1. The Euro Zone Outlook: Short Term and Long Term Deutsche Bank European Strategy Team Jenny Calixte Audrey Pinn Bruno Maimone Greg Napolitano Karun Aulakh

2. Overview The Euro Zone The European Central Bank (ECB) Outlook and Comparison with US Outlook

3. The Euro Area represents the collaboration of sixteen nations who share one currency, the Euro, and collaborate on monetary policy. The sixteen nations in the Euro area listed below: Austria Germany Belgium Cyprus Finland France Greece Italy Luxemberg Malta The Netherlands Portugal Slovakia Spain Slovenia Ireland Euro Zone

4. Euro Area /Euro Zone The Euro Area was created in 1999 to serve as the primary currency for the member countries. The Euro did not go into circulation for three years. It served as an invisible currency for accounting purposes until 2002 In 2002 the Euro replace the bank currency of the current members at established fixed conversation rates The flow of currency within the Euro area is closely monitored to assure that there is not a shortage or surplus in one country. The Central bank works to maintain this balance through bulk transfers between nations The European Central Bank is responsible for the maintaining monetary policy and assuring euro’s purchasing power and price stability. To join the Euro area a country had to fulfill convergence criteria that set out the economic and legal preconditions of the monetary union The Governing Council is the main decision making arm of the European Central Bank ◦ it includes a six member governing board ◦governors of the national central banks of each of the sixteen area countries The European Central Bank is politically independent

5. Implement monetary policy in the Euro Zone FX Operations Management of foreign reserves Promotion of smooth operation of payment systems ECB versus The Fed ECBFED Implement Monetary Policy in the US in pursuit of maximum employment, stable prices and moderate interest rates Bank supervision Containing systemic rick within the financial system Providing financial services to depository institutions, US gov’t and foreign official institutions

6. Short-Term Interest Rates The three key interest rates for the euro area are the following: The interest rate on the main refinancing operations, which provide the bulk of liquidity to the banking system. The rate on the deposit facility, which banks may use to make overnight deposits with the Eurosystem. The rate on the marginal lending facility, which offers overnight credit to banks from the Eurosystem. Short-term rates have steadily decreased since 2007 to the present. In July 2007, the interest rate (rate on the marginal lending facility) was 5.25 percent. Throughout 2008, the rate slipped to 3.00 percent and then to 1.75 percent in May 2009.

7. The Taylor Rule i t = r* + Π t + a 1 (Π t – Π*) + a 2 (y t – y* t ) For the Taylor rule, i t is the short-term nominal interest rate, r* is a target real interest rate, Π t is the inflation rate, Π* is the target inflation rate, y t is (the log of) real output, and y* t is the target level of output (also in logs). The parameters (a 1, a 2 ) indicate the sensitivity of the interest rate to inflation and output and are usually equal to 0.5. Nominal interest rate Per the European Central Bank, the nominal interest rate (i t ) is 1.75 percent. Target real interest rate In the United States, most people set the target real interest rate (r*, nominal interest rate minus inflation) equal to 2 percent, so we will use the same figure for Europe.1 Inflation deviation This term is a reaction to the difference between current inflation (Π) and the target (Π*). For Europe, the inflation rate (Π t ) was zero percent in May 2009 and 1 percent in January 2010. Since the current inflation rate is 1 percent and the target rate is 2 percent, the inflation deviation is -1 percent. Output deviation This term (y minus y*) is a reaction of the interest rate to deviations of output from its target. The output deviation is calculated by taking the difference in the year-on-year growth rate from its mean. In January 2010, the year-on-year growth rate was zero percent. The mean real GDP growth rate for Europe is 1.55 percent. Other Following convention, a 1 and a 2 are equal to 0.5. Expected Nominal Interest Rate i t = r* + Π t + a 1 (Π t – Π*) + a 2 (y t – y* t ) i t =.02 +.01 +.05(.01 -.02) + 0.5(0-.0155) =.024225 The Taylor rule predicts the nominal interest rate to be 2.4225 percent, and the actual short-term interest rate as set by the European Central Bank is 1.75 percent. The difference between the two rates is.6725 percent, leading us to predict that the European Central Bank will raise the interest rate soon.2

8. Euro Zone Outlook Current Quarter GDP – 0% 2010E GDP -.9% Current Inflation (HICP) -.9% 12 Mo Inflation Forecast – 1.6%-1.9% Moderate concerns about fiscal tightening seem to pose a moderate threat to growth over the next two years in the EU. Growth is forecasted to be relatively unchanged throughout the remainder of 2010, and 2011 will see an increase of ~1%.

9. Euro Zone Outlook Forecasts for EU interest rates and country comparison snap shots DB Forecast

10. Forecast and Outlook Short-Term Rates During Past Month ◦ Euro Zone benchmark yields have been stable, and drop in market rate on 4/12/10 likely reflects temporary impact of market’s response to news on 4/11/10 of Greek bailout ◦ US benchmark yields have increased on front end of six-month term structure, but otherwise have been stable Forces Underlying Divergent Markets for Short-Term Rates in US & Euro zone ◦ Growing Expectation of a Divergence in Fed & ECB Policy ◦ Likelihood of rate hike by Fed or ECB strongly linked to risk of double-dip recession in respective economies ◦ In US, strong rally in markets for credit-related fixed income and equities during past two months, the Future Inflation Gauge at an 18-month high, and growing confidence in the V-shaped recovery, an unexpected negative move in future unemployment figures is the only factor standing in the way of a likely change later this month in the official “language” used by the Fed in regard to a future interest rate hike ◦ Conversely, in Euro Zone, PIGS face increased pressure to cut budget deficits, which implies a withdrawal of stimulus and thus increased risk of a double-dip recession in countries that are already vulnerable to such an event

11. Looking Ahead Going Forward, Euro Zone Rates Likely to Stagnate Relative to Rising Rates in the US ◦ Impending Increase in US rates over six-month term structure based largely on expectation of inactivity by ECB and a sooner than expected rate hike by Fed, which impacts benchmark yields ◦ Moreover, more robust recovery in US, along with greater economic certainty, will help stimulate stronger credit growth among small-to-medium sized firms ◦ Banks will begin to increase risk appetite but will continue to move slowly during the near-term to meet this growth in credit demand, thus pushing market rates in US higher initially