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Chart 73: Fundamentals — CEE beats periphery Chart 74: Poland and Hungary wide relative to Chart 75: HUF vol lagging EUR and PLN Italy and Spain 190% 5% 12 140% ©) 4% "8 ; eo | 3% 90% © 29 10 40% 1% -10% 0% 5 Spain France Portugal Italy Hungary Czech Poland Romania fam] 6 Jan/14 TN NN MO WA WHO WO LO € = G6 GB € FS SG S&S Ss. S&S © @ 5 S&S © @ 35> 2 a6 7 2 A WH ——Italy = Spain ——Portugal == France © 2016 growth (rhs) —— Hungary Poland ——EURIUSD ——— Romania Czech Source: IMF Source: Bloomberg. m Debt/GDP (Ihs) m 5y change in debt/GDP (Ihs) Source: Bloomberg juncture has also weighed on public finances, and all peripheral countries are running deficits above the structural levels. The fundamental picture is not reflected in interest rate dynamics. ECB easing has pushed Eurozone interest rates lower despite worsening public finances (Chart 74). Participation in the QE program has been a strong determinant of low long-term rates, as shown by the tightening of the periphery vs CEE. Hungary, Poland and Romania have been yielding 3-3.5% in the past year, while Italy remained constantly below 2%. If stress comes back, the gap will close. Within the periphery, Italy is the most vulnerable. Fundamentals are the worst in the region, only comparable to Portugal, which trades 160bp above it. Political risks also remain high, with the referendum providing some downside risk to the prime minister. The market is apparently reaching the same conclusion: during the most recent global bonds sell-off (20 Sep-14 Nov), Italy widened 95bp, while Spain widened 70bp, in line with CEE, despite the higher beta nature of the latter and the higher FX risk. Still, there may be room for further widening: the 10y spread to Germany widened in the current move, but is still lower than it has been the three years following the latest Italian political crisis. Our European rates team argued this summer that the rally in Italy spreads was far from fundamental. Flatteners in the 30s5Qs area look the best hedge as 50y are not eligible for QE, and term premia in the 2-31y sector would increase if QE was to end. Also, in times of sovereign debt stress, the curve tends to invert, further supporting long-end flatteners. Total carry is 1bp per month, making it cheaper and less sensitive to timing of stress than an outright short bond position. On further EZ stress, the euro would weaken and euro vol rise. While a less dovish ECB would be euro-positive, peripheral stress would ignite concerns on the monetary union, and ultimately weaken the euro (as in Dec 2011). A cleaner hedge is buying EUR/HUF vol, as it proxies EUR/USD vol but has moved less so far. HUF options are historically very reactive to EZ stress, but the increase in vol lagged EUR/USD post-elections, and EUR/PLN vol has been higher in the past two years due to higher perceived risks in Poland (Chart 75). In Dec 2011, the vol spike in the three crosses had been the same. CEE rates tend to widen in times of Eurozone stress, but their fundamentals are much more solid, so further EZ stress may bring opportunities to buy dips. CEE capitalized the past five year much better, with fiscal consolidation in Hungary, balanced budget in Czech Republic, and low debt/GDP ratios in Poland. Also, the growth picture is much more rosy, making leverage much more manageable. Trade recommendation: Buy 50y BTPs vs 30y BTPS at 30bp, targeting -8bp and with stop at 55bp. Risk is ECB QE continues and peripheral risk premium stays low. Jan/15 Jan/16 == EUR/HUF —— EUR/PLN 44 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 HOUSE_OVERSIGHT_014774 BankofAmerica <2” Merrill Lynch