ScotiaBank JUL 16 Fixed Income and Relative Value Weekly

Fixed Income Research
Fixed Income Relative-Value Weekly

Roger Quick, CFA Friday, July 16, 2010
Highlights
• Canada 1y/2y Update: last month’s flattener recommendation worked well, improving by close to 20
bps. We would now take profits. A lot of the front-end flattening trades are now I think largely done,
though one that should still have reasonable potential left is 1y/3y.
• Canada-US spreads: I think Canada should underperform going into the BoC statement, but I think a
widening in the spread back out to 110 bps represents reasonable value from an income standpoint.
• Canada 10s: after being positive on 10-year Canadas vs the curve for many months, we are now more
neutral. In particular, we recommended earlier this week taking profits on the 5/10/30 butterfly.
• What is priced in for the BoC? the market is fully pricing in a July 20th rate increase, but the implied
pace of tightening after that is relatively modest. For example, the market is pricing less than 35 bps of
tightening for the remainder of this year after July 20th, followed by an even more modest pace in
2011.
• The low implied tightening expectations further out the curve are likely as much a byproduct of short
covering, as they are a reflection of a change in fundamental view on the part of investors, which sug-
gests they may not be sustained.
• Scotia Economics recently revised its BoC forecast (July 7th), and now forecasts just two more rate in-
creases this year, including July 20th, which takes the overnight target to 1.0% by the end of the year.
For 2011, Scotia Economics now forecasts that the BoC will raise rates to 2.25% by mid year.
• The Appendix shows 1) updates of various yield curve rate-cycle charts, 2) an extract from the daily but-
terfly report for swaps and bonds, 3) Canada bonds valued off our theoretical multi-factor yield curve
model, and 4) Canada bond asset-swap spreads.
VIX Index of Implied Volatility vs US 10-Yr Treasury Yield
10
US10 Generic VIX
4 15
20
VIX (Scale Reversed, %)
25
3.5
US 10-Year Yield
30
35
3
40
45
2.5 Source: Bloomberg
50
55
2 60
12/31/08
1/31/09
2/28/09
3/31/09
4/30/09
5/31/09
6/30/09
7/31/09
8/31/09
9/30/09
10/31/09
11/30/09
12/31/09
1/31/10
2/28/10
3/31/10
4/30/10
5/31/10
6/30/10
Fixed Income & Relative-Value Strategy Friday, July 16, 2010
Deep Thoughts on the BoC:
One of the things I have been pondering after a few weeks away from the office is the relationship between the strong
Canadian economic data, the BoC’s decision last month to take a significantly less hawkish stance than could have
been justified by the domestic fundamentals, and what these things might mean going forward. I don’t know the an-
swer, but here are a few thoughts.
Canadian economic data have continued to come in strong, most notably employment. Earlier this week, BoC surveys
suggested excess capacity was declining, and that credit conditions were easing. One recent exception to the good
news was the drop in existing home sales reported this week. Though perhaps also a sign of a further slowdown to
come, this was at least in part likely a reflection of the tendency for people to have rushed to buy homes in the first half
of the year ahead of things like higher mortgage rates, the HST, and stricter mortgage rules.
A counterpoint to the generally strong Canadian economic numbers has been the weakness of the US data. Concerns
about the US economy have kept US 10-year yields low in recent weeks, even as concerns about contagion from
Europe have apparently subsided (subsided at least as measured by a decline in the VIX, a one-week rally in US stocks,
and by a couple of well-received auctions by Greece and Portugal. Credit spreads on peripheral European debt remain
high. I am guessing that many investors are hoping that Europe’s bank stress tests will have the same dramatic effect
that the US ones did last year. The risk would seem to be these investors are disappointed.). Concern about the US eco-
nomic outlook was also highlighted this week in the FOMC minutes.
Implications for the BoC? Presumably the risk of a deteriorating US economy adversely affecting Canada in the future
will be one factor that causes the BoC to be again less hawkish than the strong domestic fundamentals alone would
seem to justify.
What is Priced In for the BoC?
My colleagues in Scotia Economics have revised down their forecast for BoC tightening since the last RV Weekly on
June 11th. Scotia Economics now calls for two more hikes this year, taking the BoC target to 1pct by year end. Scotia
Economics has lowered its BoC call twice in the past few months, reducing its year-end target from 1.5 pct to 1.0 pct,
most recently on July 7th. For 2011, Scotia Economics now forecasts that the BoC will raise rates to 2.25% by the sum-
mer of 2011, down from the May forecast of 2.75%.
Scotia’s forecast for the BoC is actually less aggressive than what is priced into the market for the remainder of 2010,
and more aggressive for the first half of 2011. Based on OIS levels as of Friday morning, the market is fully pricing a July
20th hike, followed by about a 50% probability of rate hikes at each meeting through December, and an even more
gradual pace in 2011.
The fact that the market’s implied tightening in 2011 is less aggressive than Scotia’s forecast isn’t too surprising, if only
because it is likely that short-covering in BAXs and short-term Canadas has likely played a significant role in driving
down the implied probability of central bank tightening next year, at least as much as have fundamental expectations
for the Canadian economy.
2
Update: 1y/2y Flattener Recommen- 1s/2s CDA Swaps Slope vs. BoC Tightening
dation Average 9/8/2004 4/16/2002 6/26/1997 Forwards 6/1/2010
120
Recommended April 6th,
The 1y/2y flattening recommendation and reiterated frequently
since then.
has worked out well, improving close to 100
20 bps since our recommendation last
month. (it is 3 bps tighter at the time of Recommended 1y/2y
again June 16th
writing Friday, which is not captured in 80
the graph shown here).
Spread (bps)
60
We would now recommend taking prof-
its. When we recommended the flat-
tener again on June 16th, our target was 40
Take profits May 21st
a further 15-20 bps of flattening in the
next two months. We have reached that 20
target, a bit faster than planned. The
spread may ultimately flatten further, as Source: Scotial Captial
suggested by the long-run cyclical pat- 0
-200 -150 -100 -50 0 50 100 150 200
tern in the chart, but that may be at Business Days Before First Rate Hike
least several months away. The charts at
right suggest to me that the 1y/2y 1s/2s CDA Par Slope vs. BoC Tightening
spread has already reached quite flat Average 9/8/2004 4/16/2002 6/26/1997 Forwards 6/1/2010
levels for this point in the cycle, espe- 120

Recommended April 6th,
and reiterated frequently
cially the 1y/2y spread in swaps. since then.
100
N.B. The 1y/2y flattener trade had been Recommended 1y/2y

again June 16th
one of our major recommendations
since early April. We recommended tak- 80
ing profits May 21st (RV Weekly). We

Spread (bps)
then recommended entering the trade 60
again on June 16th (daily note). Between

early April and now the spread has flat-
tened some 40 bps. 40
Take profits May 21st
20
Source: Scotial Captial

0
-200 -150 -100 -50 0 50 100 150 200
Business Days Before First Rate Hike

1s/3s CDA Par Slope vs. BoC Tightening
CDA 1y/3y Average 9/8/2004 4/16/2002 6/26/1997 Forwards 6/1/2010
200
For those readers who may still be inter- 180

ested in entering into a front-end flat-
tener trade, I think a somewhat better 160
opportunity than 1y/2y now may be 140

1y/3y. The graph at right shows that the
1y/3y spread may still have somewhat 120
Spread (bps)
greater flattening potential, based on 100

the experience in past cycles..
80
Recommended April
21st, and reiterated
frequently since then.
60
40
20

0
-200 -150 -100 -50 0 50 100 150 200
3
Canada/US Govt Yield Spreads (Constant-Maturity Theoretical Bonds)

140
Update: Canada – US Spreads CU2
June 15th: "Back to
120 levels that are getting
interesting"
Last month we suggested that Canada
2s were reasonable value at about 105 100
bps over the US from a carry and roll-
down standpoint. This was based on 80
Yield spread (bps)

the view that a reasonable amount of
divergence between the BoC and Fed 60
had been priced in, and skepticism that

the BoC would continue to tighten 40
much more than 100 bps beyond the

20
Fed. Since that time, the spread initially
tightened almost 25 bps, which I think
0
had as much or more to do with inves-
tors covering short Canada positions as
-20
it had to do with a fundamental shift in
Source: Scotia Capital constant-maturity par bond series
investors’ views. The spread has wid- -40
ened back out since then, in particular
Jun-07
Aug-07
Oct-07
Dec-07
Feb-08
Apr-08
Jun-08
Aug-08
Oct-08
Dec-08
Feb-09
Apr-09
Jun-09
Aug-09
Oct-09
Dec-09
Feb-10
Apr-10
Jun-10
after last week’s very strong Canadian
employment number.
I think a move back out to 105-110 bps above the US in the 2-year sector would again be a reasonable opportunity to
buy Canada vs the US. I would wait until after the BoC meeting before doing anything though. I think Canada 2s
should cheapen further going into the BoC meeting (Friday morning’s outperformance in Canada 2s seems to be an-
other round of short-covering, since it has come amid weaker US data and a rallying Treasury market).
NB: the long-term graph shows “true” constant-maturity 2-year spread, which was at about 101 bps as of Thursday’s
close (and about 95 bps Friday morning at the time of writing). This corresponds to the spread between the Canada
Sep 2012 benchmark and the Treasury June 2012 benchmark of about 106 bps as of Thursday’s close.
4
CDA 10-Year Sector Expensive Conventionally Weighted Can Par 5s-10s-30s Fly vs. Slope
Par5s-Par10s-Par30s Par5s-Par30s Slope

We have liked the 10-year sector vs the
rest of the Canada bond curve for a 35 250
long time. This general view has taken
30
various forms. Back in December and 200
January we began recommending the 25
5/10/30 butterfly as an early way to
Butterfly (bps)
150
Slope (bps)
take advantage of eventual central 20
bank tightening. In late April we rec- 100
15
ommended the 10s/longs steepener.
More recently, in May we argued that 50
10
the 10-year fly should continue to do
well heading into the start of BoC 5 0
tightening, even though by that point

0 -50
the fly had already rallied from cheap
7/19/05
10/19/05
1/19/06
4/19/06
7/19/06
10/19/06
1/19/07
4/19/07
7/19/07
10/19/07
1/19/08
4/19/08
7/19/08
10/19/08
1/19/09
4/19/09
7/19/09
10/19/09
1/19/10
4/19/10
to largely neutral levels vs the curve
(May 13th). This more recent view
worked out well, though not necessar-
ily for all the expected reasons. The 10-
year sector continued to outperform over the past two months, in part related to the start of BoC tightening, but even
more due to the overall safe-haven bid into bonds and concerns about global growth, which were driven by events in
Europe, and more recently by weak US economic data.
The 10-year sector is now relatively expensive vs the curve. This can be seen in the top chart, which shows the 5/10/30
fly graphed against the slope of the yield curve. This chart uses our constant-maturity par bond series in order to show
a long history. A similar chart using actual bonds is shown on the next page.
As argued earlier this week, although the 5/10/30 fly is not at extreme levels, it had become rich enough that we would
get out of long 10-year positions vs the curve. I don’t have an especially strong view that the butterfly will cheapen,
though it would seem that the risk is for some underperformance if the BoC is a bit more hawkish next week, given the
generally strong Canadian data since the last BoC statement, the latest drop in housing starts notwithstanding. (Note
that in making this argument we are implicitly placing more emphasis on the market-directional nature of the butterfly,
than on its tendency to be correlated with the slope of the curve, since a slightly more hawkish BoC should be associ-
ated with a flattening of the curve, all else equal).
What about vs rate cycle? The 10-year 5s/10s/30s CDA Par Fly vs. BoC Tightening
butterfly looks fairly neutral when com- Average 9/8/2004 4/16/2002 6/26/1997 Forwards 6/1/2010
pared to the typical tightening cycle ex- 35
perience, in contrast to what we see

30
when comparing the fly to curve slope.
The typical rally in the 10-year fly associ- 25
ated with a tightening cycle has already

happened. There has not been a strong 20
pattern to this butterfly in the months

Spread (bps)
15
after the BoC starts tightening. If you
want to bet on a more hawkish BoC via 10
this part of the curve, a better option

would seem to be just a 5/10 flattener. 5
See the chart of 5/10 vs the rate cycle on

0
the next page
-5

-10
-200 -150 -100 -50 0 50 100 150 200
5
Can 3.75 Jun-19 vs (Can 4.5 Jun-15 & Can 5 Jun-37) (LHS)
Another 5/10/30 Chart:

Can 5 Jun-37 - Can 4.5 Jun-15 (RHS)
This graph shows the 5/10/30 fly using ac- 16 160
tual bonds. In this case, we have shown old
14 150
10s, June 2019, in order to show a longer
YTM Butterfly Spread (bps)

history. 12 140
Yield Spread (bps)

10 130
The butterfly has cheapened from its richest
8 120
levels referred to in our July 13th note, but
remains expensive vs the curve. See the 6 110
previous page for further discussion. 4 100
2 90
CDA 5/10 Slope & Rate Cycle 0 80

In early June we argued that the flattening -2 70
6/10/09
7/10/09
8/10/09
9/10/09
10/10/09
11/10/09
12/10/09
1/10/10
2/10/10
3/10/10
4/10/10
5/10/10
6/10/10
7/10/10
trend in Canada was largely over, with a
couple of exceptions. One of those was
front-end flatteners like 1y/2y, which Trade Date
worked out well. Another possible flat- 5s/10s CDA Swaps Slope vs. BoC Tightening
tener was 5s/10s (mentioned in bullet in Average 9/8/2004 4/16/2002 6/26/1997 Forwards 6/1/2010
120
June 11th weekly), which has not worked
out at all. The spread continued to
steepen, exacerbated in swaps by the rela- 100
tive tightening of the 5-year spread rela-

tive to 10s.
80
In a world where many of the flattening

Spread (bps)
opportunities may be over, 5s/10s still 60
looks like one of the better ones. It seems

to me that the 5-year sector has benefit-
40
ted a lot from safe-haven concerns and
short covering (n.b. short covering in the
bond sense), which may have contributed 20
to the ongoing steepening of 5s/10s.

Some of this steepening should therefore Source: Scotial Captial
0
reverse on either a decline in safe-haven -200 -150 -100 -50 0 50 100 150 200
concerns, or a slightly more hawkish BoC Business Days Before First Rate Hike
than last time.
10s/30s CDA Par Slope vs. BoC Tightening

CDA 10s/Longs Update Average 9/8/2004 4/16/2002 6/26/1997 4/28/1994 Forwards 6/1/2010
90
We had been negative on long bonds for
some time. For example, back in April we 80
suggested a 10s/longs steepener. The curve

has re-steepened by about 20 bps since that 70
time, helped in part by the safe-haven rally

60
over the past six weeks, which has tended to
favour the 10-year sector.
Spread (bps)
50
I think the re-steepening of the past few 40
months has brought long bonds to fairly 30

attractive levels vs 10s again. However, I
don’t have a strong view that this spread 20
should tighten. I am not recommending 10s/

longs flatteners as an RV trade, but I 10
thought it was something worth pointing 0

out. -200 -150 -100 -50 0 50 100 150 200
6
Update: 5/10/30 (CDA Swaps) Conventionally Weighted Can Swap 5s-10s-30s Fly vs. Slope
The recommendation to receive 10s in CSW5s-CSW10s-CSW30s CSW5s-CSW30s Slope

swaps vs paying 5s and 30s is onside,
30 250
though it did not perform as well as
planned, because the difference between 5 25
200
and 10-year swap spreads has continued to 20
widen. The butterfly spread has tightened
Butterfly (bps)
15 150
about 3.5 bps from our original May 13th
Slope (bps)
recommendation, and about 8 bps from its 10
100
widest levels on June 4th. 5
0 50
I would take profits on this trade, based on
-5
our view of the underlying bond curve. I 0
think eventually the 5 and 10-year swap -10
spread term structure should flatten more, -15 -50
but I don’t have a strong view at the mo-
7/19/05
10/19/05
1/19/06
4/19/06
7/19/06
10/19/06
1/19/07
4/19/07
7/19/07
10/19/07
1/19/08
4/19/08
7/19/08
10/19/08
1/19/09
4/19/09
7/19/09
10/19/09
1/19/10
4/19/10
ment on when this will happen, and would
ultimately look to play that view directly
through an asset-swap trade rather than
through this butterfly trade.
7
Fixed Income & Relative-Value Strategy: Friday, July 16, 2010
2s/5s/10s CDA Par Fly vs. BoC Tightening 2s/5s CDA Par Slope vs. BoC Tightening
Average 9/8/2004 4/16/2002 6/26/1997 Forwards 6/1/2010 Average 9/8/2004 4/16/2002 6/26/1997 Forwards 6/1/2010
50 180
160
40
140
30 120
Spread (bps)
Spread (bps)
100
20
80
10 60
40
20
Source: Scotial Captial Source: Scotial Captial

-10 0
-200 -150 -100 -50 0 50 100 150 200 -200 -150 -100 -50 0 50 100 150 200
Business Days Before First Rate Hike Business Days Before First Rate Hike
2s/10s CDA Par Slope vs. BoC Tightening 10s/30s CDA Par Slope vs. BoC Tightening
300 70
60
250
50
200
Spread (bps)
Spread (bps)
40
150
30
100
20
50
10

0 0
-200 -150 -100 -50 0 50 100 150 200 -200 -150 -100 -50 0 50 100 150 200
8
Fixed Income & Relative-Value Strategy: Canada Swap Conventionally-Weighted Butterflies Friday, July 16, 2010
2s/5s/10s CDA Swaps Fly vs. BoC Tightening 2s/5s CDA Swaps Slope vs. BoC Tightening
50 180
160
40
140
30
120
Spread (bps)
Spread (bps)
20
100
80
10
60
0
40
-10
20

-20 0
-200 -150 -100 -50 0 50 100 150 200 -200 -150 -100 -50 0 50 100 150 200
2s/10s CDA Swaps Slope vs. BoC Tightening 5s/30s CDA Swaps Slope vs. BoC Tightening
300 200
180
250
160
140
200
120
Spread (bps)
Spread (bps)
150 100
80
100
60
40
50
20

0 0
-200 -150 -100 -50 0 50 100 150 200 -200 -150 -100 -50 0 50 100 150 200
9
Fixed Income & Relative-Value Strategy: Canada Swap Conventionally-Weighted Butterflies Friday, July 16, 2010
Can Swap 10/20/30 Fly

MA500 MA1250 ZScore500 ZScore1250 RegrZScoreRegrZScore1 CorrSlope5CorrSlope12 CorrBody5 CorrBody125CarryRolldown1mo
Moving Average Z-Score Z-Score vs. Regr. ρ - Fly vs. Slope ρ - Fly vs. Body Inc + Roll Income Wing 1 Wing 2
Spread 1-Day Chg 5-Day Chg 500 Day 1250 Day 500 Day 1250 Day 500 Day 1250 Day 500 Day 1250 Day 500 Day 1250 Day 1-month 1-month DV01 Weight: 0.50 0.50
Fly: 41.00 -1.62 -2.25 42.22 25.09 -0.12 1.01 0.52 1.32 0.84 0.93 -0.48 -0.83 -29,033 -4,515 Par Weight: 0.82 0.40
Slope: 55.36 1.59 2.16
118
Fly
64 64.0 Current
98 Day Ago
Week Ago
54 54.0 Month Ago
Butterfly Spread (bps)

Linear (Fly)
Wing Slope (bps)

78
44 44.0
58
34 34.0
38
24
24.0
14 18
14.0
Fly Slope
4 -2
4.0
J-05
O-05
J-06
A-06
J-06
O-06
J-07
A-07
J-07
O-07
J-08
A-08
J-08
O-08
J-09
A-09
J-09
O-09
J-10
A-10
J-10
-2.0+ 0.4565
y = 0.5956x 18.0 38.0 58.0 78.0 98.0 118.0
R2 = 0.8683 Wing Slope (bps)
Can Swap 5/10/30 Fly

Moving Average Z-Score Z-Score vs. Regr. ρ - Fly vs. Slope ρ - Fly vs. Body Inc + Roll Income Wing 1 Wing 2
Fly: 14.25 -0.07 -1.14 9.10 3.73 0.74 1.59 0.69 1.32 -0.32 0.49 0.55 -0.36 54,973 22,328 Par Weight: 0.94 0.24
Slope: 139.23 3.04 2.05
Fly
25 201 25.0
Current
y = 0.0596x - 1.649Day Ago
20 2
R20.0
= 0.241 Week Ago
Month Ago
151 Linear (Fly)

Wing Slope (bps)
15 15.0
10 10.0
101
5 5.0
0
51 0.0
-5
-5.0
Fly Slope
-10 1
-10.0
J-05
O-05
J-06
A-06
J-06
O-06
J-07
A-07
J-07
O-07
J-08
A-08
J-08
O-08
J-09
A-09
J-09
O-09
J-10
A-10
J-10
1.0 51.0 101.0 151.0 201.0

Wing Slope (bps)
10
Fixed Income & Relative-Value Strategy: Canada Par Bond Conventionally Weighted Butterfly Friday, July 16, 2010
Can Par 10/15/30 Fly

MA500 MA1250 ZScore500 ZScore1250 RegrZScoreRegrZScore1 CorrSlope5CorrSlope12 CorrBody5 CorrBody125Rolldown1mo
Moving Average Z-Score Z-Score vs. Regr. ρ - Fly vs. Slope ρ - Fly vs. Body Roll/Carry Carry Wing 1 Wing 2
Fly: 14.35 0.78 0.89 23.72 14.22 -1.33 0.01 -1.88 -1.90 0.71 0.89 -0.27 -0.71 27,700 17,823 Par Weight: 0.68 0.32
Slope: 48.30 1.20 1.01
43 43.0 Fly
81 Current
Day Ago
38 38.0
Week Ago
Month Ago
61

33 33.0 Linear (Fly)
Wing Slope (bps)

28 28.0
41
23 23.0 y = 0.3428x + 5.7575
18 21 R2 = 0.7905
18.0
13
1 13.0
8
Fly Slope 8.0
3 -19
3.0
J-05
O-05
J-06
A-06
J-06
O-06
J-07
A-07
J-07
O-07
J-08
A-08
J-08
O-08
J-09
A-09
J-09
O-09
J-10
A-10
J-10
-19.0 1.0 21.0 41.0 61.0 81.0
Wing Slope (bps)
Can Par 10/20/30 Fly

Moving Average Z-Score Z-Score vs. Regr. ρ - Fly vs. Slope ρ - Fly vs. Body Roll/Carry Carry Wing 1 Wing 2
Fly: 29.84 1.09 1.12 39.10 22.97 -0.94 0.45 -1.81 -1.86 0.86 0.96 -0.24 -0.65 -36,104 -11,855 Par Weight: 0.82 0.39
Slope: 48.30 1.20 1.01
Fly y = 0.6239x + 7.5667

81 Current
60 60.0 R2 = 0.9251
Day Ago
Week Ago
50 Month Ago
61 50.0
Linear (Fly)
Wing Slope (bps)
40 40.0
41
30 30.0
21
20
20.0
1
10
10.0
Fly Slope
0 -19
0.0
J-05
O-05
J-06
A-06
J-06
O-06
J-07
A-07
J-07
O-07
J-08
A-08
J-08
O-08
J-09
A-09
J-09
O-09
J-10
A-10
J-10
-19.0 1.0 21.0 41.0 61.0 81.0

Wing Slope (bps)
11
Appendix: Canada Bonds vs Theoretical Yield Curve

Chg vs Chg vs
Coupon Maturity Dt Yield OAS Chg 1 Chg 5 Avg 20 20 MA SD 20 # SD 20* Avg 75 75 MA SD 75 # SD 75*
1.250 6/1/11 1.131 8.0 0.4 -0.3 6.3 1.8 2.0 0.9 2.1 5.9 3.9 1.5
3.750 9/1/11 1.205 1.5 0.1 0.7 1.1 0.4 2.5 0.2 -0.7 2.1 1.9 1.1
1.000 9/1/11 1.210 2.4 0.1 0.8 1.3 1.1 0.9 1.3 -0.2 2.6 1.6 1.6
1.250 12/1/11 1.305 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
1.500 3/1/12 1.413 -0.8 0.1 -1.2 0.0 -0.8 0.6 -1.3 0.8 -1.6 0.9 -1.8
3.750 6/1/12 1.518 -0.8 -1.3 -1.9 0.8 -1.6 1.2 -1.3 2.1 -2.9 1.6 -1.9
5.250 6/1/12 1.513 -1.0 -1.3 -1.9 0.6 -1.6 1.2 -1.3 2.3 -3.3 1.7 -1.9
1.500 6/1/12 1.528 -0.4 -1.3 -1.8 1.2 -1.5 1.2 -1.3 2.4 -2.7 1.6 -1.7
2.000 9/1/12 1.658 1.0 -1.4 -1.6 3.8 -2.9 1.5 -1.9 3.0 -2.1 1.8 -1.2
1.750 3/1/13 1.879 5.1 -1.4 -1.2 7.9 -2.8 1.6 -1.7 7.9 -2.8 1.9 -1.5
5.250 6/1/13 1.964 5.8 -1.4 0.1 7.7 -1.9 1.5 -1.3 7.4 -1.6 1.7 -1.0
3.500 6/1/13 1.969 5.4 -1.9 -0.3 7.7 -2.3 1.5 -1.5 7.3 -1.9 1.7 -1.1
2.500 9/1/13 2.077 6.9 -1.3 -0.7 10.1 -3.2 1.8 -1.8 10.0 -3.0 1.7 -1.7
5.000 6/1/14 2.282 7.0 -1.5 -3.1 9.0 -1.9 1.6 -1.2 8.9 -1.9 1.7 -1.1
3.000 6/1/14 2.290 6.3 -1.5 -3.0 8.2 -1.9 1.6 -1.1 7.7 -1.4 1.8 -0.8
2.000 12/1/14 2.403 3.3 -1.6 -2.6 4.8 -1.5 1.6 -1.0 3.8 -0.5 1.9 -0.2
4.500 6/1/15 2.464 -0.2 -2.0 -2.1 0.9 -1.2 1.5 -0.8 1.2 -1.4 1.7 -0.8
2.500 6/1/15 2.483 -0.5 -1.8 -1.4 0.2 -0.7 1.6 -0.4
3.000 12/1/15 2.611 1.6 -1.9 -2.8 3.4 -1.9 1.5 -1.3 3.4 -1.9 1.7 -1.1
4.000 6/1/16 2.706 2.1 -1.7 -2.3 3.4 -1.3 1.6 -0.8 2.7 -0.5 1.8 -0.3
4.000 6/1/17 2.860 -0.1 -2.5 -2.8 2.4 -2.5 0.9 -2.8 1.7 -1.8 1.0 -1.8
4.250 6/1/18 3.016 1.2 0.2 -0.6 2.1 -1.0 0.5 -1.9 1.9 -0.8 0.6
3.750 6/1/19 3.142 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.2
3.500 6/1/20 3.233 -1.9 -0.2 1.2 -2.9 0.9 0.7 1.4 -1.8 -0.2 1.1 -0.2
8.000 6/1/23 3.468 7.8 -0.6 3.0 4.0 3.8 2.1 1.8 4.4 3.4 2.0 1.7
8.000 6/1/27 3.681 11.5 0.0 1.3 10.5 1.0 0.9 1.2 9.6 1.9 1.2 1.6
5.750 6/1/29 3.739 7.6 0.5 0.8 6.9 0.8 0.5 1.4 6.2 1.4 0.8 1.8
5.750 6/1/33 3.796 6.8 0.3 0.2 6.3 0.5 0.4 1.2 5.5 1.3 0.7 1.9
5.000 6/1/37 3.768 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
4.000 6/1/41 3.737 -4.8 -0.4 -0.5 -4.4 -0.4 0.5 -0.9 -3.6 -1.2 0.7 -1.7
Canada OAS (Multifactor Model)

OAS 5 days prior Yield Fitted Par Curve
75
4.25
70
4.00
65
3.75
60 3.50
55 3.25
50 3.00
45 2.75
40 2.50
2.25
35
2.00
OAS (bps)
Yield (%)
30
1.75
25 1.50
20 1.25
5.25 Jun 13
8 Jun 23
15 1.00
4.25 Jun 18
2 Dec 14
0.75
3 Dec 15
2 Sep 12
10
4 Jun 17
5 Jun 37
3.5 Jun 20
8 Jun 27
5 0.50
1.25 Jun 11
5.75 Jun 29
2.5 Sep 13
5.75 Jun 33
0.25
0
0.00
3.75 Jun 19
1.5 Mar 12
-5
-0.25
4 Jun 41
-10 -0.50
-15 -0.75
-20 -1.00
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32
Term (Years)
Description of the model: The option-adjusted spread (OAS) is the spread to the theoretical curve that would equate
the model price to the market price. A positive OAS means that a bond is cheap to the theoretical curve, all else equal,
while a negative OAS means that a bond is rich.
The term-structure model that underlies this report is similar to models used for option pricing, in that it explicitly models
the uncertainty in the future evolution of interest rates (as a simplified analogy, think of the standard binomial option-
pricing tree). However, it differs from the usual option pricing model in two main ways. First, the term structure model
used here has multiple, partially-correlated sources of risk, which enables it to capture a wide range of interest-rate and
volatility term structures. Second, it is a so-called equilibrium model. Models for interest-rate options typically try to fit
the underlying term structure exactly. In contrast, the equilibrium model is calibrated to fit the prices of just a few key
benchmark bonds (typically 6-month T-Bills, and 2, 10, and 30-year benchmarks). We do, however, make use of option-
market data to estimate the model’s volatility and correlation parameters.
12
Appendix: Canada Asset-Swap Spreads
Par Asset Y ld/Yld Chg vs Chg vs Carry Carry Delta

Coupon M aturity Dt Swap Swap Chg 1 Chg 5 Avg 20 20 M A SD 20 # SD 20* Avg 60 60 MA SD 60 # SD 60* ($K)1 ($K)2
1.250 12/1/2011 -14.9 -14.7 1.5 -2.7 -14.7 -0.1 2.1 0.0 -12.9 - 1.8 3.4 -0.5 98.9 68.7
1.500 3/1/2012 -14.7 -14.4 1.9 -2.4 -14.5 0.0 1.5 0.0 -13.6 - 0.8 2.5 -0.3 79.0 58.0
3.750 6/1/2012 -14.7 -14.5 0.9 -1.5 -14.9 0.3 1.0 0.4 -14.8 0.3 1.6 0.2 84.0 50.7
1.500 6/1/2012 -13.7 -13.5 0.9 -1.5 -13.9 0.3 1.0 0.4 -13.7 0.2 1.7 0.1 79.0 49.8
5.250 6/1/2012 -15.1 -15.0 0.9 -1.5 -15.4 0.3 1.0 0.4 -15.2 0.2 1.6 0.1 87.7 51.3
2.000 9/1/2012 -12.3 -10.8 0.8 -0.4 -10.4 -0.4 1.0 -0.4 -12.0 1.2 1.7 0.7 81.1 44.3
1.750 3/1/2013 -8.6 -8.4 0.9 0.8 -9.3 1.0 1.2 0.8 -11.0 2.6 1.7 1.6 70.5 35.6
3.500 6/1/2013 -9.5 -9.3 0.4 2.2 -11.5 2.2 1.8 1.2 -14.1 4.8 2.4 2.0 75.9 33.1
5.250 6/1/2013 -9.4 -9.8 0.9 2.7 -12.5 2.7 1.9 1.4 -15.1 5.3 2.4 2.2 83.8 33.8
2.500 9/1/2013 -8.5 -7.6 1.0 1.8 -9.0 1.4 1.5 0.9 -11.5 3.9 2.8 1.4 68.2 30.3
5.000 6/1/2014 -11.0 -12.2 0.8 -1.0 -15.1 2.9 3.4 0.9 -18.0 5.8 3.3 1.8 61.6 25.4
3.000 6/1/2014 -11.3 -11.4 0.8 -1.0 -14.3 2.9 3.4 0.9 -17.3 6.0 3.3 1.8 50.6 24.6
2.000 12/1/2014 -13.9 -13.4 1.0 -0.2 -16.6 3.2 3.0 1.1 -20.2 6.8 3.6 1.9 33.4 21.5
2.500 6/1/2015 -17.8 -17.6 1.0 1.8 -22.0 4.4 2.9 1.5 -25.1 7.4 3.6 2.1 24.5 19.6
4.500 6/1/2015 -18.4 -19.6 0.8 1.2 -23.5 3.9 2.9 1.4 -26.8 7.2 3.7 2.0 35.2 20.4
3.000 12/1/2015 -15.6 -15.8 0.9 0.3 -18.8 3.0 2.5 1.2 -21.8 6.1 3.7 1.6 29.2 18.1
4.000 6/1/2016 -15.8 -16.7 0.9 0.5 -20.2 3.5 2.8 1.3 -23.6 6.8 3.9 1.8 33.1 17.0
4.000 6/1/2017 -17.8 -18.7 -0.2 0.7 -21.0 2.3 2.3 1.0 -23.8 5.1 3.9 1.3 26.8 14.8
4.250 6/1/2018 -18.4 -19.7 2.6 3.0 -23.1 3.4 1.9 1.8 -24.8 5.2 3.7 1.4 25.4 13.2
3.750 6/1/2019 -21.9 -22.3 2.4 3.6 -26.7 4.4 2.1 2.1 -27.3 5.0 4.2 1.2 16.2 11.8
3.500 6/1/2020 -27.6 -27.7 2.1 4.8 -32.9 5.2 2.2 2.4 -31.6 3.9 4.1 1.0 6.4 10.7
8.000 6/1/2023 -34.2 -38.8 2.8 7.7 -46.9 8.1 3.3 2.4 -45.0 6.2 4.7 1.3 29.4 9.9
8.000 6/1/2027 -41.4 -43.1 3.7 7.2 -48.3 5.2 2.6 2.0 -45.9 2.7 4.4 0.6 23.1 8.2
5.750 6/1/2029 -44.1 -43.8 4.3 6.7 -49.3 5.5 2.6 2.2 -46.7 2.9 4.4 0.7 6.5 7.1
5.750 6/1/2033 -40.3 -38.0 3.6 5.2 -42.9 4.9 2.3 2.1 -40.2 2.2 3.8 0.6 7.3 6.3
5.000 6/1/2037 -38.7 -35.4 2.5 4.0 -39.2 3.8 2.1 1.8 -36.2 0.7 3.7 0.2 1.1 5.6
4.000 6/1/2041 -35.2 -34.0 1.3 2.8 -37.0 3.0 2.3 1.3 -33.8 - 0.2 3.7 0.0 -6.7 4.9
1 2
Carry over 1-mo for 100K of DV01 risk, assuming bond financed at general collateral. Carry Delta is the change in carry for a 10bp decline in the bond financing rate.
Canada Yield/Yield Asset-Swap Spreads, 2 through 10 Year Bonds

Yld/Yld Swap Avg 20 Prior 5 da ys prior
0
3 Jun 1 4
-5
2 D ec 1 4
3 Dec 15
Yield/Yield Spread (bps)
4 Ju n 16
-10
4.2 5 Jun 18
4 .5 J un 1 5
4 Jun 1 7
1.7 5 Mar 1 3
2.5 Se p 13
3.75 J un 1 9
2 S ep 12
-15
5.25 Jun 1 3
5 .2 5 Ju n 12
3 .5 Jun 2 0
1 .5 Mar 1 2
-20
-25
-30
-35
-40
1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0
Term (Years)
Canada Yield/Yield Asset-Swap Spreads, all terms

Yld/ Yld Swap Avg 20 Prior 5 da ys prior
3 J un 1 4
0
3 De c 15
4.2 5 Jun 18
4 Jun 16
4 .5 Jun 15
4 Ju n 17
3 .7 5 Ju n 19
-10
2 .5 Sep 1 3
Yield/Yield Spread (bps)
3 .5 Jun 2 0
-20
4 Ju n 41
5.75 Jun 3 3
5 Jun 3 7
8 J un 2 3
-30
5 .7 5 Ju n 29
8 Ju n 27
-40
-50
-60
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33
Term (Years)
13
Scotia Capital Fixed Income Research
Fixed Income Research:
Roger Quick, CFA

Director, Fixed Income Research
(416) 863-7236
roger_quick@scotiacapital.com
Graham Chubb
Associate Director, Fixed Income Research
graham_chubb@scotiacapital.com
Scotia Plaza
40 King Street West
68th Floor
Toronto, Ontario
M5W 2X6
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members of the Scotiabank Group.
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Fixed Income Research

Fixed Income Relative-Value Weekly

VIX Index of Implied Volatility vs US 10-Yr Treasury Yield

Deep Thoughts on the BoC:

What is Priced In for the BoC?

the graph shown here).

levels for this point in the cycle, espe- 120

N.B. The 1y/2y flattener trade had been Recommended 1y/2y

ing profits May 21st (RV Weekly). We

then recommended entering the trade 60

again on June 16th (daily note). Between

Source: Scotial Captial

Business Days Before First Rate Hike

For those readers who may still be inter- 180

opportunity than 1y/2y now may be 140

greater flattening potential, based on 100

Source: Scotial Captial

Business Days Before First Rate Hike

Canada/US Govt Yield Spreads (Constant-Maturity Theoretical Bonds)

Yield spread (bps)

had been priced in, and skepticism that

much more than 100 bps beyond the

Par5s-Par10s-Par30s Par5s-Par30s Slope

tightening, even though by that point

pared to the typical tightening cycle ex- 35

perience, in contrast to what we see

ated with a tightening cycle has already

pattern to this butterfly in the months

this part of the curve, a better option

See the chart of 5/10 vs the rate cycle on

Source: Scotial Captial

Business Days Before First Rate Hike

Another 5/10/30 Chart:

YTM Butterfly Spread (bps)

Yield Spread (bps)

CDA 5/10 Slope & Rate Cycle 0 80

tive tightening of the 5-year spread rela-

In a world where many of the flattening

opportunities may be over, 5s/10s still 60

looks like one of the better ones. It seems

to the ongoing steepening of 5s/10s.

than last time.

10s/30s CDA Par Slope vs. BoC Tightening

suggested a 10s/longs steepener. The curve

time, helped in part by the safe-haven rally

I think the re-steepening of the past few 40

months has brought long bonds to fairly 30

should tighten. I am not recommending 10s/

thought it was something worth pointing 0

out. -200 -150 -100 -50 0 50 100 150 200

Business Days Before First Rate Hike

The recommendation to receive 10s in CSW5s-CSW10s-CSW30s CSW5s-CSW30s Slope

Source: Scotial Captial Source: Scotial Captial

Source: Scotial Captial Source: Scotial Captial

Source: Scotial Captial Source: Scotial Captial

Source: Scotial Captial Source: Scotial Captial

Can Swap 10/20/30 Fly

Butterfly Spread (bps)

Wing Slope (bps)

Can Swap 5/10/30 Fly

Butterfly Spread (bps)

151 Linear (Fly)

1.0 51.0 101.0 151.0 201.0

Can Par 10/15/30 Fly