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European rates
Duration preference: neutral

EUR (DE) 10-year (29 June): 1.6% (last month: 1.4%)
UBS View
EUR (DE) 10-year (6-month forecast): 1.7%
• We believe the reasons for the recent rise in Bund yields are numerous: First, signs of more Eurozone integration (e.g. European bank deposit guarantee) combined with the recapitalization of Spanish banks. Second, the firm commitment of central banks to act if downside risks materialize (possible quantitative easing by the BoE and a higher probability of a ECB rate cut) and finally, Greek election results met expectations. However, this rise was muted given the extension of Operation Twist, weak global / German data and Spain's return to the spotlight.
• Over a three- to six-month horizon, we expect growth momentum to remain subdued but still in positive territory; we should have more information on how Spain and Italy are handling their adjustment programs. Also, the new pro-memorandum Greek government should limit safe haven inflows, and thus limit short-term downside risks to yields.
• In the UK, economic data continues to be mixed as the recovery continues but is prone to external shocks. The recent liquidity provision announcement by the BoE has confirmed these concerns.
• In Switzerland, yields have traded range bound owing to conflicting economic data. The SNB stressed increased downside risks to the economy and stands ready to act. However, we believe Swiss yields will gradually normalize.

Recommendations
Tactical (6 months)
• Long term Bund yields would fall lower, in case of rising Euro zone break up probability. In contrast if Germany would need to support the periphery further, Bund yields would rise. We expect the market to oscillate between these two cases and recommend to stay 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) 1.1–1.3%
• The European debt crisis re-escalates. The resulting contagion would intensify the current flight to quality.
• The economic recovery fails to gain momentum in the second half of the year. Credit demand fails to improve further as some of the recent European Central Bank (ECB) data indicates. The ECB cuts rates.
• Further quantitative easing by the Fed would be supportive for Bunds and speaks for lower yields.

Negative scenario for German bonds
10-year Bund yield (6-month range) 1.9–2.3%
• A moderate Eurozone economic recovery kicks in, supporting debt-burdened Eurozone countries in their efforts to fulfill austerity commitments and thus reducing the demand for safe-haven assets. Alternatively, Germany gives additional guarantees and the Eurozone moves towards a transfer union.
Note: Scenarios refer to global economic scenarios (see slide 7)

What we're watching Why it matters
Elections/EU fiscal consolidation
The EU Summit will show if newly elected governments will change the dynamics in the Eurozone.
Central banks
The revival of the SMP program by the ECB would reduce the yields in the periphery. Their assessments of the current economic situation can give hints of further rate cuts or quantitative easing measures. Key dates: 5 July, ECB rate decision; 31 July, Fed FOMC meeting
Economic variables
Credit conditions (ECB bank lending survey). Key date: 14 August, Eurozone GDP Q2
Eurozone yield spreads
The level of yield spreads to German bonds influences the level of German Bund yields due to safe-haven flows.

EU 10-year yields and forecasts
[Chart showing yield trends for UK 10Y, Germany 10Y, Switzerland 10Y from Jun-09 to Jun-13]
Source: Bloomberg, UBS CIO, as of June 18th 2012
Note: Past performance is not an indication of future results.

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