12 -87,472 50,033 250k / (175k) Sell 6m10y payers and buy 1y5y payers 2-May-12 26-Sep-12 147,407 -14,448 350k / (175k)

Trades closed year-to-date in 2012

Closed P&L change on Target/Stop-out Trade Start Date Date Final P&L ($) week ($) P&L ($)

Receive spot 10yr against 2y2y 13-Sep-12 26-Sep-12 559,194 377,089 400k/ (300k) 10s30s BE Steepener 1-Aug-12 26-Sep-12 -94,281 -40,707 250k / (170k) 2s10s real rate steepener 13-Sep-12 17-Sep-12 50,158 N/A 400k/ 150k Long April 14s TIPS vs Jan 15s 5-Sep-12 14-Sep-12 282,753 N/A 400k / 200k Sell 5y5y TIPS breakevens 23-May-12 13-Sep-12 -196,346 N/A 300k / (175k) Buying 6m 5s30s CMS curve caps 24-Aug-12 13-Sep-12 100,000 N/A 250k/ (175k) 5s7s Treasury Curve Flattener 7-Sep-12 12-Sep-12 -172,163 N/A 200k / (125k) Long FHLMC 5.125 10/16s vs. FNMA 2.375 7/15s on ASW 26-Jul-12 11-Sep-12 112,600 N/A 175k / (125k) Long 5s on the 3s5s10s fly 26-Jul-12 6-Sep-12 124,317 N/A 250k / (175k) 3s7s swap flattener vs ED9-ED17 Steepener 28-Aug-12 6-Sep-12 -96,140 N/A 200k/ (100k) Short 10s 28-Aug-12 6-Sep-12 130,299 N/A 650k / (480k) Long Jan22 TIPS vs. Jul22 9-Aug-12 30-Aug-12 78,894 N/A 300k / (175k) Buy 6m7y receivers versus payers 3-Aug-12 14-Aug-12 -328,948 N/A 350k / (250k) 3m fwd 5s7s10s payer fly 26-Jul-12 6-Sep-12 -130,141 N/A 175k / (125k) 1x2x1 EDU2 put fly 17-Jul-12 23-Aug-12 12,500 N/A 250k / (175k) 10s30s flattener 21-Jun-12 31-Aug-12 -605,482 N/A 900k / (525k) Long 30y TIPS Breakevens vs. 30y CPI Swaps 21-Jun-12 31-Aug-12 -101,825 N/A 200k / (100k) 1y10y vs 5y10y strangle switch 21-Jun-12 14-Aug-12 510,594 N/A 500k / 0 Short 4y sector vs. 3s and 5s PCA-weighted 14-Jun-12 9-Aug-12 -175,936 N/A 250k / (175k) 1x2 3m10y payer spread 10-May-12 10-Aug-12 45,000 N/A 250k / (175k) 10s30s TIPS breakeven steepener (80% nom curve beta) 4-May-12 30-Aug-12 -149,093 N/A 300k / (225k) EDM5/EDM6/EDM7 Fly Widener 31-Jul-12 3-Aug-12 350,035 N/A 250k / (175k) 3s5s TIPS breakevens flattener 28-Jun-12 25-Jul-12 95,576 N/A 250k / (175k) 7s/USU2 flattener 12-Jul-12 19-Jul-12 -224,915 N/A 400k / (200k) 3yr Swap Widener vs FRA/OIS IMM3 18-Jun-12 18-Jul-12 237,036 N/A 250k / (175k) 1y10y vs 5y10y payer calendar spread 21-Jun-12 9-Jul-12 614,563 N/A 350k / (300k) Long FNMA 5.375 6.17s vs. FHLB 1.0 6/17s 7-Jun-12 9-Jul-12 183,775 N/A 175k / (100k) 3m fwd 2s4s7s receiver fly 17-May-12 6-Jul-12 385,440 N/A 250k / (175k) Sell 6m10y payers and buy 1y5y payers (v2) 2-May-12 6-Jul-12 278,204 N/A 350k / (175k) Long FHMLC 1.25 5/17s vs. FNMA 2.75 3/14s on ASW 7-Jun-12 26-Jun-12 190,152 N/A 175k / (100k) 6m fwd 10s30s bull steepener 7-Jun-12 18-Jun-12 -31,283 N/A 250k / (175k) 1x1 1m10y payer spread 26-Apr-12 29-May-12 -340,000 N/A 500k / (341k) 1m5y payer spread 4-Apr-12 4-May-12 -304,430 N/A 500k / (310k) Long Apr13s TIPS Breakevens 6-Jun-12 12-Jun-12 108,924 N/A 250k / (175k) Short 10y inflation basis 10-May-12 13-Jun-12 -71,830 N/A 250k / (175k)

US Interest Rate Strategy Weekly 3 27 September 2012

Trades closed year-to-date in 2012

Closed P&L change on Target/Stop-out Trade Start Date Date Final P&L ($) week ($) P&L ($)

10s30s Steepener 1-Jun-12 4-Jun-12 -656,000 N/A 600k / (400k) 3m Fwd 2s4s7s fly 15-Mar-12 6-Jun-12 0 N/A 250k / (175k) Long FRA/OIS IMM4 23-May-12 5-Jun-12 -209,935 N/A 375k / (200k) Long Sep expiry 3y ED mid-curve call 4-May-12 30-May-12 225,000 N/A 250k / (175k) Long 7s 24-May-12 30-May-12 825,000 N/A 450k / (200k) Long Jan 21s TIPS vs. July 21s 22-Mar-12 30-May-12 -81,046 N/A 75k / (50k) Short USU2 vs. 10s and 30s pca-weighted 21-May-12 23-May-12 -107,758 N/A 200k / (100k) EDM3/EDM5 Flattener 9-May-12 23-May-12 374,993 N/A 500k / 75k Short 10s vs. EDH5 17-May-12 23-May-12 219,129 N/A 1,000k / (500k) 5s10s TIPS breakevens steepener 17-May-12 23-May-12 229,104 N/A 250k / (175k) 2s5s swap steepener vs. 6-10 ED flattener 19-Apr-12 15-May-12 -187,421 N/A 250k / (175k) Sell 7s on the 5s7s10s fly, pca-weighted 11-Apr-12 15-May-12 -129,961 N/A 250k / (125k) Long FRA/OIS IMM5 11-Apr-12 15-May-12 546,270 N/A 500k / (250k) Sell 5y5y TIPS breakevens 26-Apr-12 16-May-12 495,555 N/A 500k / 0 Buy 3m5y straddle / Sell 3m10y strangle 12-Apr-12 15-May-12 -200,000 N/A 250k / (175k) 10s30s Flattener 9-May-12 15-May-12 378,723 N/A 350k / (150k) 10s30s steepener into refunding 26-Apr-12 9-May-12 342,124 N/A 240k / (120k) Long 3s on the 2s3s5s fly 19-Apr-12 4-May-12 -117,760 N/A 200k / (100k) Conditional ED Z3-Z4-Z5 tightener 29-Mar-12 3-May-12 37,477 N/A 120k / (80k) Pay 18x24 OIS 18-Apr-12 3-May-12 -87,433 N/A 250k / (125k) EDU2 bull risk reversal 9-Mar-12 3-May-12 6,259 N/A 100k / (50k) ED Z3/Z4/Z5 20-Mar-12 3-May-12 -81,249 N/A 250k / (175k) Long 1y5y ATM straddles vs. 3m5y & 3y5y ATM straddles 22-Mar-12 30-Apr-12 -203,050 N/A 350k / (200k) 2Y Fwd 7s30s Steepener 26-Jan-12 27-Apr-12 318,242 N/A 300k / (200k) ED11-ED19 Steepener vs. 4s10s swaps flattener 23-Feb-12 23-Apr-12 110,084 N/A 250k / (175k) Pay 3y3y / Receive spot 10y 4-Apr-12 23-Apr-12 327,643 N/A 250k / (175k) 1m3y3y mid-curve payer spread 4-Apr-12 18-Apr-12 -205,563 N/A 250k / (200k) Short 10y TIPS Breakevens (60% nominal hedge) 12-Apr-12 18-Apr-12 89,970 N/A 375k / (250k) Long FNMA 12/16s vs. FHLB 12/16s 2-Feb-12 18-Apr-12 -8,320 N/A 225k / (125k) Sell FHLB 5.375s 9-Mar-12 18-Apr-12 -115,199 N/A 100k / (50k) Sell FHLMC 4.75s 9-Mar-12 18-Apr-12 70,099 N/A 100k / (50k) Short 10y TIPS breakevens 4-Apr-12 11-Apr-12 4,394 N/A 275k / (250k) Long 30y TIPS Breakevens vs. 30y CPI Swaps 16-Feb-12 11-Apr-12 433,498 N/A 500k / (250k) 6m1y 3s1s Basis Steepener 25-Jan-12 12-Apr-12 18,645 N/A 150k / (75k) 5y swap spreads widener 29-Mar-12 6-Apr-12 265,454 N/A 250k / (200k) Long 10s on the fly vs. 7s and 30s 22-Mar-12 3-Apr-12 75,618 N/A 200k / (100k) 2y fwd 10s30s bear steepener 1-Mar-12 3-Apr-12 -205,917 N/A 250k / (175k) 1Y Fwd 2s10s CMS Straddle 27-Oct-11 28-Mar-12 282,675 N/A 250k / (175k) Short 10y inflation basis 9-Mar-12 20-Mar-12 -234,702 N/A 250k / (200k) 1s2s Flattener 15-Mar-12 20-Mar-12 -162,390 N/A 160k / (120k) Long FFJ2 7-Oct-11 21-Mar-12 -29,984 N/A 420k / (300k) Long 10y20y TIPS Breakevens 25-Jan-12 20-Mar-12 454,871 N/A 750k / (375k) 10s30s Flattener 9-Mar-12 16-Mar-12 362,082 N/A 300k / (225k) 3m5y Payer Ladder 16-Feb-12 14-Mar-12 -319,608 N/A 250k / (200k) Buy 1y3y, 4y2y vs. 1y5y Straddles 9-Mar-12 13-Mar-12 -437,941 N/A 250k / (175k) Sell 25 OTM 3m10y Payer vs. Receiver 9-Feb-12 14-Mar-12 -299,096 N/A 350k / (200k) 1y10y Payer Ladder 19-Jan-12 14-Mar-12 -217,468 N/A 300k / (200k) Long Jul 15 TIPS BE vs. CLZ4 Oil 1-Mar-12 14-Mar-12 683,213 N/A 750k / 350k ED mid-curve put spread 19-Jan-12 14-Mar-12 -143,750 N/A 250k / (150k) Long Jan 22 TIPS vs. Jul 21 TIPS 2-Feb-12 8-Mar-12 45,811 N/A 500k / (250k) Long 7s on the fly vs. 5s and 10s 2-Nov-11 8-Mar-12 174,145 N/A 160k / (80k) 7s30s Steepener 29-Feb-12 8-Mar-12 659,477 N/A 800k/(400k) Short FRA/OIS (IMM2) at 37.5 bps 23-Feb-12 6-Mar-12 125,366 N/A 250k / (175k) Buy 6m30y Strangle vs. 6m10y Strangle 2-Feb-12 16-Feb-12 -205,460 N/A 300k / (200k) 5s10s Flattener (110bps target) 8-Feb-12 16-Feb-12 299,805 N/A 450k / (300k) TSY Switch: Long 3.625 8/15/19, Short 8.125 8/15/19 8-Feb-12 15-Feb-12 201,309 N/A 200k / (100k) 7s30s Steepener (adjusted from 5s30s Steepener on 2/2/12) 25-Jan-12 13-Feb-12 18,043 N/A 700k / (400k) Short 5y5y inflation basis 6-Jan-12 15-Feb-12 18,447 N/A 500k / (300k) EDG2/EDH2 Flattener 24-Jan-12 13-Feb-12 56,002 N/A 120k / (60k) Tsy Switch: Long 3.25s 6/30/16, Short 1.5s 6/30/16 6-Jan-12 16-Feb-12 -53,608 N/A 225k / (115k)

US Interest Rate Strategy Weekly 4 27 September 2012

Trades closed year-to-date in 2012

Closed P&L change on Target/Stop-out Trade Start Date Date Final P&L ($) week ($) P&L ($)

Shift from Tsy 1% 5/14 to 4.75% 5/14 15-Sep-11 8-Feb-12 -50,146 N/A 200k / (150k) Shift from Tsy 0.75% 12/13 to 2% 11/13 13-Sep-11 8-Feb-12 3,248 N/A 200k / (150k) Tsy switch: Long 3 5/8% 2/15/20, Short 8 1/2% 2/15/20 26-Aug-11 8-Feb-12 -177,255 N/A 250k / (175k) Long FHLMC 2.5s of 01/07/2014 vs. T 0.125s of 12/31/2013 6-Jan-12 8-Feb-12 110,268 N/A 120k / (60k) Pay the 5-year 6s3s basis at 7.5bps 21-Jan-11 8-Feb-12 169,839 N/A 250k / (175k) 3s1s widener (EDH2 roll) 17-Nov-11 8-Feb-12 -186,052 N/A 500k / (250k) Buy 5y10y OTM payer vs. 1y10y OTM payers costless 13-Oct-11 2-Feb-12 1,018,258 N/A 1000k / 0k Receive 3y2y Fwd 1-Dec-12 26-Jan-12 3,081,610 N/A 2750k / 1000k 3m Fwd 3s5s10s Receiver Fly Tightener 6-Jan-12 31-Jan-12 322,582 N/A 300k / (200k) Sell 2x4 Cap/Floor Straddle vs. 2y2y Swaption Straddles 29-Sep-11 30-Jan-12 256,009 N/A 250k / (175k) 2y Fwd 2s5s10s fly tightener 03-Nov-11 19-Jan-12 205,764 N/A 500k / (250k) 3m Fwd 2s5s10s Receiver Fly Tightener 17-Nov-11 19-Jan-12 155,794 N/A 300k / (200k) Long 5y5y real yield 8-Dec-11 17-Jan-12 600,703 N/A 500k / (300k) Long July 2021 TIPS vs. January 2021 TIPS 15-Sep-11 18-Jan-12 22,191 N/A 500k / (250k) 3m10y 43.5 OTM rec vs. 50 OTM payer 17-Oct-11 11-Jan-12 174,6121 N/A 1000k / (1000k) Short EDH2 10-Jan-12 12-Jan-12 -150,000 N/A 300k / (150k)

Summary of trades in 2011

Profit making trades P&L $26,686,020 Loss making trades P&L ($11,385,029) Net P&L (2011) $15,300,991

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US Interest Rate Strategy Weekly 5 27 September 2012

Strategy

Carl Lantz Don’t Fade This Fed +1 212 538 5081 [email protected]  Treasury yields might temporarily move higher due to a likely near-term comeback for

risk assets, but we look for yields to fall over time. We would look to use a bear- steepening move at the beginning of the quarter to re-engage the market from the long side.  The front-end of the curve – twos and threes – should hold firm into the release of the FOMC minutes next week as the market awaits hints on the prospects for an eventual IOER cut.  We expect a recommitted Fed to eventually deliver still lower yields via even larger LSAPs and stronger rate guidance. An extension of the current $45B purchase pace in governments, without the offsetting short-end sales, would be the baseline expectation. However, the ongoing weak tone to the data suggest a bias towards an even higher purchase amount with a possible overweight in bonds.

A likely near-term comeback for risk assets might well drag Treasury yields temporarily higher. Still we think that yields can, and will, fall over time even as equities eventually make new cycle highs. We expect a recommitted Fed to deliver still lower yields via even larger LSAPs and stronger rate guidance. We would expect the front end of the curve – twos and threes – to hold firm into the release of the FOMC minutes next week as the market awaits hints on the prospects for an eventual IOER cut.

Exhibit 1: Capital goods orders point to a reluctance to expand business that is unlikely to be consistent with the “substantial” improvement in the labor market needed to prevent additional asset purchases from the Fed

40% 600

30% 400 20% 200 10% 0 0%

-10% -200

-20% -400 -30% -600 -40% -800 -50% Core Capex orders (6m chg in 3m ma, annlzd) Payrolls (000s, RHS) -60% -1000 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Source: US Census Bureau, Bureau of Labor Statistics

The drop in yields over the past few days, which we attribute partly to quarter-end rebalancing, has modestly outperformed the average seen in similar periods. Equities have outperformed bonds by about 6% for the quarter – since 2008, this level of outperformance or more has seen 10s rally by an average of 8 bps over the last week of the quarter. The current decline is nearer to 10 bps as of this writing.

US Interest Rate Strategy Weekly 6 27 September 2012

Exhibit 2: Quarterly outperformance of S&P 500 over the bond index

Source: Credit Suisse

Exhibit 3: Change in yields around quarter-end when stocks have outperformed by 6% or more on the quarter

Source: Credit Suisse Locus

While the initial response to mortgage QE has been seen most dramatically in pass- through prices, portfolio adjustments will eventually lead to additional real money purchases of Treasuries. More importantly, perhaps, we expect the Fed to launch a QE3.5 in December that features the ongoing purchase of Treasuries beyond the scheduled year-end expiry of Twist. An extension of the current $45B purchase pace in governments, without the offsetting short-end sales, would be the baseline expectation. However, the ongoing weak tone to the data suggest a bias towards an even higher purchase amount. We would not be at all surprised to see the Fed begin 2013 with a monthly purchase pace of $100B in securities ($60B Treasuries and $40B mortgages). Within an upsized purchase mandate an even larger allocation to the bond sector would be possible.

US Interest Rate Strategy Weekly 7 27 September 2012

A higher percentage in bonds would work to balance the mortgage program. MBS purchases are mainly felt in the intermediate part of the curve given current mortgage durations (the average life of a FNMA 3.0% is currently about 6.5 years). Throughout Operation Twist, the market’s liquidity provision in the back-end has been more than adequate - although the Fed has tended to pay above market prices in its operations in the 10-year and bond sectors, there is nothing to suggest that prices are deteriorating.

Exhibit 4: Prices paid in Fed operations relative to market prices do not appear to be deteriorating over time, suggesting liquidity is still sufficient

10 32nds 10-year sector 30-year sector 8 6 4 2 0 -2 -4 -6 -8 10/3 11/3 12/3 1/3 2/3 3/3 4/3 5/3 6/3 7/3 8/3 Source: Federal Reserve, Credit Suisse

The Fed continues to have work to do on the communication front, and we look forward to next week’s release of the September FOMC minutes for some insight into the extent of the Committees progress in this respect. It is only a matter of time before the forward guidance on rates becomes even stronger and some more explicit form of guidance on the balance sheet emerges. In terms of balance sheet guidance, the Fed might choose to provide a forecast for the its security holdings for one or more forward horizons. This could resemble the forecasts, or range of forecasts, currently given on GDP, unemployment, inflation and the funds rate. In terms of rate guidance, it is looking more and more likely that the Fed moves towards some version of the “Evan’s rule” that would assure the market of exceptionally low rates until unemployment crosses some threshold as long as inflation remains (relatively) contained. Last Thursday’s comments on this topic by Minneapolis Fed President Narayana Kocherlakota were nothing short of remarkable. This (former?) Fed hawk had dissented against dovish policy twice in 2011 and had expressed concern early on that high unemployment was “structural” and so beyond the reach of Fed policy. Now apparently swayed that the employment problem was mainly cyclical – but at risk of becoming embedded - Kocherlakota proposed his own rule policy. Specifically he advocated amending the FOMC statement to pledge that rates would remain low at least until unemployment reached 5.5% unless the Fed’s two-year-forward forecast for inflation breached 2.25% (which he deemed unlikely). The entrenched hawks – Fisher, Plosser and the seemingly more measured but nonetheless recently dissenting Lacker – remain un-swayed but the rest of the Fed appears to be rallying around the Chairman and the recent decision to go full guns at the unemployment problem in the US.

US Interest Rate Strategy Weekly 8 27 September 2012

Having removed the cap on the balance sheet and borne the associated political risks, we see no reason why the Fed would do anything but push policy to the limit in order to secure the best chance of success. This means stronger guidance and larger asset purchases that push to the limits of Treasury market liquidity – feeling for those limits would tend to suggest reaching a point at which purchases themselves drive another burst higher in bond prices. We would look to use a bear-steepening move at the beginning of the quarter to re- engage the market from the long side.

US Interest Rate Strategy Weekly 9 27 September 2012

Market Insight Scott Sherman Fears of negative bill rates in January overblown 212 325 3586 [email protected]  FDIC emergency coverage of non-interest-bearing accounts is likely to be Ira Jersey extended; regardless, money market funds have already moved out of such 212 325 4674 [email protected] deposits.

William Marshall  The termination of the Fed’ s “Twist” operation is well telegraphed, and the 212 325 5584 stock of front-end Treasuries sold will remain part of floating supply. [email protected]  The most tangible risk is a full-on “fiscal cliff,” but we see the risk as very

unlikely.  We think that Agency callables have some additional value relative to long mortgages against the backdrop of the latest round of Fed asset purchases.

As the third quarter draws to a close, and with the introduction of QE3 now in the rear-view mirror, market discussion has increasingly turned to the confluence of potential risks facing the front end of the rates market around year-end. These include the scheduled expiration of the FDIC’s emergency unlimited coverage of non-interest-bearing transaction accounts, the conclusion of the Fed’s “Operation Twist,” and the “fiscal cliff.” Understandably, the majority of attention is being paid to the prospects for the very front end of the Treasury curve. This is because if the FDIC emergency insurance were to lapse, in theory it should affect T-bills and the general collateral repo market most directly. These two markets are the closest substitutes for short-maturity, risk-free assets. In addition, any fall off the “fiscal cliff” would likely affect the outstanding stock of Treasury bills before it would prompt broader changes to the Treasury’s benchmark issuance calendar. Last, the end of the Fed’s “twist” program means the termination of Treasury sales by the Fed at the front end of the curve. We tackle these threats one at a time and suggest that there is little reason to believe T- bill yields will plummet into negative yield territory in January.

FDIC emergency coverage is likely to be extended, but money market funds are not holding FDIC-insured deposits anyway First and foremost, we expect that the emergency FDIC unlimited coverage of non- interest-bearing transaction accounts, which has been in place since the fall of 2008, is very likely to be extended. The crisis is not yet over, evidenced by the fact that the Fed continues to seek new, original methods of providing stimulus and insuring the economy from external shocks. It would be odd then for the Administration to pull the plug on this important source of confidence in a still-recovering banking system. In addition, the banks are paying fees to the FDIC to compensate for the risk involved, so it’s not a free ride for the banks, meaning that there should be less pressure to terminate the coverage. Even if the coverage were to lapse, though, we don’t believe that this would directly result in T-bill yields plummeting into negative yield territory. Admittedly, this is difficult to prove, because such accounts have been insured for nearly four years ‒ first the “Transaction Account Guarantee Program” and later through provisions in the Dodd-Frank Act. However, in our view, the withdrawal of the insurance is unlikely to prompt a desperate grab for Treasury collateral on its own. We do believe that the absence of the insurance will leave the T-bill market much more vulnerable to periods of negative rate trading, but these periods should only occur in response to substantial adverse shocks to the economic outlook.

US Interest Rate Strategy Weekly 10 27 September 2012

There is no denying that the balance in non-interest-bearing accounts has grown substantially over the past few years in the presence of the insurance. However, we believe that it is notable that balances in interest-bearing accounts, which do not enjoy the same unlimited coverage, have similarly swelled. Presumably, if the emergency insurance were to lapse, some of the balance in non-interest-bearing deposits would simply shift into interest-bearing accounts, which, though also uncovered, would provide a modicum of yield in compensation.

Exhibit 5: Balances in non-interest-bearing transaction accounts have swelled through the crisis and QE, but so have balances in interest-bearing accounts Cumulative growth in billions of US$

$ Blns 1200 Growth in non-interest bearing deposits 1000 Growth in interest-bearing deposits

800

600

400

200

0 3/1/2008 5/1/2008 7/1/2008 9/1/2008 1/1/2009 3/1/2009 5/1/2009 7/1/2009 9/1/2009 1/1/2010 3/1/2010 5/1/2010 7/1/2010 9/1/2010 1/1/2011 3/1/2011 5/1/2011 7/1/2011 9/1/2011 1/1/2012 3/1/2012 5/1/2012 11/1/2008 11/1/2009 11/1/2010 11/1/2011

Source: FDIC, Haver Analytics®, Credit Suisse

In addition, there are a variety of other types of money market instruments, aside from Treasury bills, that could absorb the funds. Most cash investors have the flexibility to assess the relative risk and return among available money market investment options, so they could split their cash among interest-bearing accounts, slightly longer-maturity credit assets (such as commercial paper and certificates of deposit), floating-rate notes, and other front-end securities. The main issue is the population of investors that must remain in short-maturity, risk-free assets ‒ for example, Treasury-only and Treasury & repo money market mutual funds. However, it is notable that while money market funds greatly reduced their T-bill holdings as available yields dropped toward zero, they have since steadily risen. In addition, the holdings of other short-term Treasury securities have risen substantially, which has at least partially been due to the Fed’s sales of coupons with less than three years to maturity as part of “Twist.” In any case, it suggests that these funds have already moved back into the front end of the Treasury market.

US Interest Rate Strategy Weekly 11 27 September 2012

Exhibit 6: Treasury-only and Treasury & repo money market funds have already accumulated T-bills and other short-term Treasuries after pulling back their exposure in 2009-2010 $ Blns 500 Holdings of T-bills in money market funds 450 Holdings of non-T-bill Tsys in money market funds 400 350 300 250 200 150 100 50 0 1/1/2009 3/1/2009 5/1/2009 7/1/2009 9/1/2009 11/1/2009 1/1/2010 3/1/2010 5/1/2010 7/1/2010 9/1/2010 11/1/2010 1/1/2011 3/1/2011 5/1/2011 7/1/2011 9/1/2011 11/1/2011 1/1/2012 3/1/2012 5/1/2012 7/1/2012

Source: ICI Mutual Fund Data, Haver Analytics®, Credit Suisse

Indeed, the aggregate cash holdings among money market mutual funds have already collapsed back to zero after swelling last year, when T-bill yields were pushed down to the zero bound. Thus, in aggregate, there are no balances among these investors that would require reinvestment if the insurance coverage were to lapse. It also supports our view that the absence of the insurance would not, in itself, lead to negative T-bill yields. Rather, it would exacerbate the richness that can happen in T-bills in the event of safe-haven flows resulting from an adverse shock to growth expectations.

Exhibit 7: Cash reserves within taxable money market funds have already collapsed to zero after swelling last year, when T-bill yields were compressed against the zero bound

$ Blns 25 20 cash balances in taxable money market funds 15 10 5 0 -5 -10 -15 -20 1/1/2001 6/1/2001 4/1/2002 9/1/2002 2/1/2003 7/1/2003 5/1/2004 3/1/2005 8/1/2005 1/1/2006 6/1/2006 4/1/2007 9/1/2007 2/1/2008 7/1/2008 5/1/2009 3/1/2010 8/1/2010 1/1/2011 6/1/2011 4/1/2012 11/1/2001 12/1/2003 10/1/2004 11/1/2006 12/1/2008 10/1/2009 11/1/2011 Source: ICI Mutual Fund Data, Haver Analytics®, Credit Suisse

US Interest Rate Strategy Weekly 12 27 September 2012

The termination of the Fed’s Maturity Extension Program should have few ramifications for the front end given that the stock of sales would remain a part of floating supply As the Fed has sold out of its shorter-maturity Treasury holdings through its maturity extension program, T-bills and other short-maturity have cheapened with the increase in floating supply.

Exhibit 8: The sale of the Fed’s front-end Treasury holdings have cheapened front-end Treasuries relative to OIS % 0.10 Spread of 12-month T-bill over 1-year OIS 0.08 maturity extension program begins 0.06 0.04 0.02 0.00 -0.02 -0.04 -0.06 -0.08 6/4/2010 7/4/2010 8/4/2010 9/4/2010 1/4/2011 2/4/2011 3/4/2011 4/4/2011 5/4/2011 6/4/2011 7/4/2011 8/4/2011 9/4/2011 1/4/2012 2/4/2012 3/4/2012 4/4/2012 5/4/2012 6/4/2012 7/4/2012 8/4/2012 9/4/2012 10/4/2010 11/4/2010 12/4/2010 10/4/2011 11/4/2011 12/4/2011 Source: the BLOOMBERG PROFESSIONAL™ service

Nonetheless, as “Twist” reaches its conclusion, it is important to note that while the flow of securities out of the Fed and into the market will be shut off, the stock of securities sold will remain part of the floating supply. Thus, there is little reason to believe that shorter- maturity Treasuries will need to reprice, particularly with the end of the program being well understood by the market in advance.

The “fiscal cliff” presents the most tangible threat, but we see full-on “fiscal cliff” as very unlikely We see the biggest potential driver of an acute rally in the bill market as a full-on “fiscal cliff” in January, as the expiration of the Bush tax cuts and other temporary tax breaks would sharply increase tax revenue and commensurately reduce the Treasury’s need to raise cash. If this situation were to occur, the Treasury’s practice of maintaining “regular and predictable” issuance of benchmark coupon issues would require that the outstanding stock of Treasury bills would have to drop by hundreds of billions of dollars over the calendar year. As exhibited in the past, the outstanding stock of T-bills is the main driver of yields in the secondary market.

US Interest Rate Strategy Weekly 13 27 September 2012

Exhibit 9: Treasury bill yields have been most influenced by fluctuations in the outstanding stock

% $ Blns 0.50 Outanding T-bill supply (RHS) 2150 0.45 Yield on 3-month bill (LHS) Yield on 6-month bill (LHS) 2050 0.40 0.35 1950

0.30 1850 Thousands 0.25 1750 0.20 0.15 1650 0.10 1550 0.05 0.00 1450 -0.05 1350 1/1/2009 3/1/2009 5/1/2009 7/1/2009 9/1/2009 1/1/2010 3/1/2010 5/1/2010 7/1/2010 9/1/2010 1/1/2011 3/1/2011 5/1/2011 7/1/2011 9/1/2011 1/1/2012 3/1/2012 5/1/2012 7/1/2012 11/1/2009 11/1/2010 11/1/2011 Source: the BLOOMBERG PROFESSIONAL™ service, Haver Analytics®, Credit Suisse

However, it is our view that a full fall over the “fiscal cliff’ is an unlikely scenario. Particularly with the Democrats looking increasingly likely to remain in the oval office, we believe that the Bush tax cuts are very likely to be extended for another year, perhaps with some minor amendments after a highly factious and partisan debate. This should provide time for the President to work with Congress to reach an agreement on budget reform and ultimately arrive at a solution more in line with the Simpson Bowles proposal or perhaps even the House Republicans to compromise, leading to fundamental tax reform. Callable mortgage replication We think that Agency callables have some additional value relative to long mortgages. Net mortgage supply has remained tame since the federal government’s first- time homebuyer tax credit expired, and the latest round of Fed asset purchases only exacerbates the shortage. The extension risk given the historically low mortgage coupons may also concern some investors. Some may consider callable agencies as an alternative. We look at the three-month carry of different callable structures relative to 15- and 30-year mortgages. To benefit from selling vol via purchasing callables rather than MBS, it requires buying structures with somewhat longer durations. 7nc2 structures do offer some pick-up over 15-year MBS, but there is very little to be gained relative to 30-year mortgages. 10nc2 Bermudan callables look reasonably attractive relative to the 15-year MBS and also offer some benefit relative to 30-year MBS.

Exhibit 10: Buying longer-duration callables instead of mortgages can offer some benefits in carry Indicative Coupon Yield to (as of 8:13 AM, Maturity First Call OAS Effective Effective Yield vol 3‐Month Carry Structure Maturity (%) 9/26) Date Date Pricing (bps) Duration Convexity vega (bps of notional) 10nc2 FNMA, Berm 2.06 2.06 9‐Oct‐22 9‐Oct‐14 Par ‐12 5.89 ‐1.84 ‐0.10 63.4 10nc2 FNMA, 1x 1.95 1.95 9‐Oct‐22 9‐Oct‐14 Par ‐10 5.84 ‐2.18 ‐0.08 62.2 7nc2 FNMA, Berm 1.40 1.40 9‐Oct‐19 9‐Oct‐14 Par ‐10 4.70 ‐1.45 ‐0.04 51.1 7nc2 FNMA, 1x 1.35 1.35 9‐Oct‐19 9‐Oct‐14 Par ‐9 4.66 ‐1.65 ‐0.03 51.9 15yr Agency MBS 1.52 2.50 15y NA 105.1 ‐11 3.59 ‐2.37 ‐0.02 41.5 30yr Agency MBS 2.48 3.00 30y NA 107.5 2 3.85 ‐2.77 ‐0.06 49.5

Source: Credit Suisse, Yield Book

US Interest Rate Strategy Weekly 14 27 September 2012

This year through August, callable gross and net supply have been $317bn and -$79.5bn, respectively. It bears mentioning that it looks as though August was the first month this year with positive net issuance (FNMA net issuance estimated). This is consistent with the back-up in rates, which likely saw fewer bonds being called away.

Exhibit 11: Gross callable issuance has been Exhibit 12: August looks like the first month this relatively steady overall year with positive net issuance August FNMA and September Credit Suisse estimates August FNMA Credit Suisse estimates

80 Gross Callable Issuance (US$ bn) 30 Net Callable Issuance (US$ bn) 70 FNMA FHLMC FHLB FFCB 20 FNMA FHLMC FHLB FFCB 60 10 50 0 40 -10 30 20 -20 10 -30

0 -40 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Source: Credit Suisse, company reports Source: Credit Suisse

With the continued (and now hastened) reduction in Fannie’s and Freddie’s retained portfolios, callable issuance is likely to resume its decline, which should keep spreads relatively tight as scarcity value should increase – with the GSEs only issuing when it is very attractive to do so.

US Interest Rate Strategy Weekly 15 27 September 2012

Trade Idea Carlos Pro Long 5y5y vs. 10y10y inflation swaps 212 538 1863 [email protected]  A cross-market PCA decomposition suggests that TIPS spent the past 10 days mainly catching up with other markets in the risk-off move. We view the “catch- up” sell-off nearly done.  We recommend going long 5y5y versus 10y10y inflation swaps expecting the intermediate sector of the inflation curve to be better supported than the long end.

Following their sharp post-auction sell-off, breakevens continued their downtrend this week. They now appear to us to be nearly done in “catching up” with other asset classes in their reaction to QE according to our cross-market PCA. Recent volatility in breakevens reflects deep discrepancies in market views about what QE3 means for the inflation curve. The wide range of assessments, and the firm convictions involved in many of them, led 10-year breakevens to trade within a 25bp range over the past 10 days. Such macro-debate, as measured by the min-max range of breakevens, has not taken place in this market since early 2010, as shown in Exhibit 13. The swiftness of the recent intra-day moves suggests a price-discovery process Exhibit 13: The post-QE macro debate in a market with reduced liquidity. led BEIs to widen their range markedly 10-year BEI (10-day max vs. min, in percent) Incidentally, the market took a liquidity 0.6 event last Thursday (namely, the 10-year 10-day Max vs. Min auction) to rule that breakevens were not 0.5 leading the post-QE reaction as some

participants initially thought, but instead 0.4 lagging it.

0.3 So, how aligned are breakevens now with other markets after a week of adjustment? 0.2 We think that at this point the catch up is

almost done. 0.1 We performed a PCA decomposition of a 0 broad basket of cross-market assets J-10 A-10 J-10 O-10 J-11 A-11 J-11 O-11 J-12 A-12 J-12 (equities, commodities, spread products Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service and currencies) to assess this relationship. As shown in Exhibit 14, we find that the richness in 10- and 5-year breakevens has declined significantly over the past 10 days (at 6bps and 5bps as of this writing). At current levels, we consider the catch-up to be nearly done and do expect breakevens to break below the pre-QE3 2.40% level in the near-term.

US Interest Rate Strategy Weekly 16 27 September 2012

Exhibit 14: A PCA decomposition shows that TIPS spent the past 10 days catching up with other markets, lagging the QE3 reaction rather than leading it PCA-based regression of 10-year breakevens versus returns across global markets (in percent)

Source: Credit Suisse

Going forward, it will likely all be about economic data, and of course Europe. We think the market needs data, for one to update its assessment of what QE means for inflation (for better or worse) and, perhaps more importantly, to get real-sector indications of what is likely lying ahead. Even when the effect of monetary policy actions does not generally pass-through before 18 months, a QE-amplified positive feedback loop – led by sentiment – may ignite if better data comes along. In the meantime, while data have not been unequivocally stronger, we have had some silver linings, mainly in the housing market. We looked at one-period changes in economic data and find that, consistent with our other market-data metrics, we have been improving modestly in absolute terms in recent weeks (Exhibit 15). We expect data’s modest improvement to persist and provide support for breakevens to not break their floor in the near term.

Exhibit 15: While labor market data remains soft, we have had silver linings in recent data that may prevent breakevens from falling off drastically near term Weighted average change in economic data vs. 10-year TIPS breakevens

120 2.85 100

80 2.65

60 2.45 40 2.25 20

0 2.05 -20 1.85 -40

-60 1.65

-80 Change in data (Lagged 1m) 1.45 -100 BEI (RHS) -120 1.25 1-Feb-10 1-Aug-10 1-Feb-11 1-Aug-11 1-Feb-12 1-Aug-12 Source: Credit Suisse

US Interest Rate Strategy Weekly 17 27 September 2012

With a neutral view on the data and expecting it to extend its recent trend, we favor breakevens and inflation swap curve trades at current levels. Sector wise, we favor being long the belly and intermediate sectors of the breakeven curve in forward space (to avoid current oil weakness), versus short positions in the long end of the curve. This fundamental view, as we have explained before, is predicated on the idea that above- average inflation, if at all to be tolerated by the Fed, will likely be so while cyclical unemployment is still high. In contrast, on a longer-term horizon (e.g. 20- and 30-years) we anticipate the tightening cycle to have started and inflation, on average, to be near the FOMC’s 2% level. Natural expressions of this view are forward breakevens flatteners or inflation swap flatteners. In particular, we recommend long positions in 5y5y inflation swaps (receive inflation, pay fixed rate) versus short positions in 10y10y inflation swaps. We add a $25k position to our model portfolio with $250k target and $175k stop-loss. The risk of the trade is steepening of the curve on, for instance, emerging sponsorship for the long-end of the curve.

Exhibit 16: We express our forward inflation flattening view by recommending going long 5y5y inflation swaps versus 10y10y. In percent 5y5y vs. 10y10y Inflation Swaps 3.2

3.1

3.0

2.9

2.8

2.7

31-Mar-12 30-Apr-12 31-May-12 30-Jun-12 31-Jul-12 30-Aug-12 Swap USCPI 5Y Fwd 5Y Swap USCPI 10Y Fwd 10Y

Source: Credit Suisse Locus

US Interest Rate Strategy Weekly 18 27 September 2012

Trade Idea Michael Chang Favor Selling 2-year Forward 9-year Final Maturity +1 212 325 1962 [email protected] Cap/Floor Straddles Against 2y7y Swaption Straddles George Oomman 212 325 7361  The vol spread between the 2-year forward 9-year final maturity (2x9) cap/floor [email protected] straddle and the 2y7y swaption straddle appears to be too wide after adjusting

for the steepness of the vol surface.  We favor selling 2x9 ATM cap/floor straddles and buying 2y7y ATM swaption straddles at flat vega and look to profit from a tightening in the 2x9 wedge.

Implied volatility on forward-starting 3-month Libor cap/floor options with long final maturities currently appear to be rich relative to corresponding implied swaption volatility. Specifically the spread in implied volatilities between the 2-year forward 9-year final maturity (2x9) Libor cap/floor straddle and the 2y7y swaption straddle, also known as the 2x9 implied vol wedge, is currently near the high-end of its recent range. While part of the increase in the vol wedge can be attributed to the recent steepening of the implied vol term structure, we believe that there is still room for convergence in the two implied volatilities even after adjusting for the slope of the vol term structure. Thus we favor selling 2x9 ATMF cap/floor straddles and buying 2y7y ATMF swaption straddles at flat vega and look to profit from a tightening in the 2x9 wedge.

Exhibit 17: The 2x9 implied vol wedge is currently near the high-end of its recent range

0

-10 Vol Wedgevol) (bp -20

-30 30-Dec-04 01-Jul-07 30-Dec-09 30-Jun-12 2yr Fwd 9yr Final Cap/Floor Vol - 2y7y Swaption Vol Source: Credit Suisse Locus

Exhibit 18: Trade Detail: Sell $67MM 2x9 ATM cap/floor straddle and buy $100MM 2y7y ATM swaption straddle for premium take-in B/S NPA Instrument Strike ATMF Premium ($) N Vega ($) Sell 66.7 MM 2x9 ATM Cap/Floor Straddle 1.84% 1.84% $7,466,667 -75,466 Buy 100.0 MM 2y7y ATM Swaption Straddle 1.89% 1.89% $5,740,000 75,466 $1,726,667 0

Source: Credit Suisse

Although both the 2x9 cap/floor straddle and the 2y7y swaption straddle refer to the same part of the rate curve, their implied volatilities can move differently due to the difference in their optionalities. The 2y7y swaption is a single option expiring in two years on the 7-year swap whereas the 2x9 cap/floor is a series of options on 3-month Libor starting in two years over the subsequent seven years. Intuitively this suggests that the shape of the vol surface would have a meaningful impact on the wedge. A steep vol term structure should suggest a relatively wide wedge (cap/floor relatively rich to swaption) and a flat vol term structure should suggest a relatively tight wedge (cap/floor relatively cheap to swaption). Exhibit 19 shows that the 2x9 wedge has generally tracked the slope of vol on seven-year swaps.

US Interest Rate Strategy Weekly 19 27 September 2012

Exhibit 19: The 2x9 wedge has generally tracked the slope of the vol term structure

7.5 20

15 5.0

10 Vol Wedge Vol Wedge (bp vol)

2.5 Swaption Vol Slope (bp vol) 5

30-Sep-11 31-Dec-11 31-Mar-12 30-Jun-12 2yr Fwd 9yr Final Cap/Floor Vol - 2y7y Swaption Vol 3y7y-6m7y Swaption Vol Slope (rhs)

Source: Credit Suisse Locus

However the 2x9 vol wedge still appears to be too wide even after adjusting for the steepness of the vol surface. A regression of the 2x9 wedge on 3y7y-6m7y swaption vol slope over the past few months suggests that the 2x9 cap/floor straddle is approximately two standard deviations too rich relative to the 2y7y swaption straddle. The trade is also consistent with our near-term view on implied swaption vol where we expect vega to continue to grind lower against the backdrop of an accommodative Fed but look for gamma to be relatively supported due to risks of negative European headlines.

Exhibit 20: The 2x9 vol wedge appears to be two standard deviations too wide after adjusting for the steepness of the vol surface Past 5 months

7.5 +2 Std: 1.81 +1 Std: 0.91 1

5.0 Avg: 0.00 0

-1 Std: -0.91 Vol Wedge (bp vol) -1Regression Residual 2.5 -2 Std: -1.81

12.50 15.00 17.50 20.00 22.50 30-Apr-1231-May-12 31-Jul-1230-Aug-12 3y7y-6m7y Swapton Vol Slope y= 0.509 x -4.251 r: 0.784 r2: 0.615 T: 12.881 y= 0.509 x -4.251 r: 0.784 r2: 0.615 T: 12.881 Avg +/-Std +/-2*Std

Source: Credit Suisse Locus Source: Credit Suisse

Additionally extreme changes in correlation between different parts of the curve also have an impact on the wedge. As correlation between the forward swap rates decreases, cap/floor vol tends to richen relative to swaptions and vice versa. Exhibit 21 shows that the widening in the vol wedge earlier in the month was accompanied by a sharp decline in the one-month correlation (shown inverted in the exhibit) between 2y1y and 5y1y forward swap rates. However, recently the rolling correlation has been trending higher, which should pressure the vol wedge to tighten from current levels.

US Interest Rate Strategy Weekly 20 27 September 2012

Exhibit 21: The one-month rolling correlation between 2y1y and 5y1y forward rates has been trending higher recently, which should pressure the vol wedge to tighten from current level

7.5 -0.5

5.0 0.0

Vol Wedge (bp vol) Vol Wedge 0.5 2.5 1m Rolling Correlation (Inverted)

30-Sep-11 31-Dec-11 31-Mar-12 30-Jun-12 2yr Fwd 9yr Final Cap/Floor Vol - 2y7y Swaption Vol 1m Rolling Correlation Between 2y1y and 5y1y Rates (rhs, inverted)

Source: Credit Suisse Locus

The primary risk to the trade is further relative richening of cap/floor vol to swaption vol, which would be most likely if the implied vol term structure becomes substantially steeper.

US Interest Rate Strategy Weekly 21 27 September 2012

Technical Analysis David Sneddon +44 20 7888 7173  The S&P 500 has found a near-term cap at multi-year channel resistance at [email protected] 1267, but we look for better support at 1400/1395 to maintain the uptrend. Christopher Hine +1 212 538 5727 [email protected] The S&P 500’s advance into September has found a near-term cap at the top end of the multi-year channel now showing at 1467. The retracement back from here has coincided with the risk off phase that has seen commodities also correct lower, credit spreads widen after achieving major resistance level and rates rally back into their ranges. Our broader bias remain bullish, however, further weakness in the near term is expected initially to channel support at 1417 where we would look for a bounce. A surrender here would target more robust levels at 1400/1395 – the 63-day moving average, price lows and the 38.2% retracement of the June-September rally. We look for solid buying here and for it to hold to maintain the uptrend. Only below here would suggest a deeper correction to 1370 ahead of the 200-day moving average at 1358. Above 1467 and follow through 1475 would see a significant hurdle cleared and the uptrend extend for 1520/25 next with the major obstacle presented at the October 2007 peak at 1576. The VIX has bounced from 5-year trendline support now showing at 13.26. Resistance shows initially at 17.91/18.96 – price resistance and the 200-day moving average. We would expect this to try and cap initially. Above is needed for a base and through 21 to signal a more extended turn higher. Below 13.32/26 is needed to signal a leg lower to 11.21 next.

Exhibit 22: S&P 500 – weekly Exhibit 23: VIX – weekly

Source: CQG, Credit Suisse Source: CQG, Credit Suisse

US Interest Rate Strategy Weekly 22 27 September 2012

Economics Events Calendar Jonathan Basile Credit Suisse Market Prior Director estimates estimates results +1 212 538 1436 [email protected] Monday, October 1 8:58AM Markit US PMI Final (Sep) NA NA 51.5 Jay Feldman Director 10:00AM ISM Manufacturing (Sep) 49.0 50.0 49.6 +1 212 325 7634 -ISM Prices Paid 56.0 55.0 54.0 [email protected] 10:00AM Construction Spending (Aug) NA 0.5% -0.9%

Dana Saporta 12:00N San Francisco Fed’s Williams speaks at Capital Markets for Impact at Scale conference (Non-Voter) Director +1 212 538 3163 Tuesday, October 2 [email protected] 7:45AM ICSC-GS Chain Store Sales, Wk/Wk (Sep 29) NA NA 0.6% 8:55AM Redbook Retail Store Sales, MoM (Sep 29) NA NA 1.7% Neal Soss Managing Director 9:45AM ISM New York (Sep) NA NA 51.4 +1 212 325 3335 AM ASA Staffing Index, Wk/Wk (Sep 18) NA NA 1.7% [email protected] PM Total Vehicle Sales (Sep) 14.5M 14.4M 14.5M -Domestic Vehicle Sales 11.5M 11.4M 11.5M Wednesday, October 3 8:15AM ADP Employment (Sep) NA 134K 201K 10:00AM ISM Non-Manufacturing (Sep) 53.0 53.5 53.7 10:00AM Help Wanted Online Ads (Sep) NA NA -108.7K 10:30AM DOE Crude Oil Stocks, mn/bbl (chg) (Sep 28) NA NA 365.2(-2.4) Thursday, October 4 7:00AM BoE Rate Announcement 0.50% 0.50% 0.50% 7:30AM Challenger Layoffs (Sep) NA NA 32,239 7:45AM ECB Rate Announcement 0.75% 0.75% 0.75% 8:30AM Initial Jobless Claims (Sep 29) 375K NA 359K 10:00AM Factory Orders (Aug) -6.0% -2.2% 2.8% 11:00AM UST 3- and 10-Year Note and 30-Year Bond Announcement AM St. Louis Financial Stress Index (Sep 28) NA NA -0.2 2:00PM FOMC Minutes (From Sept 13 Meeting) 8:00PM St. Louis Fed’s Bullard will speak to the Economic Club of Memphis (Non-Voter) Friday, October 5 AM BOJ Rate Announcement 0.10% 0.10% 0.10% 8:30AM Employment Report (Sep) -Nonfarm Payrolls 95K 118K 96K -Private Payrolls 125K 123K 103K -Unemployment Rate 8.2% 8.2% 8.1% -Average Hourly Earnings 0.2% 0.1% 0.0% 3:00PM Consumer Credit (Aug) $8.5B $8.0B -$3.3B Source: the BLOOMBERG PROFESSIONAL™ service, © 2012 Thomson Reuters Limited, Credit Suisse estimates.

US Interest Rate Strategy Weekly 23 27 September 2012

Databank Exhibit 24: Treasury yields (09/27/2012) Exhibit 25: Treasuries yield weekly change

Exhibit 27: Treasuries asset swap yield-yield weekly Exhibit 26: Treasuries asset swap yield-yield (daily) change

Exhibit 28: Eurodollar strip Exhibit 29: AGY, TSY, swap weekly change

Exhibit 30: US Treasuries 2s10s Exhibit 31: UST 2s-5s-10s fly

Source for all: Credit Suisse PLUS Link to intra-week updates

US Interest Rate Strategy Weekly 24 27 September 2012

Exhibit 32: USD forward yield (%) September 26, 2012 closing values

Exhibit 33: Forward swap curves Exhibit 34: Forward swap rates

Exhibit 35: Forward 2s10s curve Exhibit 36: Forward 5s30s curve

Source for all: Credit Suisse PLUS Link to intra-week updates

US Interest Rate Strategy Weekly 25 27 September 2012

Exhibit 37: 10yr Treasury seasonals Exhibit 38: 2s-10s Treasury curve seasonals

Exhibit 39: 10yr swap spread seasonals Exhibit 40: 3m10y vol. seasonals

Exhibit 41: AGY OTR 10yr spread to TSY OTR 10yr seasonals Exhibit 42: LUCI+ benchmark spread seasonals

Exhibit 43: 10yr Treasury roll around auctions Exhibit 44: 5yr Treasury roll around auctions

Source for all: Credit Suisse PLUS Link to intra-week updates

US Interest Rate Strategy Weekly 26 27 September 2012

Exhibit 45: 2yr and 10yr swap spreads Exhibit 46: FNMA sr. debt vs. MBS spreads

Exhibit 47: FNMA asset swaps Exhibit 48: FNMA spread to Treasuries

Exhibit 49: Corporate 5yr CDS spreads Exhibit 50: Bank & broker CDS vs. swap spreads

Exhibit 51: IG corporate bond term structure (LUCI Index) Exhibit 52: VIX Index

Source for all: Credit Suisse PLUS Link to intra-week updates

US Interest Rate Strategy Weekly 27 27 September 2012

Exhibit 53: Current coupon vs. agency debt Exhibit 54: Mortgage Index Price

Exhibit 55: Extension/contraction risk imbalance vs. Exhibit 56: Rolling 1m beta: 10yr spreads vs. 10-yr duration levels OTR yields

Exhibit 57: USD vol. term structure; Exhibit 58: USD vol. term structure; 10-year swap rate 2-year swap rate

Exhibit 59: USD, 10-year swap volatility cones Exhibit 60: USD, 2-year swap volatility cones

Source for all: Credit Suisse PLUS

Link to intra-week updates

US Interest Rate Strategy Weekly 28 27 September 2012

Exhibit 61: Basis point swaption vol ratio to 6mo-10yr September 26, 2012. Color evaluated over the last three months. Color extreme is three standard deviations from average.

Source: Credit Suisse

US Interest Rate Strategy Weekly 29 27 September 2012

Exhibit 62: Credit Suisse interest rate forecasts (as of September 26)

US - Treasuries Last 2012 Q3 2012 Q4 2013 Q1 2013 Q2 Fed Funds 0-0.25 0 – 0.25 0 – 0.25 0 – 0.25 0 – 0.25 2-Yr Yield 0.26 0.25 0.25 0.25 0.30 5-Yr Yield 0.63 0.55 0.55 0.60 0.65 10-Yr Yield 1.62 1.25 1.35 1.45 1.55 30-Yr Yield 2.79 2.25 2.30 2.40 2.50

UK - Gilts Last 2012 Q3 2012 Q4 2013 Q1 2013 Q2 Base Rate 0.50 0.50 0.50 0.50 0.50 2-Yr Yield 0.19 0.30 0.30 0.35 0.40 5-Yr Yield 0.71 0.80 1.10 1.25 1.30 10-Yr Yield 1.69 1.80 2.00 2.30 2.35 30-Yr Yield 3.03 3.00 3.10 3.50 3.55

Euro - German Benchmarks Last 2012 Q3 2012 Q4 2013 Q1 2013 Q2 ECB Repo 0.75 0.50 0.50 0.50 0.50 2-Yr Yield 0.04 0.00 0.00 0.10 0.20 5-Yr Yield 0.52 0.55 0.70 0.80 0.90 10-Yr Yield 1.47 1.40 1.65 1.90 2.10 30-Yr Yield 2.29 2.10 2.30 2.45 2.55

Japan - JGBs Last 2012 Q3 2012 Q4 2013 Q1 2013 Q2 Overnight 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 2-Yr Yield 0.10 0.10 0.10 0.10 0.10 5-Yr Yield 0.20 0.30 0.30 0.35 0.35 10-Yr Yield 0.78 0.90 0.95 1.00 1.10 30-Yr Yield 1.88 1.90 1.95 2.00 2.00

Source: Credit Suisse

US Interest Rate Strategy Weekly 30 US Interest Rate Strategy Weekly

Exhibit 63: Credit Suisse global economic, growth and interest rate forecasts (as of September 20) 2012E 2013E Q4/Q4 Annual Avg. Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 10 11 12E 13E 10 11 12E 13E US Real GDP 2.0 1.7 1.3 2.2 2.4 2.6 3.0 3.0 2.4 2.0 1.8 2.8 2.4 1.8 2.2 2.3 IP 4.4 4.8 3.3 2.3 1.8 2.2 3.7 5.1 6.3 4.0 2.3 5.1 5.4 4.1 3.7 3.2 Inflation 2.8 1.9 1.6 1.6 1.1 1.0 1.2 1.3 1.2 3.3 1.6 1.3 1.6 3.1 2.0 1.2

Credit Suisse Official Effective Fed Funds 0 - .25 0 - .25 0-.25 0 – .25 0 – .25 0-.25 0 – .25 0 – .25 ... … … … ...... 2-Yr Yield 0.25 0.25 0.25 0.30 0.35 0.40 … … … … … … … 5-Yr Yield 0.55 0.55 0.60 0.65 0.70 0.75 … … … … … … … 10-Yr Yield 1.25 1.35 1.45 1.55 1.65 1.75 … … … … … … … 30-Yr Yield 2.25 2.30 2.40 2.50 2.60 2.75 … … … … … … … Global Real GDP 3.4 3.3 3.1 3.3 3.4 3.6 3.9 4.1 4.8 3.4 3.3 4.1 5.0 3.8 3.3 3.8 IP 3.4 3.1 2.9 3.6 3.5 4.1 4.8 5.3 8.0 3.7 3.6 5.3 9.6 5.1 3.2 4.4 Inflation 4.1 3.7 3.5 3.4 3.1 3.2 3.4 3.4 3.7 4.7 3.4 3.4 3.5 4.7 3.6 3.3 Japan Real GDP 5.3 0.7 -1.3 -0.5 1.7 2.6 2.8 2.8 3.4 -0.6 1.0 2.5 4.5 -0.8 2.1 1.2 IP 4.7 5.3 -3.4 -4.0 -4.5 -1.6 3.0 4.8 6.0 -1.6 -4.0 4.8 16.5 -2.4 0.6 0.4 Inflation 0.1 0.0 0.2 0.0 -0.4 -0.3 -0.3 -0.2 0.0 -0.2 0.0 -0.2 -1.0 -0.3 0.0 -0.3 Overnight Call Rate 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 ... … … … … … … 10-Yr Bond Yield 0.90 1.00 1.00 ... … … … … … ... Euro-16 Real GDP 0.0 -0.8 -0.6 0.2 1.0 1.0 1.5 1.5 2.2 0.7 -0.6 1.2 1.9 1.5 -0.5 0.5 IP -1.6 -2.4 -3.8 -2.0 -1.5 -1.0 0.2 0.8 8.0 -0.1 -2.0 0.8 7.3 3.6 -2.5 -0.4 Inflation 2.7 2.5 2.6 2.7 2.3 2.1 2.1 1.9 2.2 2.7 2.7 1.9 1.6 2.7 2.6 2.1 ECB Repo Rate 1.00 1.00 0.50 0.50 0.50 0.50 … … … … … … 10-Yr Bund Yield 1.40 1.65 1.90 2.10 ... … … … … … … UK Real GDP -1.7 -1.4 1.9 1.2 1.5 1.7 2.3 2.1 1.7 0.5 0.0 1.9 2.1 0.7 -0.3 1.4 IP 0.2 1.8 2.7 3.1 2.5 3.5 4.1 4.1 3.3 -1.5 3.1 4.1 2.1 -0.5 1.9 3.5 Inflation 3.5 2.7 2.3 2.0 2.0 2.2 2.6 2.5 3.4 4.6 2.0 2.5 3.3 4.5 2.6 2.3 BOE Base Rate 0.50 0.50 0.50 0.50 0.50 0.50 ... … … … … … … 10-Yr Gilt Yield 1.80 2.00 2.30 2.35 ... … … … … … … IMF PPP weights are used to compute regional and global aggregate figures. GDP growth is quarter/quarter annualized, except for global GDP, which is year/year. Industrial production and inflation are expressed as year/year changes. US, UK, and Euro-16 inflation rates are headline, whereas Japan inflation rates are excluding fresh food. Fed fund target rate changed to effective rate starting Q1 2008, and annual forecasts are year-end forecasts. Actual reported quarterly interest rates are the average of closing rates over the last month of the quarter.

Source: Credit Suisse

27 September 2012

31

INTEREST RATE STRATEGY

Eric Miller, Managing Director Global Head of Fixed Income and Economic Research +1 212 538 6480 [email protected]

US RATES EUROPEAN RATES US DERIVATIVES Carl Lantz, Director Helen Haworth, CFA, Director George Oomman, Managing Director US Head European Head Derivatives Head +1 212 538 5081 +44 20 7888 0757 +1 212 325 7361 [email protected] [email protected] [email protected]

Ira Jersey, Director Michelle Bradley, Director TECHNICAL ANALYSIS +1 212 325 4674 +44 20 7888 5468 [email protected] [email protected] David Sneddon, Managing Director +44 20 7888 7173 Scott Sherman, Vice President Sabine Winkler, Director [email protected] +1 212 325 3586 +44 20 7883 9398 [email protected] [email protected] Christopher Hine, Vice President +1 212 538 5727 Michael Chang, Vice President Panos Giannopoulos, Director [email protected] +1 212 325 1962 +44 20 7883 6947 [email protected] [email protected] Pamela McCloskey, Vice President +44 20 7888 7175 Carlos Pro, Associate Thushka Maharaj, Vice President [email protected] +1 212 538 1863 +44 20 7883 0211 [email protected] [email protected] Cilline Bain, Associate +44 20 7888 7174 William Marshall, Analyst Florian Weber, Associate [email protected] +1 212 325 5584 +44 20 7888 3779 [email protected] [email protected]

Marion Pelata, Analyst +44 20 7883 1333 marion.pelata @credit-suisse.com

LOCUS ANALYTICS (US AND EUROPE)

Jennifer Drag, Director Locus Analytics Specialist +1 212 538 4303 [email protected]

PARIS SINGAPORE TOKYO Giovanni Zanni, Director Jarrod Kerr, Director Tomohiro Miyasaka, Director European Economics – Paris +65 6212 2078 Japan Head +33 1 70 39 0132 [email protected] + 81 3 4550 7171 [email protected] [email protected] Shinji Ebihara, Vice President +81 3 4550 9619 [email protected]

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