The Goldman Sachs Group, Inc.

Goldman Sachs Research

Macro Rate Markets Outlook Francesco Garzarelli Co-Head of Global Macro-Markets Research and of European Economics Goldman Sachs International

Frankfurt, 7th April 2016

Investors should consider this research as only a single factor in making investment decisions. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.

Goldman Sachs Global Investment Research

1

United States Resilient Growth and a More Dovish Fed Core Inflation Trending Higher

US Data Surprising Positively as FCI Eases GS US MAP Score and GS US FCI

US Headline CPI Inflation and Trend in US Service Inflation

0.4

100.0 Index

Easier Financial Conditions, Better Growth

0.2

6.0

Index

4.0 %

%

100.2

0.0 100.4

5.0

Oil Shock

4.0

3.0

3.0

-0.2 100.6 -0.4

2.0

100.8

1.0

-0.8

101.0

0.0

101.2

GS US MAP (LHS)

-1.2

US FCI (Inverted, RHS)

-1.4 Oct-15

Nov-15

Dec-15

2.5

2.0

-0.6

-1.0

1.5

-1.0

Headline CPI (LHS)

1.0

-2.0

Services Inflation Trend (RHS)

0.5

101.4 Jan-16

Feb-16

Mar-16

-3.0 0.0 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jan-13 Jul-14 Jan-16

Real Rates Driving the Rally in Nominals

FOMC Converging to Market Expectations FOMC March and December FOMC ‘Dots’ and US$ OIS 4.0

Decomposition of Change in US Treasury Yields Since Dec FOMC 150

%

bp

Change in:

3.5

Inflation Compensation

100 3.0

FOMC Dec Dots

Real Rate

Longer Run

FOMC March Dots 2.5

3.5

50

Nominal

USD OIS 1m

0

2.0 1.5

-50

1.0

-100 0.5

0.0 Mar-16

-150 Sep-16

Mar-17

Sep-17

Mar-18

Sep-18

Mar-19

Sep-19

2yr

Goldman Sachs Global Investment Research Source: Bloomberg, Haver Analytics, Goldman Sachs Global Investment Research

5yr

10yr

30yr

2

Euro Area ECB Still the Marginal Price Setter for Euro Rates Activity Data Improving from Lows

Inflation Dynamics Remain Subdued

GS Euro Area MAP Score and GS Euro Area FCI

Euro Area Headline Inflation and Trend in Service Inflation

1.5

95.5 Easier Financial Conditions, Better Growth

1.0

4.0

3 %

96.0

% 2.5

3.0

0.5

2 2.0

0.0

96.5

1.5 1.0

-0.5

1

Headline CPI (LHS)

97.0

0.0

GS EA MAP

-1.0 Index

0.5

Services Inflation Trend (RHS)

EA FCI (Inverted, RHS) Index

-1.5

97.5

Oct-15

Nov-15

Dec-15

Jan-16

Feb-16

Mar-16

-1.0 0 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jan-13 Jul-14 Jan-16

Market is No Longer Expecting Further Rate Cuts EONIA Curve Pre and Post ECB March Meeting

Steep Term Structure of Periphery Spreads Euro Area Core Periphery Spread and Germany 10 Year Yield

-20

1

bp

0.9 -25

9th March 2016 (Pre ECB)

150 Germany 10-year Yield (LHS)

%

bp

Euro Area Periphery Core 10Year Spread * (RHS)

0.8

130

10th March 2016 (Post ECB)

0.7

31st March 2016

0.6

-30

120

0.5

-35

110

0.4 -40

140

100

0.3

ECB Deposit Rate

90 0.2

-45

80

0.1

-50

Spot

1m

2m

3m

4m

5m

6m

9m

10m

1y

1y1y

2y1y

0 Jan-15

* Germany and France constitute core; Italy and Spain make up periphery

Mar-15 May-15

Goldman Sachs Global Investment Research Source: Bloomberg, Haver Analytics, Goldman Sachs Global Investment Research

Jul-15

Sep-15 Nov-15

Jan-16

70 Mar-16

3

Japan Negative Rates Result in Tighter Financial Conditions Core Inflation Is Stabilizing

Activity Data Still Weak

Japan Headline Inflation and Trend in Service Inflation

GS Japan MAP Score and GS Japan FCI

0.5

Easier Financial Conditions, Better Growth

92.5

4.0

2.0 %

Headline CPI (LHS)

% 3.0

1.5 Services Inflation Trend (RHS)

0.0 93.0 -0.5

93.5 -1.0 94.0

GS JPY MAP (LHS) -1.5

JPY FCI (Inverted, RHS)

Index -2.0 Oct-15

Index 94.5 Nov-15

Dec-15

Jan-16

Feb-16

Mar-16

2.0

1.0

1.0

0.5

0.0

0.0

-1.0

-0.5

-2.0

-1.0

-3.0

-1.5

-4.0 -2.0 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jan-13 Jul-14 Jan-16

...And Led to an Increase in Market Volatility

NIRP has Dragged JGBs Lower.. JPY OIS 1m and 10-Year JGB

JPY Swaption Implied Volatility and Realized

0.6

4.0

%

4.0 JPY Swaption 1y10y Implied vol (LHS)

0.5

3.5

0.4

3.0

3.0

0.3

2.5

2.5

0.2

2.0

2.0

0.1

1.5

1.5

0

1.0

1.0

1m JPY OIS

0.5

-0.1 JPY 10 Year Yield -0.2 Jan-15

Mar-15

May-15

Implied to Realised JPY 1y10y vol ratio (RHS)

Jul-15

3.5

0.5

bp/day Sep-15

Nov-15

Jan-16

Mar-16

0.0 Apr-13

Oct-13

Goldman Sachs Global Investment Research Source: Bloomberg, Haver Analytics, Goldman Sachs Global Investment Research

Apr-14

Oct-14

Apr-15

Oct-15

0.0 Apr-16

4

Japan in the ‘Driving Seat’ of Global Rate Rally

Yields in G-4 Have Co-Moved Since the Start of Year

JGBs have Been in the Driving Seat Since Last November Idiosyncratic ‘shocks’ originating in each market, estimated through a methodology based on Rigobon (2003)

10-yr nominal bond yields in G-4 countries 6

2.4

%

%

4

0.7

2.2

Cumulative 'Shocks' Standardised

2

2.0

0.5

0 -2

1.8 0.3 1.6

UK

-4

US

-6

US 1.4

UK

0.1

Japan (RHS) Germany (RHS)

-0.1 Sep-15

Oct-15

Nov-15 Dec-15

Japan

-10

1.2 Aug-15

-8

Jan-16

Feb-16 Mar-16

-12 Aug-15

Germany

Sep-15

Oct-15

Nov-15

Bullish Shocks

Dec-15

Jan-16

Feb-16

Mar-16

Apr-16

Source: Bloomberg, Haver Analytics, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research

5

Investors Fear Further Bond Rally More than Selloff

In Spite of Lower Yields, Investors Fear a Further Rally More than a Selloff...

...Both in the US and the Euro area

US$ 30y swap plotted against 1y30y 100bp out-of-the-money low recv. vol less1y30y 100 bp out-of-the-money high payer vol

7

0.5

%

EUR 30y swap plotted against 1y30y 100bp out-of-the-money low recv. vol less1y30y 100 bp out-of-the-money high payer vol 6.0

2.0

bp per day

%

bp per day

1.5

0.3 5.0

6

0.1 -0.1

5

1.0 4.0

0.5

-0.3 4

-0.5

0.0

3.0 -0.5

-0.7 3

-0.9

1 2006

-1.1

US 30y Swap (LHS)

2

US$ 1y30y 100bp low recv vol less 100bp high payer vol (RHS)

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2.0

-1.5

1.0 EUR 1y30y 100bp low recv vol less 100bp high payer vol (RHS)

-1.3 -1.5

-1.0 EUR 30y Swap (LHS)

0.0 2006

-2.0 -2.5

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: Bloomberg, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research

6

The Market Prices Persistent Low-flation

Market Still Assigns High Probability to Moderate Inflation in the US…

...But Sees Very High Chance of Persistent Low-flation in the Euro area

Option-implied probability distribution of 5-year inflation by strike ‘clusters’: low inflation (≤1%), medium, and high (≥3%)

Option-implied probability distribution of 5-year inflation by strike ‘clusters’: low inflation (≤1%), medium, and high (≥3%)

100%

100%

80%

80%

60%

60%

Probability low inflation

Probability low inflation

40%

40%

Probability medium inflation Probability high inflation

20%

0% 2010

Probability medium inflation

2011

2012

2013

2014

2015

Probability high inflation

20%

2016

0% 2010

2011

2012

2013

2014

2015

2016

Source: Bloomberg, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research

7

Central Bank Bond Purchases Create ‘Fiscal Space’

From ‘End of Austerity’ (2014-15) to Synchronous Modest Fiscal Expansion

Government Debt Moves onto Official Sector Balance Sheet Central Bank Ownership of Government Debt as % of Stock Outstanding

Estimates of contribution of fiscal policy annual real GDP growth in selected countries 140

50 45

bp

% % of outstanding stock of government debt directly held by central bank (est. end-2017)

40 35 30

120 2015 100 2016

80 Median

25

60

20 15

40

10

20

5

0

0 Japan

UK

Euro Area

US

USA

Euro Area

Japan

China

Source: Bloomberg, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research

8

Global Risk Sentiment Sensitive to Oil Prices

Broader Asset Classes Increasingly Correlated to Oil

Oil Market Imbalances to Narrow from H2-16 Onwards Global Oil Market Imbalances, WTI Price and GS WTI Forecast

3m Rolling Absolute Correlation of Weekly Returns to WTI

3000

140

2500

0.9

100%

$/bbl

kbd Global Oil Imbalance

2000

120

WTI Price (RHS)

90%

0.8 Current 0.7

1500

100

1000 80

500

80%

Percentile since 1990

70%

0.6

60%

0.5

50%

0

60

-500

0.4

40%

0.3 40

-1000 -1500

20

30%

0.2

20%

0.1

10%

0.0

0%

Japan 10-year yield

16

EUR/US$

15

German 10-year yield

13

US 5y5y BE

12

JPY/US$

10

EM FX

09

EUR IG

07

USD IG

06

USD TWI

04

TOPIX

03

MSCI EM

01

MSCI Asia ex Japan US 10-year breakeven US 10-year yield

00

S&P 500

0

STOXX Europe 600

-2500

USD HY

-2000

Source: IEA, EIA, JODI, China NBS, Datastream, Haver Analytics, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research

9

The ECB Is Gluing EMU Bond Markets Together

ECB is Absorbing a Large Share of Gross Government Issuance

The Inclusion of Corporates Should Mitigate ‘Scarcity’ Issues

Estimated ECB purchases under PSPP for 2016 as percentage of gross bond issuance

Breakdown of Pool of Corporate Credit Eligible for ECB Purchase 120

140

Bn Euro

% ECB Purchases in 2016/Gross Government Bond Issuance in 2016

120

Germany Spain

100

France 100

Italy

80

Other countries

80

60 60

40 40

20

20

0

0 Germany

France

Italy

Spain

Electric Utilities

Auto Mfg

Telecoms

Oil & Gas

Source: Haver Analytics, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research

10

‘Brexit’ Risk For Now Mostly Limited to UK Assets Polls Still Too-Close-To-Call

Brexit Concerns have Increased GBP Vols

30 Day Average of Brexit Polls

GBP USD plotted with GBP USD 1y1y Implied Vol

Source: ORB, YouGov, BMG Research, ICM, ComRes, Survation, Ipsos Mori, The Times, TNS, Panelbase, GQRR, Pew, Opinium, TNS-BMRB

1.75

70%

1.7

Leave

60%

Undecided

6

2015 UK Parliament Elections

Remain

UK Referendum Announcement

7

1.65

8

50%

1.6 40%

9

1.55

10

1.5

30%

1.45

11

GBPUSD Spot (LHS)

20%

1.4 10%

0% Mar-15

1.35 May-15

Jul-15

Sep-15

Nov-15

Jan-16

Mar-16

May-16

UK Equities Are Pricing Brexit Risk

GBP USD plotted with 1y1y Cross Currency Basis

1.7

2015 UK Parliament Elections

UK Equity Performance After EU Referendum Announcement 5

UK Referendum Announcement

1.65

13

1.3 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16

..& Driven Cross-Currency Basis Lower 1.75

12

GBPUSD 1y Implied Vol (RHS, Inverted)

104 Index

EU referendum date set

102

0 100

1.6 -5

1.55

1.5 1.45

-10 GBPUSD Spot (LHS)

1.4

1.35

GBP 1y1y Cross Currency Basis (RHS)

98

96 94 FTSE 250

-15 92

UK domestic (GSSTUKDE) UK domestic + Investment-sensitive screen

1.3 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16

-20

90 Sep-15

Oct-15

Nov-15

Dec-15

Goldman Sachs Global Investment Research Source: DataStream, Bloomberg, Haver Analytics, Goldman Sachs Global Investment Research

Jan-16

Feb-16

Mar-16

11

European Government Bond Liquidity A Case Study of BTPs on ECB Meeting Day

Goldman Sachs Global Investment Research Source: MTS Market Data

12

European Government Bond Liquidity A Case Study of BTPs on ECB Meeting Day

Goldman Sachs Global Investment Research Source: MTS Market Data

13

Disclaimer I, Francesco Garzarelli, hereby certify that all of the views expressed in this report accurately reflect my personal view, which have not been influenced by considerations of the firm’s business or client relationships. Unless otherwise stated, the individuals listed on the cover page of this report are analysts in Goldman Sachs' Global Investment Research division. Global product; distributing entities The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. This research is disseminated in Australia by Goldman Sachs Australia Pty Ltd (ABN 21 006 797 897); in Brazil by Goldman Sachs do Brasil Corretora de Títulos e Valores Mobiliários S.A.; in Canada by Goldman, Sachs & Co. regarding Canadian equities and by Goldman, Sachs & Co. (all other research); in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs (India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs New Zealand Limited; in Russia by OOO Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman, Sachs & Co. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union. European Union: Goldman Sachs International authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, has approved this research in connection with its distribution in the European Union and United Kingdom; Goldman Sachs AG and Goldman Sachs International Zweigniederlassung Frankfurt, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht, may also distribute research in Germany. General disclosures This research is for our clients only. Other than disclosures relating to Goldman Sachs, this research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various regulations may prevent us from doing so. Other than certain industry reports published on a periodic basis, the large majority of reports are published at irregular intervals as appropriate in the analyst's judgment. Goldman Sachs conducts a global full-service, integrated investment banking, investment management, and brokerage business. We have investment banking and other business relationships with a substantial percentage of the companies covered by our Global Investment Research Division. Goldman, Sachs & Co., the United States broker dealer, is a member of SIPC (http://www.sipc.org). Our salespeople, traders, and other professionals may provide oral or written market commentary or trading strategies to our clients and principal trading desks that reflect opinions that are contrary to the opinions expressed in this research. Our asset management area, principal trading desks and investing businesses may make investment decisions that are inconsistent with the recommendations or views expressed in this research. The analysts named in this report may have from time to time discussed with our clients, including Goldman Sachs salespersons and traders, or may discuss in this report, trading strategies that reference catalysts or events that may have a near-term impact on the market price of the equity securities discussed in this report, which impact may be directionally counter to the analysts' published price target expectations for such stocks. Any such trading strategies are distinct from and do not affect the analysts' fundamental equity rating for such stocks, which rating reflects a stock's return potential relative to its coverage group as described herein. We and our affiliates, officers, directors, and employees, excluding equity and credit analysts, will from time to time have long or short positions in, act as principal in, and buy or sell, the securities or derivatives, if any, referred to in this research. The views attributed to third party presenters at Goldman Sachs arranged conferences, including individuals from other parts of Goldman Sachs, do not necessarily reflect those of Global Investment Research and are not an official view of Goldman Sachs. Any third party referenced herein, including any salespeople, traders and other professionals or members of their household, may have positions in the products mentioned that are inconsistent with the views expressed by analysts named in this report.

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