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European rates
Duration preference: neutral

EUR (DE) 10-year (24 Oct): 1.6% (last month: 1.6%)
EUR (DE) 10-year (6-month forecast): 1.8%

UBS view
• Bund yields have trended sideways over the month, lacking a directional trigger. Markets still await crucial developments in Spain, Greece and the extent of the US fiscal cliff, and have not fully reflected mixed but stabilizing fundamentals. However, when compared to the all-time lows witnessed in August (~1.2%), yields are still trading at decisively higher levels. This is supported by the ECB announcement to act as a lender of last resort by intervening in the secondary markets with unlimited and conditional government bonds purchases. In addition, the open-ended Fed stimulus hinging on the labor market contributed to improving sentiment. This provides a cap for short-term peripheral yields and a floor for Bund yields.
• Over a six-month horizon, we expect yields to trend slightly higher, returning to previously higher ranges. The central bank backstops have already improved confidence and resulted in convergence between the periphery and the core. This speaks for slightly better growth prospects and thus slightly higher yields.
• However, growth is still structurally weak, and short-term uncertainties (US elections, fiscal cliff, Spain) remain. Consequently, short-term downside risks persist around year end. The ECB, however, will limit the spread from widening, providing a bottom to Bund yields as well.
• In the UK, economic data stabilized and we expect the BoE to extend quantitative easing in November.
• In Switzerland, yields rose only slightly owing to mixed economic data. The Swiss National Bank stands ready to act. With much negative news priced in, we believe Swiss yields will gradually start to normalize.

Recommendations
Tactical (6 months)
• If the ECB were to intervene with massive amounts in the peripheral bond markets, Bund yields would rise more significantly. But, for the time being, we expect only moderate interventions that do no meaningful harm to Germany's credit quality. We recommend staying neutral on duration tactically.

Strategic (1 to 2 years)
• Yields have significant upside potential over the next couple of years. Thus clients with a long time horizon should focus on bonds with short and medium maturities.

Positive scenario for German bonds
10-year Bund yield (6-month range): 1.2–1.5%
• Implementation risks in the ECB framework remain, in particular the need for Italy and Spain to apply for aid. At the same time, Greece may announce a second debt restructuring and is likely to leave the Eurozone in 2013.
• US fiscal deleveraging beyond our expectations weighs on the cyclical recovery and is a drag on yields.
• Further non-standard policy measures by the Fed are supportive for Bunds and speak for lower yields.

Negative scenario for German bonds
10-year Bund yield (6-month range): 1.8–2.3%
• A moderate Eurozone economic recovery kicks in. Spain and Italy are ahead on their austerity commitments without needing ECB support. This reduces safe-haven inflows, driving Bund yields higher. Alternatively, Germany gives additional guarantees and the Eurozone moves towards a transfer union.
Note: Scenarios refer to global economic scenarios (see slide 7)

EU 10-year yields and forecasts
[Chart showing forecasts vs Oct-09 to Oct-13 for UK 10Y, Germany 10Y, Switzerland 10Y]
Source: Bloomberg, UBS, as of October 15, 2012
Note: Past performance is not an indication of future returns.

What we're watching
Political risks and fiscal cliff
Central banks
Economic variables
Eurozone yield spreads

Why it matters
The US fiscal cliff, Greek negotiations, Spanish local elections and Spain delaying its application for assistance add to policy uncertainty.
Key dates: Nov 8, ECB; Dec 11, Fed FOMC meeting
Credit conditions (ECB bank lending survey)
The level of yield spreads to German bonds influences the level of German Bund yields due to safe-haven flows.

UBS
For further information, please contact CIO's asset class specialist Daniela Steinbrink Mattei, daniela.steinbrinkmattei@ubs.com, Sebastian Vogel, sebastian.vogel@ubs.com or Nina Gotthelf, nina.gotthelf@ubs.com
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Please see important disclaimer and disclosures at the end of the document.
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