The Quest for Value in Global Bonds

The Quest for Value in Global Bonds Francesco U. Garzarelli Managing Director, Macro & Markets Research Goldman Sachs International, London francesco.garzarelli@gs.com Tel: +44 207 774 5078 Oslo, 28 November 2006

The Bond Yield Sudoku We posit that 10-yr rates are a function of: (i) The current stance of policy (3-mth rates, or SR x ); and (ii) Expectations on the future trajectory of policy, as influenced by economic activity (IP x ) and inflation (INF x ) We allow for changes in one country s term premium to influence the level of bond yields abroad, as described by the following equation: LR X = β X,0 X,1 IP X X,2 INF X X,3 SR X + X,4 LR X * + ε X Where LR* X is a global bond yield variable specific to county X constructed as the weighted-average of foreign long rates, using trade shares with countries A, B, etc. as weights*. LR X * = ωx, A LRA + ωx, B LRB +K *: Our approach draws on the GVAR-VARX* VARX* framework as described in, for example, Pesaran and Smith (2006). 2

A Simultaneous Macro Pricing Approach We concentrate on 4 countries: US, Japan, Germany, UK, using monthly data starting 1986. We employ a 2-stage least square estimation procedure: In 1 st stage of estimation, each of the endogenous foreign rates is instrumented by macro variables. LR LR LR LR US GR JP UK = β = β = β = β US,0 GR,0 JP,0 UK,0 US,1 US,4 GR,1 GR,4 JP,1 JP,4 UK,1 UK,4 IP IP US LR IP JP LR US GR LR IP LR GR JP UK UK US,2 * + ε * + ε US GR,2 JP,2 * + ε GR JP * + ε INF UK,2 UK INF US INF JP GR INF UK US,3 GR,3 JP,3 SR SR UK,3 US SR JP GR + SR + UK + + In the 2 nd stage, the fitted values are substituted in the structural form system for estimation. The reduced-form coefficients γ are functions of the structural form coefficients β. LR US = γ US,0 + γ + γ + γ + γ US,1 GR,1 JP,1 UK,1 IP IP IP US GR JP IP UK + γ + γ + γ + γ US,2 GR,2 JP,2 UK,2 INF INF INF GR JP INF US + γ UK + γ + γ US,3 GR,3 JP,3 + γ UK,3 SR SR SR JP US GR SR + UK + + + υ US 3

Yields Abroad Influence Domestic Ones Shifts in yields implied by the relationship between bonds and macro factors in one country have a direct bearing on the level of yields in other markets. Most coefficients are statistically significant at the conventional levels, and display little sensitivity to varying samples. The model corrects for first order autocorrelation of error terms, arising from persistent nature of departures from equilibrium. The model s residuals are stationary (hence, the nonstationary variables in the system are co-integrated). Estimation results* β X,0 β X,1 β X,2 β X,3 β X,4 US Germany Japan UK 1.94 1.18-0.67-0.32 (4.94) (1.96) (-0.84) (-0.40) 0.05 0.00 0.01 0.03 (2.72) (0.64) (1.10) (2.49) 0.04 0.03-0.05 0.03 (0.71) (0.87) (-1.41) (0.47) 0.26 0.23 0.51 0.12 (3.99) (3.19) (5.35) (1.28) 1.39 1.21 1.03 1.54 (6.41) (5.12) (2.92) (6.13) AC coefficient 0.89 0.95 0.89 0.93 (27.02) (44.92) (29.11) (41.18) DW statistics 1.98 2.33 1.93 2.12 Observations 244 244 244 244 * t-statistics in parenthesis. 4

Bonds Are Still Expensive Across the Board... 11 10 USA Actual value 10 9 Germany Actual value 9 8 7 Fundamental value Fundamental value, predicted 8 7 6 Fundamental value Fundamental value, predicted 6 5 5 4 4 3 3 86 88 90 92 94 96 98 00 02 04 06 08 2 86 88 90 92 94 96 98 00 02 04 06 08 9 8 7 6 5 4 3 2 1 Japan Actual value Fundamental value Fundamental value, predicted 0 86 88 90 92 94 96 98 00 02 04 06 08 14 12 10 8 6 4 UK Actual value Fundamental value Fundamental value, predicted 2 86 88 90 92 94 96 98 00 02 04 06 08 5

...And Approaching a 2 Std. Dev. Event! Why? 1.0 0.5 St.Dev. G3: Residuals from GS Sudoku Bond Model 0.0-0.5-1.0-1.5-2.0 USA Germany Japan UK -2.5 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 6

A: Official Buying Is on the Rise Again... TIC Data: Official Purchases of UST and Agencies 40 US$bn 30 20 10 0-10 -20 01 02 03 04 05 06 07 Source: US Treasury 7

A:...But Asia Is No Solution to Bond Puzzle US 10-yr Rates, Actual vs. Model 10 9 8 7 6 Is demand from Asia exogenous? Published time series analysis produced estimates of the impact of Asian buying on USTs ranging between 30bp and 200bp. 5 4 3 2 Actual Baseline model with FX misalignment 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 8

B: The Growth-Inflation Trade-off Has Improved Consensus Expectations on US Real Growth and Inflation, 6-10y 6 ahead 4.5 US Inflation, 6-10y ahead 7.0 4.0 US GDP Growth, 6-10y ahead 6.5 3.5 US Nominal Growth, 6-10y ahead 6.0 5.5 3.0 5.0 2.5 4.5 2.0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 4.0 9

B: Same Magnitude of CPI Shocks as in the 70s... 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 p.p. US Headline CPI Inflation: Conditional Variance* * Estim ated by GARCH model. 0.00 50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 10

B: But a Much Lower Pass-Through to Core 0.20 0.18 0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 p.p. US Core CPI Inflation: Conditional Variance* * Estim ated by GARCH model. 0.00 50 54 58 62 66 70 74 78 82 86 90 94 98 02 06 11

B: Are We More Relaxed About Inflation? US 10-yr Rates, Actual vs. Model 11 10 9 8 7 6 5 4 Actual Baseline model with inflation vol 3 Baseline model with inflation vol (allowing for shifts in vol sensitivity) 2 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 12

B: Caveat: Service Inflation Shows Strong Inertia 1.1 1.0 Persistence coefficient* Persistence of US Core Services Inflation 0.9 0.8 0.7 0.6 0.5 * A sum of autoregressive coefficients in rolling ARM A m odel. Persistence coefficient of 1 m eans inflation is perfectly persistent, larger than 1 m eans inflation 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 13

C: Lower Corporate Borrowing, Lower Yields Financing Gap and Real Rates 3.5 3.0 of GDP 4.5 4.0 2.5 3.5 2.0 3.0 1.5 2.5 1.0 2.0 0.5 1.5 0.0-0.5-1.0 G3 Financing Gap (lhs) Real 10yr Yield (rhs) 1991 1993 1995 1997 1999 2001 2003 2005 1.0 0.5 0.0 14

C: But Free Cash Flow Surge Gradually Turning Nonfinancial Corporate Financing Gap in G-3 G 3 Economies 8 6 of GDP 4 2 0-2 -4 JAPAN* USA EMU3 Aggregate *Japanese data are fiscal year, not calendar year. -6 1980 1984 1988 1992 1996 2000 2004 2008 Source: Flow of Funds, GS Economics calculations Source: Flow of Funds tables from national central banks; Goldman Sachs calculations. 15

On a Relative Basis, Japan More Attractive 6.0 USA 5.0 Germany 5.5 4.5 5.0 4.0 4.5 Actual value 3.5 Actual value 4.0 Forecast value 3.0 Forecast value 3.5 Forward value 05 05 06 06 07 07 08 2.5 Forward value 05 05 06 06 07 07 08 3.0 2.8 Japan 5.5 5.3 UK 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 Actual value Forecast value Forward value 05 05 06 06 07 07 08 5.1 4.9 4.7 4.5 4.3 4.1 3.9 3.7 3.5 Actual value Forecast value Forward value 05 05 06 06 07 07 08 16

USTs on Safer Cyclical Ground than Bunds Local Factors GrowthInflation 3mth rates Global Factors Fundamental Factors US 10-yr Bonds Contribution of Factors 3mth 3mth Growth Inflation Local Global GrowthInflation rates rates Misvaluation Nov-06 5.84 4.56 + 3mth -0.05 0.00-0.11 0.00 0.02 0.05-0.16 0.06-0.05 0.02-0.06-0.09 0.32 0.23 + 6mth -0.11-0.01-0.23-0.01 0.01 0.08-0.35 0.08-0.11 0.00-0.15-0.26 0.55 0.29 Total Total Total Local Factors GrowthInflation 3 mth rates Global Factors Fundamental Factors Germany 10-yr Bonds Contribution of Factors 3 mth 3 mth Growth Inflation Local Global GrowthInflation rates rates Misvaluation Nov-06 5.05 3.70 + 3mth 0.00 0.04 0.06-0.02 0.00-0.02 0.09-0.04-0.03 0.04 0.04 0.05 0.25 0.30 + 6mth -0.01 0.04 0.06-0.05-0.01-0.05 0.10-0.11-0.06 0.03 0.01-0.01 0.45 0.44 Total Total Total 17

Stay Put on Gilts, Watch the BoJ! Local Factors GrowthInflation 3 mth rates Global Factors Fundamental Factors Japan 10-yr Bonds Contribution of Factors 3 mth 3 mth Growth Inflation Local Global GrowthInflation rates rates Misvaluation Nov-06 2.12 1.71 + 3mth -0.01 0.00 0.10-0.02 0.01-0.02 0.09-0.03-0.03 0.01 0.08 0.06 0.07 0.14 + 6mth -0.01-0.01 0.17-0.04 0.01-0.07 0.15-0.10-0.05 0.00 0.10 0.05 0.13 0.19 Total Total Total Local Factors GrowthInflation 3 mth rates Global Factors Fundamental Factors UK 10-yr Bonds Contribution of Factors 3 mth 3 mth Growth Inflation Local Global GrowthInflation rates rates Misvaluation Nov-06 6.02 4.50 + 3mth 0.00 0.00 0.00-0.04 0.04 0.02 0.00 0.03-0.03 0.04 0.02 0.02 0.30 0.32 + 6mth 0.00-0.01-0.01-0.07 0.03-0.02-0.02-0.06-0.08 0.02-0.02-0.08 0.53 0.45 Total Total Total 18

The Bond Scorecard Valuation 1 Business Cycle 2 Technicals 3 Strategy TYZ6 very negative very positive neutral Long 5yr 5yr real vs Euroland; (2 std dev) (- 9-26 bp in 3-6mths) (range 4.53-4.85) long 2yr inflation vs Euroland; long 10yr breakeven RXZ6 very negative neutral neutral Breakeven steepeners (2 std dev) (flat in 3-6mths) (range 3.60-3.90) JBZ6 slightly negative slightly negative neutral Long 10yr breakeven (1/2 std dev) (+ 5-6 bp in 3-6mths) (range 1.58-1.87) G Z6 negative positive neutral Neutral (3/2 std dev) (- 8 bp in 3-6mths) (range 4.44-4.77) 1 : Based on the long-run equilibrium estimates from GS' Sudoku model; see chp. 12 of our 2006 FX Annual for details. 2 : Based on GS' Sudoku model, fed with factor forecasts taken from our global macro team, and assuming no 'error correction'. 3 : Technical analysis inputs from Kevin Edgeley, London (kevin.edgeley@gs.com). 19

Bond-Equity Return Correlation Unstable... 0.8 Correlation Between Bunds and DAX Returns 0.6 0.4 0.2 0-0.2-0.4-0.6 80 82 84 86 88 90 92 94 96 98 00 02 04 06 20

...But Inflation Tends to Increase It Correlation Between Bund and DAX Returns Short Rates Inflation Growth Correlation* * Impacts on correlation are calculated using an OLS regression of the rolling 1-year correlation betw een Bund and DAX returns on changes in the level of short rates, yoy CPI inflation and yoy industrial production grow th betw een time t and time t-12, estimated on a monthly sample from 1981:M07 to 2006:M07. 21

Credit Spreads Supported by Fundamentals US: GS-SPREAD SPREAD Model GS-Spread Spread Long-Term Multipliers If our Variables...... Then Spreads 3.5 3.0 US: Baa Corporate Bond Spread* Real GDP Growth by 1 yoy by 18bp 2.5 Financing Gap by 1 of GDP by 45bp 2.0 Stock Market Volatility by 5 annual 30-yr Bond Yield by 100bp Based on the long-run parameter estimates from the ARDL model. by 25bp by 03bp 1.5 1.0 Actual GS-SPREAD *Moody's Baa-30yr less Treasury *Latest 0.5 99 00 01 02 03 04 05 06 * 22

Free Cash Flow Remains Abundant 4.0 3.0 of GDP US Nonfinancial Corporates: : Financing Gap Headline 2.0 1.0 0.0-1.0-2.0 long-term average Surplus Adjusted for one-offs -3.0 99 00 01 02 03 04 05 06 23

Relative Debt and Growth Trends Matter Fundamental Impact on 10-year EMU Government Spreads Basis Points Pre-EMU Post-EMU 1 Increase in Growth Differential 2.4* -0.2* 1 Increase Debt/GDP Differential 0.4* 0.4* 1 Increase Surplus/GDP Differential -5.6* -1.3** 100bp Increase Baa-Treasury Spread 2.1* 2.1* Relative to the average of Germany and France * Significant at 95 level or above; ** Significant at 85 level (White std.err.) calculations. See: Have Bond Market Vigilantes Lowered Their Guard,, 27 July 05. 24

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