JP Morgan - Global Fixed Income Markets Weekly - March 9 2012

Global Fixed Income Markets Weekly

Pavan WadhwaAC

(44-20) 7777-3370 [email protected]

Fabio Bassi (44-20) 7325-8615 [email protected]

www.morganmarkets.com J.P. Morgan Securities Ltd.

See page 54 for analyst certification and important disclosures.

Overview Pavan Wadhwa, Kedran Panageas • CACs have been invoked on Greek domestic-law bonds, and Greece has

received 60% participation on its foreign law bonds, suggesting at least 96% of the total eligible universe of bonds will be restructured. This will reduce Greece’s net debt burden by 30% of GDP. Greece’s upcoming interest payments will be reduced by 1/3rd, and upcoming bond redemptions by 2/3rds; official sector ownership of Greek debt will increase from 37% pre-PSI to over 60% post-PSI. This reduces the chance of a second private-sector default. We remain in risk-on trades.

Euro Pavan Wadhwa, Fabio Bassi, Gianluca Salford • Euro area growth has historically surprised to the downside, and inflation

to the upside. Stay tactically short duration. 20Y German bonds are cheap to 30Y. Stay long peripherals and implement 4s/10s Italian curve flatteners. Underperformance of Spain vs. Italy is due to technical and fundamental factors. Sell DSL Jul20 vs. RFGB Apr20. Hold weighted greens/10Y steepeners and receive 5Y in the 1s/5s/12s level-neutral fly. We favour 1s/3s and 1s/5s bull flatteners, and recommend 3s/7s/15s OTM bear belly cheapeners. We target 2Y b/m swap spreads at 75bp; hold June Schatz swap spread narrowers – both outright and hedged-with June FRA/OIS basis wideners. Stay bearish 3Mx10Y swaption gamma but delta hedge less frequently. Hold shorts in Jun12 Schatz unhedged strangles.

UK Francis Diamond • Momentum and techicals suggest staying neutral duration. Keep

reds/greens swap curve steepener, or 4H13/5s14 gilt curve steepener. The 5s/10s gilt curve is too flat – keep tactical stepeener. Stay long the belly of the 10s/30s/50s gilt fly. We preview the FY12/13 gilt financing remit, and expect an £11bn reduction in gross gilt sales to £168bn. We expect a small increase in short nominal gilt issuance in FY12/13, and a decline in medium and long nominal issuance.

US Terry Belton, Srini Ramaswamy • Stay bearish on duration over the medium term. Remain in 30Y swap

spread widener and 10Y swap spread narrower hedged with FRA/OIS widener. Turn bearish on gamma and sell 3Mx10Y straddles.

Japan Takafumi Yamawaki, Yuya Yamashita • Stay neutral on duration and hold JGB curve steepeners. The BoJ’s

purchase is expected to support JGBs, but any downside in yields should be limited unless the BoJ introduces more easing measures.

European Rates StrategyJ.P. Morgan Securities Ltd. March 9, 2012

Contents Overview 2 Euro Cash 7 European Derivatives 12 United Kingdom 20 US Cross Sector 26 US Treasuries 29 US Interest Rate Derivatives 36 Japan 42 …………………………………………………. Interest rate forecasts 46 Recent curve movements 47 Recent sov cash spread movements 48 Recent sov CDS spread movements 49 Sov & bank redemptions 50 Event risk calendar 51 Euro-area fact sheet / SMP Purchases 52 Global Market Movers 56

European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Pavan WadhwaAC (44-20) 7777-3370 Kedran Panageas (44-20) 7777-0326 J.P. Morgan Securities Ltd.

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Overview

• Greece received enough participation to invoke CACs on its domestic-law bonds; 60% of foreign law bondholders tendered as well….

• …suggesting that at least 96% of the total eligible universe of bonds will be restructured, slightly better than the IMF target of 95%

• A 96% participation rate allows Greece to reduce its net debt burden by €68bn, or around 30% of GDP

• The domestic-law exchange will be settled Monday 12 March; the foreign-law exchange extends through late March and will settle in April

• PSI reduces the near-term market relevance of Greece in two ways:…

• First, the magnitude of the issue posed by Greece has shrunk: Greece’s upcoming interest payments are reduced by 1/3rd, and upcoming bond redemptions are reduced by 2/3rds

• Second, PSI increases the official ownership share of Greek debt from around 37% pre-PSI to over 60% post-PSI (growing to nearly 75% by 2020)…

• …while the official share of upcoming bond redemptions over the next 3 years is even higher (95%) due to ECB SMP holdings

• Successful PSI and high official sector exposure reduce the chance of a disruptive private-sector default

• We remain in risk-on trades. Yields, front-end swap spreads, and tenor basis have retraced the least since mid-2011

• Ambitious austerity measures and Greek election rhetoric may eventually lead to fiscal slippage and friction with the Troika, creating medium-term risk

Mission PSI: (almost) accomplished Last Thursday was the deadline for Greek bondholders to submit participation instructions for the Greek debt exchange. On Friday Greece announced a participation rate around 84%, in line with our expectations. They also announced that they would indeed invoke collective

action clauses (CACs) on domestic-law bonds. This brings the overall participation rate to 96% (Exhibit 1), which is above the IMF’s target of 95%, as laid out in the IMF’s latest debt sustainability analysis (DSA) from 15 Feb. We expect the formalities to be concluded early next week, with the domestic-law exchange settling Monday 12 March. The new Greek bonds are already trading in the when-issued market. The invocation of CACs triggered a CDS credit event (as determined by ISDA late Friday) and an auction will be held to settle Greek CDS on Monday 19 March.

The foreign-law exchange is still ongoing, and foreign-law bondholders have until late March to respond (Exhibit 2). Each specific issue has a separate bondholders’ meeting scheduled for the last week of March; investors can submit participation instructions up to Friday 23 March or can vote at their respective meetings (occurring between 27-29 March). We expect that on Friday 30 March Greece will tally the foreign-law responses and announce their intentions. Because the CACs are issue-specific rather than aggregate, Greece will likely accept all voluntary tenders and apply CACs where the particular voting thresholds have been met, on a bond-by-bond basis.

In theory, the foreign-law participation rate could go up or down from here. It could go up in two ways: first, more positive responses could be received, and second, Greece has decided to pursue the use of CACs on a set of bonds which were previously exchange-only.1 On the 1 These bonds are mostly small private placements issued by state-owned entities. They tally €6.7bn but the reported voluntary participation was already close to €6.4bn. The settle date was initially 12 March. Now that Greece will pursue CACs, the participation deadline will be extended and the settle date has been pushed to 11 April. However, participation instructions that have already been submitted cannot be revoked.

Exhibit 1: Greece received enough participation to use CACs on its domestic-law bonds, and 60% of foreign law bonds have been tendered as well. At least 96% of the total eligible universe of bonds will be restructured, slightly better than the IMF target of 95% Greek debt exchange participation rates; €bn

Domestic Foreign* Total Domestic Foreign* TotalTendered 158 13 172 184 13 197Total 184 22 206 184 22 206% 86% 61% 83% 100% 61% 96%

without CACs with CACs*

* The deadline for participation from foreign-law bonds is in late March. We expect revocations of previously submitted instructions for foreign-law bonds to be minimal. Also, CACs may be applied across individual foreign-law issues, boosting the total. Note: The IMF assumed 95% PSI participation in their 15 Feb 2012 debt sustainability analysis. Source: Greek Finance Ministry, IMF


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other hand, participation could go down if investors revoke their previously submitted instructions. Instructions can generally be revoked up to two days prior to the bondholders’ meetings (although note, current participation for the above-mentioned set of bonds cannot be revoked). In general, we expect revocations to be minimal, and for the overall participation rate to continue to inch higher. This is because the risk of a later Greek default or debt restructuring is high, and a subsequent writedown is likely to be on worse than current terms (discussed further below).

The current level of participation is enough to reduce Greece’s gross debt burden by €106bn. After subtracting exchange-related recapitalization expenses of €23bn for banks and €15bn for social security funds, the net debt reduction is €68bn (Exhibit 2), around 30% of GDP. This is a substantial reduction but is still modest in the scale of Greece’s overall debt burden (Exhibit 3). Furthermore, we expect continued fiscal slippage amounting to around €20bn over the next three years.2 Greece’s high debt burden and challenging fiscal targets will keep it in the longer-term spotlights.

2 See Challenges facing the second Greek package, Nicola Mai, 9 March 2012

However, the PSI and the accompanying EU/IMF aid package do reduce Greece’s near-term market relevance, for two key reasons. First, obviously the magnitude of upcoming liabilities has been reduced. For instance, we estimate that the face value haircut reduces Greece’s upcoming interest payments by around 1/3rd, and the haircut and maturity extension reduce upcoming bond redemptions by around 2/3rds (Exhibit 3).

Exhibit 2: A 96% participation rate allows Greece to reduce its net debt burden by €68bn, or around 30% of GDP. The domestic-law exchange will be formally approved and settled early next week; the foreign-law exchange extends through late March and will settle in April Bonds targeted in the Greek debt exchange, reported participation rates and consequent debt reduction benefit to Greece

Group Governing Law €bn % Participation Revocation Settlement To be used? Threshold†† Participation Gross Net^

(1) Domestic 177 86% Thu 8 Mar Wed 7 Mar Mon 12 Mar Yes (aggregate across issues) 66% 100% 95 57^

(2) Domestic exch-only* 7 3% TBD*** Wed 7 Mar*** Wed 11 Apr*** Likely (aggregate across issues)† TBD*** 100% 4 4

(3) Foreign 21 10% Fri 23 Mar, mtngs Tue-Thu 27-29 Mar

two days before mtng Wed 11 Apr Partial (by issue) 66% - 75% 61% 7 7

(4) Foreign (Swiss)** 0.5 0% Fri 23 Mar, mtng Wed 28 Mar -- Wed 11 Apr Possibly (single issue) na 61% 0.2 0.2

206 100% 96% 106 68

Debt Reduction (€bn)Bond Type

Total

Collective action clauses (CACs)Key deadlinesAmount

* A small group of domestic-law bonds was targeted in a separate offering memorandum. These are primarily private placements from state-owned enterprises Hellenic Railways, Athens Urban Transport Organisation, and Hellenic Defense. Initially these bonds were to be exchanged only (i.e. no use of CACs)***. ** The Swiss-denominated bond was targeted in a separate offering memorandum due to Swiss legal requirements. *** Initially the bond offer to Group (2) was to exchange only and settlement was anticipated for 12 March. However, the Greek Finance Ministry announced on 9 March that they would delay settlement in order to pursue the use of CACs. The participation deadline and the voting threshold will be clarified when the new offering memorandum is sent out. Settlement is delayed to 11 April. Previously submitted participation instructions cannot be revoked on Group (2). † Greek will pursue the use of CACs on Group (2). These will likely be in the form of aggregate CACs (voting across issues), and since the vast majority of these bonds have already tendered (€6.4bn out of €6.7bn), CACS should be successfully invoked. †† Voting threshold to allow the use of CACs. For domestic-law bonds, the threshold is defined as a percentage of those voting. Foreign-law bonds are mixed, but most frequently the voting threshold is defined as a percentage of total outstanding principal. This occurs in the case of 2/3rds of the total principal, predominantly Greek Republic international bonds (€14bn). The remaining 1/3rd (€7bn, predominantly railway bonds) have thresholds defined as a percentage of those voting. ^ Net debt reduction is defined as the debt reduction after exchange-related bank and social security fund recapitalization (€23bn and €15bn, respectively). Source: Greek Finance Ministry, Bloomberg

Exhibit 3: PSI reduces the near-term market relevance of Greece in two ways. First, Greece’s upcoming interest payments are reduced by around 1/3rd, and upcoming bond redemptions are reduced by around 2/3rds Estimated Greek debt burden before and after PSI

Period Post-PSI Pre-PSI ChgCurrent 131% 163% -32%end-2012 157% 193% -36%end-2015 154% 195% -41%end-2020 124% 167% -43%2012 - 2015 48 68 -202016 - 2020 72 98 -252012 - 2015 38 102 -642016 - 2020 21 77 -56

Total Debt (% of GDP)

Interest Ex pense (€bn) Bond redemptions* (€bn)

* Does not include T-bills and official loans Note: we assume economic, interest rate and fiscal scenarios based on the IMF’s latest DSA from 15 Feb 2012. PSI profile and participation rates are based on 9 March press release from the Greek Finance Ministry. Source: Bloomberg, IMF, Greece, J.P.Morgan


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Second, the debt restructuring effectively transforms much of Greece’s private debt into official-sector debt (by granting EFSF sweeteners in the exchange, providing bank recapitalization funds, etc.). This high official sector exposure means less chance of a disruptive private sector default in the near-term. For instance, we estimate the following:

• The official ownership share of Greek debt will grow from around 37% currently to over 60% after the PSI exercise is concluded, and will grow to nearly 75% in subsequent years (Exhibit 4). There is considerable scope to restructure official sector debt via maturity extensions, interest rate reductions, ECB profit-sharing, etc.

• Around 95% of upcoming maturities over the next few years will be bonds owned by the ECB or various national central banks (Exhibit 4).3 EU governments won’t want the ECB to realise a loss, and private sector maturities will be minimal due to the 10-30Y maturity extension on exchanged bonds. For small issues/holdouts that mature over the next 3-6 months, it may be preferable to pay out at par rather than risk a hard default.

• Similarly, around 3/4ths of upcoming Greek interest payments will go to the official sector due to the ECB/NCB owned bonds and large stock of official sector loans (Exhibit 5).

• The escrow account and the EFSF co-financing arrangement will lower near-term payment risk for new Greek bonds, to a certain extent.

Over the medium-term, we are less sanguine on Greece’s prospects. In April or May they will likely hold elections, which will produce heated anti-austerity rhetoric and potentially a less cooperative government. Also, in the summer large-scale public sector layoffs are supposed to begin. In all likelihood Greece will slip on reform targets such as these, which will become evident fairly soon. As fiscal slippage mounts and the bill to the official sector grows (yet again), there is likely to be pressure for a 2nd restructuring or a hard default. Any subsequent private-sector debt restructuring is likely to target holdouts from the current exchange and will likely offer worse terms. Furthermore, even if Greek private sector obligations are considerably reduced by the current PSI, Greece remains relevant in its implications for the path that other Eurozone peripherals such as 3 Note: we exclude bills and private loans from this analysis, as we assume they will be rolled by domestic investors.

Portugal and Ireland may take, and in whether frictions with the official sector could eventually lead to a Eurozone exit.

Nevertheless, the above factors are unlikely to play out over the near term, and thus we continue to hold risk-on trades. In particular, Exhibit 6 highlights the performance of various asset classes since mid-2011 when the EU sovereign crisis began escalating to its most extreme phase. Most assets have retraced about 2/3rds of their move since then. Yields, front-end swap spreads, EUR/USD, and tenor basis have retraced the least. As

Exhibit 4: Second, PSI increases the official ownership share of Greek debt from around 37% to over 60% (growing to nearly 75% by 2022). Given the large amount of ECB SMP holdings, the official sector share of upcoming Greek redemptions is even higher, at around 95% excluding T-bills Estimated official sector ownership of Greek debt and share* of private debt maturities post-PSI; %

0%10%20%30%40%50%60%70%80%90%

100%

2011 2013 2015 2017 2019 2023 2027 2029

ECB/NCB % of priv ate debt maturities (ex c bills)**

Official % of total debt stockPSI

* We show the 3Y moving average of the share of upcoming maturities beginning in 2014. ** Private debt maturities exclude T-bills and private loans which we assume are rolled each year. Note: PSI profile and participation rates are based on 9 March press release from the Greek Finance Ministry. Source: Bloomberg, IMF, Greece, J.P.Morgan Exhibit 5: Similarly, around 3/4ths of upcoming Greek interest payments will go to the official sector. High official sector exposure means less chance of a disruptive default in the near-term… Estimated interest costs for Greece post-PSI; €bn

PeriodPriv ate /

Market DebtECB/N

CBsOfficial Loans Total

Official/ Total

2012 - 2015 11 8 29 48 77%2016 - 2020 17 4 51 72 76%2021 - 2025 21 1 51 73 72%2026 - 2030 25 0 54 79 69%

Note: we assume economic, interest rate and fiscal scenarios based on the IMF’s latest DSA from 15 Feb 2012. PSI profile and participation rates are based on 9 March press release from the Greek Finance Ministry. Source: Bloomberg, IMF, Greece, J.P.Morgan


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such, we remain short duration in Germany and hold peripheral spread narrowers (see Euro Cash). Also, we hold 2Y swap spread narrowers (see Derivatives).

Trade recommendations

• Duration − In Euro, hold short duration in 10Y Bunds; − In UK, turn neutral on duration. • Curve − In Euro, have a steepening bias on curve; − In UK, hold 5s/10s gilt steepeners.

Exhibit 6: …and we remain in risk-on trades over the near term. Yields, front-end swap spreads, EUR/USD and tenor basis have retraced the least since mid-2011 Current level of various assets vs. peak crisis level since mid-2011 and % retracement* from peak;

Sector Asset 08 Mar 12 Extreme 01 Jul 11Extreme -

InitialCurrent - Extreme % Retracement*

German 10Y 1.80 1.69 3.03 -1.34 0.11 8%US 10Y 2.01 1.71 3.20 -1.48 0.30 20%UK 10Y 2.07 1.96 3.39 -1.43 0.11 8%Italy 10Y 4.99 7.53 4.87 2.66 -2.54 95%Spain 10Y 5.02 7.10 5.38 1.72 -2.07 121%Wtd*** periph 2Y spread to Germany, ex-Greece 288 741 256 485 -452 93%Wtd*** periph 10Y spread to Germany, ex-Greece 378 560 273 288 -182 63%2Y b/m swap spread 91 115 55 59 -23 39%2Y 3s/6s 30 31 14 16 -1 4%2Y FX basis -52 -91 -25 -65 39 60%Itraxx 132 209 103 106 -77 73%EUR HY CDS 574 879 384 495 -305 62%S&P500 1366 1099 1340 -240 267 111%EUR Stoxx 50 2514 1995 2876 -881 519 59%FTSE100 5860 4944 5990 -1045 915 88%Crude Oil 107 76 95 -19 31 160%Gold 1684 1889 1503 386 -205 53%EUR/USD 1.33 1.27 1.45 -0.18 0.06 33%

Average 65%

Commodities / FX ($)

b/m yields (%)

Spreads (bp)

Equity Indices (pts)

* Retracement defined as (current – extreme level) / (initial - extreme level)


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Exhibit 7: Bird’s eye view of our major trade recommendations by currency Euro area UK US Japan

Duration Short 10Y Neutral Bearish bias NeutralPay 12Mx6M in swaps

Curve Steepening bias Reds/greens steepener Neutral 8s/30s steepenerWeighted greens/10s steepener 5s/10s steepener 5s/8s flattener1s/3s bull flattener Long 10s/30s/50s gilts fly Long 7Y JGB in 5s/7s/10s wtd. fly

Pay 10Y in 5s/10s/20s swap wtd flySwap spreads Jun12 Schatz narrower Neutral 30Y widener 1s/5s FX basis steepener

Jun12 Schatz narrower hedged with Jun12 FRA/OIS widenerSwap spread curve Neutral Neutral 10Y narrower hedged with FRA/OIS widener 20s/30s wtd. steepener

Gamma Short Schatz unhedged strangle Neutral Sell 3Mx10Y NeutralShort 3Mx10Y straddle w/infrequent hedging

Vega Neutral Neutral Bearish NeutralInflation Pay 5Yx10Y HICP (rec. fixed) Long ILG16 b/e Bullish bias Neutral

Rec. 10Y French CPI vs. Euro HICP swapsLong BTANi16, OBLi13 & OATei15 b/e

Cross-market 4s/10s Italy flattenerLong 2Y Belgium vs. GermanyLong 5Y Italy vs. FranceSell protection in 3Y Spain CDSShort 2Y Italy CDS-cash basis

European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Gianluca SalfordAC (44-20) 7325-4334 Aditya Chordia (44-20) 7777-9841 J.P. Morgan Securities Ltd.

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Euro Cash

• The ECB press conference highlighted a chronic problem in the Euro area region: there is a tendency for growth to surprise on the downside and inflation on the upside

• German bond yields are expensive vs. fair value, and we keep a tactical short duration

• On the German curve, we find 20Y bonds cheap vs. 30Y, especially boxed vs. swaps

• We remain cautiously positioned for a further compression of sovereign spreads, but our level of conviction is declining

• After the Greek exchange, the focus will shift to Portugal. The macro adjustment is very challenging, but whether the PSI is replicated over the next few years is a political decision

• The underperformance of Spain vs. Italy is due to technical and fundamental factors. Despite the fact that we have assigned similar medium-term risk to both countries, we believe that Italy’s outperformance in the medium term can continue

• On the Italian curve, we recommend 4s/10s flatteners

• We recommend selling the DSL Jul20 vs. the RFGB Apr20 on valuations and relative headline risk

• Supply next week: around €20bn with new 3Y Italy

Same story but less conviction The tug of war between improving market sentiment and ample liquidity left German yields broadly unchanged on the week and not far from the historical record lows across maturities. Even the ECB press conference sent conflicting messages: on the one hand, Draghi closed the door on further short-term easing as inflation forecasts were revised higher with upward risks; on the other hand, the growth outlook continues to deteriorate. Unfortunately, it was typical of the Euro area, even before the sovereign crisis, to disappoint on growth whilst experiencing higher-than-expected inflation (Exhibit 1 and 2), the worst possible combination for a region with fiscal and competitiveness problems. Higher inflation at the margin favours debtors vs. creditors, but

Exhibit 1: Even before the sovereign crisis, it was typical of the Euro area to disappoint on growth… Realised minus forecasts made 1Y and 2Y back of Euro area GDP growth; %y/y

-7-6-5-4-3-2-1012

2000 2002 2004 2006 2008 2010

Realised - 2Y back fcst Realised - 1Y back fcst

Source: Consensus Economics Exhibit 2: …and still experience higher-than-expected inflation Realised minus forecasts made 1Y and 2Y back of Euro area HICP inflation; %oya

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2000 2002 2004 2006 2008 2010

Realised - 2Y back fcst Realised - 1Y back fcst

Source: Consensus Economics Exhibit 3: 20Y Bunds are cheap, making the 20s/30s swap spread curve very steep Bund Jul42 swap spread minus Bund Jan31 swap spread; bp

-20-18-16-14-12-10-8-6-4-20

Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12


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makes the competitiveness problem worse, especially if the euro remains strong. We, therefore, remain sceptical about the macro prospects for the region and peripherals in particular, but do not base our tactical recommendations on it. We still recommend short-duration exposure on valuations. On the client side, many investors seem to have a token short-duration exposure but positions are light according to our client survey. On the curve, we continue to see bearish steepening/bullish flattening going forward. From an RV point of view, 2019 and 2020 Bunds remain slightly expensive, as discussed last week, and we highlight the cheapness of the 20Y sector of the German curve: the swap spread curve between 20Y and 30Y is trading close to zero, suggesting limited downside (Exhibit 3), especially given the shape of the other segments. Intra-EMU Despite some intra-week noise related to the Greek PSI, intra-EMU spreads have not moved much on a weekly basis. For choice, we remain cautiously positioned for a further compression of spreads, but our level of conviction is declining as the LTRO impact fades, spread compression makes valuations less attractive and next week’s supply might find some resistance. Portugal and Spain continued to suffer, whereas 10Y Italy was the best performing sector. After a successful resolution of the Greek exchange, it is natural to look at the next candidate for a debt restructuring. We have covered Portugal in the past (see Overview, 27 January 2012, and IMF assessment of Portugal looks consistent with no near term PSI by Nicola Mai, 2 March 2012). We essentially see Portugal as a country with problems similar to Greece (namely, too much debt and lack of competitiveness), but with two important differences – one positive and one negative. On the positive side, the political and social support to the Troika programme is considerably higher than in Greece; however, on the negative side, the enormous amount of private sector debt (Exhibit 4) is an additional problem compared to Greece. We are sceptical about Portugal’s ability to hit fiscal targets without experiencing years of recession, and talks about a second package might start as early as 3Q12. Whether bond holders will be asked to provide some support (maybe in the mild form of maturity extensions) will be a political decision. Therefore, we are reluctant to express strong views on Portuguese bonds.

Spain’s outperformance vs. Germany essentially halted a month ago, allowing Italian bonds to catch up across the curve. Italy’s outperformance vs. Spain is due to a combination of technical factors and fundamentals. Spanish banks started purchasing domestic government bonds earlier than Italian ones and their market support anecdotally has greatly diminished recently, especially in the secondary market. At the same time, the aggressive frontloading by the Spanish Treasury also might have weighed on the Spanish bonds. From a fundamental point of view, the technocratic Italian government has stabilised markets and won international praise (in line with the experience 20 years ago, see Global Fixed Income Markets Weekly, 29 November 2011), and the probability that the experience will continue after the 2013 elections is rising. On the Spanish side, despite the

Exhibit 4: Portugal’s private sector debt is an additional problem compared to Greece Household, corporate and general government debt/GDP; 2010

0

50

100

150

200

250

300

350

Greece Portugal

Household Corporate General gov ernment

Source: Eurostat Exhibit 5: The 1Y and 3Y sectors on the Spanish curve are trading rich vs. Italy, but the 2Y sector is trading cheap Spanish bonds vs. the interpolated Italian curve; bp

-20

-15

-10

-5

0

5

10

15

20

2013 2014 2015 2016

Spain cheap

Spain rich


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approval of draconian labour reforms, the attention is on the public spat over the 2012 deficit/GDP target and on local governments. In our sovereign risk framework published in the 2012 Outlook, Italy and Spain shared a similar score, although the strengths and weaknesses were quite different. In a nutshell, we believe that Spain is more competitive in the medium term, but the short-term rebalancing is more profound, with higher execution risk. We, therefore, expect Italy’s outperformance vs. Spain to continue in the short term. Exhibit 5 shows Spanish bonds vs. the interpolated Italian curve, with interesting dislocations at the short end of the curve: 1Y and 3Y Spain is expensive vs. Italy, but 2Y is cheap. On the Italian curve, after the strong performance the 5Y 5Y forward is better valued: we replace a long in the forward with a 4s/10s BTP curve flattener and recommend closing the 10s/15s steepener. The recent market normalisation has only partially involved low- high-coupon trades at the long end. We still find that the BTP 4% Feb37 is expensive, given the level of yields vs. the 5% Aug34 (Exhibit 6). Among core countries, we recommend investors buy the RFGB Apr20 vs. the DSL Jul21 at an attractive yield pickup compared to other parts of the curve (Exhibit 7). The recent Dutch macro and political developments are not fully reflected in the current spreads, in our view. On the Dutch curve, we believe the new 20Y DSL issued last week is 2-3bp cheap. Issuance/News Next week’s conventional bond issuance is expected to be very heavy (Exhibit 8), greater than €20bn. The supply will be skewed towards the short-to-medium sector. On the T-bill side, peripheral supply will come from Italy (on Tuesday). On Tuesday, the Netherlands will issue €2.5-3.5bn of the 3Y benchmark DSL Apr15, likely around €3.0bn. The DSL Apr15 is trading close to its richest levels relative to the surrounding bonds since its creation in early January 2012. As discussed above, we find the 7-10Y sector on the Dutch curve expensive relative to the Finnish curve and recommend buying RFGB Apr20 vs. the DSL Jul21. On Wednesday, Italy will issue €4-5bn of a new 3Y benchmark, BTP 2.5% Mar15 and €0.5-1bn of the BTP Sep19. Contrary to the previous benchmark, the 6% Nov14 the new bond will be issued with a low coupon in line with surroundings making it more appealing. We look at the existing 5Y and 10Y benchmarks to estimate

Exhibit 6: The BTP 4% Feb37 is trading expensive vs. BTP 5% Aug34 Residual from regressing BTP 4% Feb37 – BTP 5% Aug34 yield spread against BTP 5% Aug34*; since January 2011; bp

-20

-15

-10

-5

0

5

10

15

20

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12

* BTP Feb37 – BTP Aug34 = -9.7*(BTP Aug34) + 97.6*(BTP Aug34)^2 – 250.7; R-squared 87% Exhibit 7: The RFGB Apr20 vs. the DSL Jul21 provides attractive yield pickup compared to other parts of the curve Dutch and Finnish bonds vs. the interpolated German curve; bp

0

25

50

75

2012 2017 2022 2027 2032 2037

Finland Netherlands

Finland cheap

Exhibit 8: The Euro area bond redemption and tentative conventional issuance calendar until the end of March 2012 Euro area marketable bond* redemption by settlement date and conventional bond issuance calendar; official announcements and J.P. Morgan forecast; peripheral supply highlighted in grey; €bn

Date IssuerBond red.

(by set. date)13-Mar Netherlands Apr15 3.014-Mar Italy Mar15 5.0 Sep19 1.015-Mar France Apr14, Oct14 3.0 Feb16, Feb17 5.015-Mar Spain Jan15 1.0 Apr16, Jul18 2.516-Mar Germany 19.020-Mar Greece 14.421-Mar Germany Mar14 5.026-Mar Belgium 1.0 1.0 1.028-Mar Belgium 4.329-Mar Italy 3.0 3.0

34.5 37.7Total for March

Short Medium Long Ultralong

*Marketable bonds include conventionals, linkers, floaters and zero coupons.


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the benchmark discount for the Mar15. For the BTP May17 the discount on the BTP curve is 11bp, whereas it is 13bp for the Sep22. We expect the new bond to trade around 1bp cheap to the Apr15, equivalent to a benchmark discount of 9bp on the curve. The Sep19 is optically trading a touch expensive on the BTP curve, but the Mar19/Sep19/Mar20 fly is directional to the level of interest rates (Exhibit 9). On Thursday, France will issue €7.5-8.5bn of the off-the-runs OAT Apr14, OAT Oct14 and BTAN Feb16, and the 5Y benchmark BTAN Feb17. We expect around €1bn each of the OAT Apr14 and BTAN Feb16, €2bn of the OAT Oct14 and €4bn of the BTAN Feb17. The off-the-runs OAT Apr14 and BTAN Feb16 are trading fair on the interpolated French curve and also cross-market. The OAT Oct14 is trading close to its richest levels relative to the surrounding BTANs over the past two years (Exhibit 10). The BTAN Feb17 was issued rich relative to the surrounding bonds in mid-February and has cheapened since then, currently trading at an asw pickup of around 2bp. Historical 5Y benchmarks on average came at an asw pickup of 2-3bp and remained in that range for a few months following their creation. We expect the BTAN Feb17 to follow the historical trend and remain range-bound (at an asw pickup of 2-3bp) in the near future. Also on Thursday, Spain will tap the off-the-runs Bono Jan15, Bono Apr16 and Bono Jul18; the issuance size ranges will be announced on Monday. Spain is not tapping any of the benchmark bonds at the mid-month auction, which might be consistent with a slowdown in its issuance pace after front-loading aggressively since the start of 2012. We expect around €3.5bn to be issued: around €1bn each of Bono Jan15 and Apr16, and €1.5bn of Bono Jul18. The Bono Jan15 and Bono Jul18 are trading rich on the interpolated Spanish curve, whereas the Bono Apr16 is trading close to fair. Cross market, the Bono Jan15 is expensive vs. Italy, whereas the Bono Apr16 and Jul18 are trading close to fair vs. Italy. Trade recommendations • Open 4s/10s BTP flattener − Open long €25mn of BTP Sep22 vs short €50mn of

BTP Aug16 @ 165bp. 3M carry and slide: -6bp.

• Close long Italy 5Yx5Y − Close long €25mn of BTP Sep22 @ 5.00%. Close

short €25mn of BTP Feb17 @ 3.55%. P&L since inception (5Y leg equivalent, 2 March): 27bp.

• Close BTP 10s/15s Italy steepener − Close long €25mn BTP Sep22 vs. short €22mn BTP

Mar26 @ 25bp. P&L since inception (2 March): 5bp.

• Keep Bono Jul32-Jan37 flattener − Keep long €25mn of Bono Jan37 and short €23.5mn

of Bono Jul32 @ -1.5bp. 3M carry and slide: -2bp. P&L since inception (2 March): -.05bp

• Keep short 10Y Bund − Keep short €100mn of Bund Jan22 @ 1.795%. 3M

carry and slide: -10bp. P&L since inception (24 February): -9.5bp.

• Keep long 5Y Italy vs. France − Keep long €25mn BTP May17 vs. short €19.8mn

OAT Oct17 @ 191bp. 3M carry and slide: 14bp. P&L since inception (24 February): 59bp.

Exhibit 9: The BTP Mar19/Sep19/Mar20 fly is directional to the level of rates 50:50 BTP Mar19/Sep19/Mar20 fly vs. BTP Sep19; since Jan2011

-8-6-4-202468

10

4.00 5.00 6.00 7.00 8.00BTP Sep19; %

Current

Exhibit 10: The OAT Oct14 is trading close to its richest levels relative to the surrounding BTANs BTAN Jul14/OAT Oct14/BTAN Jan15 50:50 barbell; bp

-4

-2

0

2

4

Mar-10 Aug-10 Dec-10 May -11 Oct-11 Mar-12


11

• Keep long 2Y Belgium vs. Germany − Keep long €25mn OLO Mar14 vs. short €26mn Schatz

Mar14 @ 113bp. 3M carry and slide: 21bp. P&L since inception (2 March): -3bp.

• Keep short protection on 3Y Spain CDS − Keep short protection on $25mn Spain 3Y CDS

protection @ 376bp. 3M carry and slide: 30bp. P&L since inception (3 February): -42bp.

• Keep BTP Dec13 vs. selling maturity-matched CDS protection

− Keep short €25mn of BTP Dec13 @ 1.94% and short $32mn of Dec13 CDS protection on Italy @ 320bp. 3M carry and slide: +5bp. P&L since inception (20 January): -45bp.

Trades closed in 2012 TRADE ENTRY EXIT P&LDURATIONShort 10Y Bund Jan22 27-Jan-12 10-Feb-12 6CURVE5s/10s flattener v s. beta adj. 2s/30s steepener 09-Dec-11 20-Jan-12 33s/10s flattener 03-Feb-12 10-Feb-12 -2COUNTRY SELECTION/RELATIVE VALUEShort 25Y Italy v s. Spain 11-Nov -11 06-Jan-12 21Long 8Y Austria v s. Germany and Spain 06-Jan-12 20-Jan-12 9Short 3Y Spain v s. Germany 09-Dec-11 20-Jan-12 -132Italy 5s/10s flattener 06-Jan-12 03-Feb-12 -56Long Bund Jan21 v s. RFGB Apr21 06-Jan-12 03-Feb-12 -5Long BTP Nov 23 v s. Aug23 03-Feb-12 10-Feb-12 14Long 10Y Spain v s. Italy 10-Feb-12 24-Feb-12 11Short BTP May 31 v s/ BTP Aug23 and Sep40 03-Feb-12 02-Mar-12 7Bono Jul19-Jul26 flattener 27-Jan-12 02-Mar-12 20Long Italy 5Yx 5Y 02-Mar-12 09-Mar-12 2710s/15s Italy steepener 02-Mar-12 09-Mar-12 5CDSSell protection on 2Y Italy CDS 20-Jan-12 03-Feb-12 105Spain 5s/10s CDS flattener 10-Feb-12 24-Feb-12 0

European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Pavan WadhwaAC (44-20) 7777-3370 Fabio Bassi (44-20) 7325-8615 Khagendra Gupta (44-20) 7777-1980 J.P. Morgan Securities Ltd.

12

European Derivatives

• The EONIA curve is pricing in an unchanged refi rate over the next 12 months

• Volatility in reds and greens EONIA is close to its lows of the past 5 years, and is expected to stay low…

• …leading to increasing demand for carry strategies further out the EONIA curve

• Slide on the EONIA curve has contributed about 40% to the overall P&L of long green EONIA trades initiated at the beginning of 2012

• Longs in greens EONIA are attractive as carry trades; however, we refrain from recommending outright longs, given our short 10Y duration view…

• …and, instead, suggest holding weighted greens/10Y steepeners, which are attractive on carry and RV considerations and should perform well in a bear market

• Receive 5Y in the 1s/5s/12s level-neutral fly

• Implied directionality is trading cheaper than delivered directionality for curve trades anchored at the very front end…

• …and for 2s/5s/10s and 3s/7s/15s butterflies

• We favour 1s/3s and 1s/5s bull flatteners and recommend 3s/7s/15s OTM bear belly cheapeners

• We target 2Y German benchmark swap spreads at 75bp, or 15bp narrower than current levels…

• …and believe that 10Y swap spreads will trade between 20bp and 40bp

• Hold June Schatz swap spread narrowers – both outright and hedged-with June FRA/OIS basis wideners

• We are biased towards narrower front-end EUR/USD FX basis and would target the 3M FX-OIS basis at -30bp

• Stay bearish gamma via 3Mx10Y swaption straddles but switch from daily delta hedging to once every two weeks

• Hold shorts in 109.90/110.50 Jun12 Schatz unhedged strangle

Swap Curve Since our last publication, the EONIA curve has remained broadly unchanged at the front end but has steepened marginally from Dec12. Outright macro flows remain limited, with the curve now broadly pricing the ECB on hold for the remainder of 2012 (Exhibit 1) under the assumption that the EONIA/refi bias remains around 85% of the refi/deposit corridor.

The decline in EONIA volatility extended further out the curve, with 1M delivered volatility on reds (1Yx1Y) and greens (2Yx1Y) EONIA declining to the lows of 2007 (Exhibit 2). Recent eye-popping increase in excess liquidity has been a key factor driving volatility lower.

Exhibit 1: The EONIA curve is broadly pricing in an unchanged refi rate over the next 12 months ECB OIS rate, EONIA/refi bias, imputed refi rate and cumulative ECB refi rate cuts priced in; % (unless stated)

Date ECB OIS (%) Bias Imputed refi Cum. cuts priced in (bp)Apr12 0.35 -0.64 0.99 1May 12 0.35 -0.64 0.99 1Jun12 0.33 -0.64 0.97 3Jul12 0.33 -0.64 0.97 3Aug12 0.33 -0.64 0.97 3Sep12 0.33 -0.64 0.97 3Oct12 0.33 -0.64 0.97 3Nov 12 0.33 -0.64 0.97 3Dec12 0.35 -0.64 0.99 1Jan13 0.34 -0.64 0.98 2Feb13 0.36 -0.64 1.00 0Mar13 0.36 -0.64 1.00 0

Exhibit 2: Delivered volatility in reds and greens EONIA has collapsed to its lows of the past 5 years and is expected to stay low 1M delivered volatility on reds and greens EONIA; bp/day

0

2

4

6

8

10

12

14

Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12

Reds

Greens


13

We believe that high excess liquidity is here to stay and therefore expect low EONIA volatility to persist, driving investor interest in carry trades.

In a low-volatility environment, carry and slide tend to contribute more to the overall performance of duration and curve trades. This has been especially true for the EONIA curve over the past few months. Exhibit 3 shows the level of constant maturity 2Y6Mx6M EONIA vs. the level of the same trade using fixed dates, initiated at the beginning of January 2012. The long position has generated P&L of 25bp since its inception in early January, of which 9bp (about 40%) has resulted directly

from the slide in the curve. Longs in greens and blues EONIA offer the highest risk-adjusted carry, with 4-5bp of positive slide per month (Exhibit 4).

Although carry remains attractive on greens EONIA, we refrain from recommending outright longs given our bearish duration view (see Euro Cash). Instead, we continue to position for a steeper curve via weighted greens/10Y steepeners, which remain attractive on carry and RV considerations (Exhibit 5), and is expected to perform well in a bear market. Investors looking to express this view and benefit from our 10Y swap spread

Exhibit 5: …and, instead, suggest holding weighted greens/10Y steepeners, which are attractive on carry and RV considerations and should perform well in a bear market Weighted greens/10Y EUR swap curve* regressed against 2s/10s EUR swap curve; past 6M; bp

-10

-5

0

5

Sep 11 Oct 11 Nov 11 Dec 11 Feb 12 Mar 12

* Curve defined as 10Y – 0.66*(greens yield). Exhibit 6: 5Y continues to trade cheap on the curve; receive 5Y in the 1s/5s/12s level-neutral fly Residual from regressing 1s/5s/12s 50:50 EUR swap butterfly* vs. 5Y EUR swap yields**; past 6M; bp

-6

-4

-2

0

2

4

6

Sep 11 Oct 11 Nov 11 Dec 11 Feb 12 Mar 12

* Swap butterfly defined as: Yield body – 0.5*(Yield Wing1 + Yield Wing2). ** Regression equation: Y = 23.9*(5Y) – 64.7; R2=84%.

Exhibit 3: In a low-volatility environment, carry and slide matter, contributing about 40% to total overall performance to longs in greens EONIA initiated at the beginning of 2012… EONIA forward rate 2Y6Mx6M versus 1Jul14x6M; %

0.80

0.85

0.90

0.95

1.00

1.05

1.10

1.15

03-Jan 16-Jan 29-Jan 11-Feb 24-Feb 09-Mar

2Y6Mx 6M

01 Jul 2014x 6M

Exhibit 4: …leading to increasing demand for carry/slide strategies further out the EONIA curve. Although long green EONIA trades appear attractive, we refrain from recommending them due to our short duration view… 6M carry (bp) and annualised risk*-adjusted carry across the EONIA curve (unitless);

Lev el (bp)

6M Carry (bp)

Risk* (bp)

Annualized risk-adjusted carry

6M 34 -3 0.5 -0.66Mx 6M 34 1 1.2 0.11Yx 6M 41 7 1.8 0.5

1Y6Mx 6M 52 11 2.2 0.72Yx 6M 70 17 2.7 0.8

2Y6Mx 6M 93 23 3.2 0.93Yx 6M 120 29 3.7 1.0

3Y6Mx 6M 147 27 4.1 0.84Yx 6M 173 25 4.3 0.7

4Y6Mx 6M 198 24 4.3 0.75Yx 6M 222 24 4.0 0.8

* Risk is defined as 1M standard deviation of daily changes of the underlying EONIA rate.


14

narrowing bias (see Swap Spreads) may consider implementing weighted greens/Bund curve steepeners as alternative carry-efficient trades.

Over the past week, the swap curve bear steepened with modest outperformance of the 5Y sector, with 2s/10s broadly unchanged and 10s/30s 1bp steeper. Despite this outperformance, we believe the 5Y sector remains cheap on the curve and recommend investors receive 5Y in the 1s/5s/12s level-neutral fly (-50%/75%/-50%). The trade has about 4bp of relative value (Exhibit 6) and carries positively by 6bp over 3M.

With the front end likely to remain anchored, we expect the swap curve to remain directional with the level of yield. The decline in volatility across various tails (see Volatility) has increased the implied directionality and reduced the attractiveness of conditional structures. Exhibit 7 shows the implied and delivered directionality across various curve trades. We draw the following conclusions from this table. First, implied directionality is extremely expensive in Bund, Bobl and Schatz, thereby limiting the attractiveness of conditional structures in these instruments. Second, implied directionality is cheaper than delivered directionality only for swap curve trades anchored at the very front end. Thus, we favour 1s/3s and 1s/5s bull flatteners.

Implied directionality appears about 15% cheap relative to delivered directionality in 2s/5s/10s and 3s/7s/15s butterflies (Exhibit 8). Our long-standing 2s/5s/10s bull belly richener is up about 2bp since inception, but offers more upside; we hold the trade. Investors wishing to express a bearish view with conditional structures should consider OTM 3s/7s/15s bear belly cheapeners implemented with 1M payers. The combined 1M negative carry from curve and volatility is only 2bp, which is broadly equivalent to the expected move for a 10bp sell-off in 7Y yields if the recent directionality holds (Exhibit 9).

Exhibit 7: On curve trades, implied directionality is cheaper than delivered directionality at the very front end; we favour 1s/3s and 1s/5s bull flatteners Current implied* and delivered** directionality for various curve trades; %

Trades Implied Deliv ered Implied-Deliv ered1s/2s 0% 40% -40%1s/3s 15% 58% -43%1s/5s 42% 76% -34%1s/10s 77% 86% -9%1s/30s 90% 88% 2%2s/5s 42% 49% -7%2s/10s 76% 65% 11%2s/30s 90% 71% 19%5s/10s 24% 20% 4%5s/30s 34% 32% 2%

Schatz/Bobl 86% 59% 27%Schatz/Bund 119% 67% 52%Bobl/Bund 18% 15% 3%

* Implied directionality for swap curve calculated as a ratio of implied volatility of 3MxLong leg/3MxShort leg -1. ** Delivered directionality for swap curve calculated as 1 - 3M beta of daily changes in Short leg regressed against daily changes in Long leg.

Exhibit 8: On butterfly trades, implied directionality is cheaper than delivered directionality in 2s/5s/10s and 3s/7s/15s; we favour 3s/7s/15s bull belly richeners and bear belly cheapeners… Implied* and delivered**directionality for various butterflies; %

Trades Implied Deliv ered Implied-Deliv ered1s/2s/3s -7% -10% 3%1s/3s/5s -6% -14% 8%2s/5s/7s 9% 9% 0%

2s/5s/10s 3% 17% -14%2s/7s/12s 12% 18% -6%2s/10s/30s 18% 33% -15%3s/7s/15s 7% 22% -16%

* Implied directionality for swap fly is calculated as (3MxLeg2 implied vol - average of 3MxLeg1 implied vol and 3MxLeg3 implied vol) divided by 3MxLeg2 implied vol ** Delivered directionality for swap fly is defined as 3M beta of daily changes in the fly vs. daily changes of Leg2 swap yields. Exhibit 9: …as the fly is expected to remain directional 3s/7s/15s 50:50 EUR swap butterfly regressed against 7Y EUR swap yields and isopremium* line for conditional trades implemented with 1M swaptions; past 3M; bp

y = 22.4x - 40.8R2 = 85%

0

2

4

6

8

10

12

14

1.60 1.80 2.00 2.20 2.407Y sw ap y ield; %

SpotForw ard

* Isopremium indicates the breakeven level for entering conditional curve trades at zero cost.


15

Swap Spreads Swap spreads widened across the curve as market participants focused on risks around the imminent Greek debt restructuring. During the week, 2Y, 10Y and 30Y German b/m spreads widened 5bp, 4bp, and 2bp, respectively.

Going forward, we expect swap spreads to narrow due to the twin factors of the mitigation of the sovereign debt crisis and high levels of excess liquidity. As Exhibit 10 shows, front-end swap spreads have been driven narrower over the past 3 months by a combination of these factors. Specifically, each 100bp of narrowing in the weighted average peripheral (ex Greece) spread to Germany has put 6-7bp of narrowing pressure on 2Y swap spreads. Additionally, each €100bn of excess liquidity has put 7-8bp of narrowing pressure.

Since the first 3Y LTRO on 21 December 2011, 10Y weighted-peripheral spreads have narrowed more than 100bp, while excess liquidity has increased by an eye-popping €500bn. Moreover, high levels of excess liquidity are expected to stay with us for a very long time since 90% of all open-market operations are now in the 3Y LTRO. Therefore, we expect peripheral spreads to continue to narrow, especially since we expect the risk-on sentiment to continue. The addition of €500bn of excess liquidity is itself expected to put about 7.5*5 = 35bp of total narrowing pressure on 2Y swap spreads.

Given that 2Y spreads have narrowed a meagre 20-25bp since the first 3Y LTRO, we believe that front-end spreads can narrow further, and target 2Y German benchmark spreads at 75bp, or about 15bp tighter than current levels.

Our target of 15bp tightening in 2Y swap spreads appears reasonable, given that front-end spreads are trading too wide relative to the FRA/OIS basis. Indeed, Exhibit 11 shows that 2Y front Schatz swap spreads are trading about 15bp too wide relative to the 2nd IMM FRA/OIS basis. We therefore recommend that investors hold

Exhibit 11: …but continue to trade too wide relative to the FRA/OIS basis; hold 2Y swap spread narrowers – both outright and hedged-with FRA/OIS wideners Residual from regressing rolling-front Schatz swap spread* against back IMM FRA/OIS basis; past 1Y; bp

-20

-10

0

10

20

Mar 11 May 11 Aug 11 Oct 11 Dec 11 Mar 12

* Futures contract rolled 20 days before expiration. Schatz swap spread = 1.00 * IMM2 FRA/OIS basis + 27.5. R-sq = 87%. Exhibit 12: Swapped issuance continues to run at high levels… 20-day MA of J.P. Morgan estimate of swapped issuance*; past 1Y; €bn

0

2

4

6

8

Mar 11 May 11 Aug 11 Oct 11 Dec 11 Mar 12

* We use fixed-rate, €-denominated issuance by financial institutions (including covered bonds) and supras/agencies, plus onehalf of corporate bond issuance, as an estimate of swapped issuance.

Exhibit 10: Front-end swap spreads have narrowed over the past 3 months due to the mitigation of the sovereign debt crisis and the recent eye-popping increase in excess liquidity… 2Y German b/m swap spreads regressed against 1) 21-day MA of NSA excess liquidity, and 2) 10Y weighted average spread of peripherals (ex-Greece) to Germany; past 3M; bp

y = -0.08*(Ex Liq) + 0.06*(Wtd Peri Sprd) + 98.9R2 = 94%

55

60

65

70

75

80

85

250 300 350 400 450 500 550 6001M MA of NSA ex cess liquidity ; €bn

* 10Y Weighted peripheral spread (ex Greece) computed against Germany for Ireland, Italy, Portugal, and Spain (weighted by the size of their outstanding bond market).


16

2Y swap spread narrowers – both outright and hedged-with FRA/OIS basis wideners.

Swapped issuance continues to run at high levels (Exhibit 12). We estimate that the 20-day MA of swapped issuance is currently at €4.3bn/day, or about 40% higher than the average over the past year (€3.1bn/day). Each €1bn/day increase in swapped issuance over a 1-month period puts around 3bp of narrowing pressure on 10Y swap spreads (Exhibit 13). With sentiment in the market improving by the day, swapped issuance is likely to remain high, putting narrowing pressure on intermediate-maturity swap spreads.

Continued abatement of the sovereign debt crisis is also expected to put narrowing pressure on the FX basis. The 3M EUR/USD FX-OIS basis has narrowed from its peak level of -100bp to its current level of -43bp. Each 100bp narrowing of weighted peripheral (ex Greece) spread to Germany causes this spread to narrow 18bp (Exhibit 14). We believe that 10Y peripheral spreads can narrow another 75bp (from 375bp to 300bp) and would target the 3M EUR/USD FX-OIS basis around -30bp from its current level of -43bp.

Euro Volatility Swaption volatility continued its decline over the past week. Specifically, the gamma surface flattened, with volatility on longer tails declining more compared to shorter tails (Exhibit 15). For instance, 3Mx10Y declined 0.2bp/day while 3Mx2Y declined 0.1bp/day. 1M delivered volatility also exhibited similar behaviour; 1M delivered volatility on 10Y swaps declined 0.5bp/day while that on 2Y swaps declined 0.1bp/day. Govie volatility surface, on the other hand, steepened over the past week. Implied volatility on Schatz options declined 0.4bp/day, while that on Bund options remained flat. 1M delivered volatility on govie futures declined between 0.1bp/day and 0.5bp/day.

We continue to remain bearish on gamma and hold short gamma positions in 3Mx10Y. Short gamma positions have been profitable since the announcement of the 3Y LTRO in December 2011, with significant contributions from both vega and gamma. Implied volatility has been on a one-way, downward track over the past several weeks. In addition, current 3M delivered volatility on 10Y swaps is well below the implied volatility of 3 months ago (Exhibit 16). This has

Exhibit 13: …putting narrowing pressure on intermediate swap spreads 10Y German b/m swap spread regressed against 1) 20-day MA of swapped issuance*, 2) 10Y German b/m yield, and 3) 3Mx10Y swaption implied volatilities; past 1Y; bp

y = -3.1*(Iss) - 12.4*(10Y) + 4.4*(3Mx 10Y) + 59.6R2 = 85%

30

40

50

60

70

80

0 2 4 6 820D MA of sw apped issuance*; €bn/day

* See Exhibit 12 for definition of swapped issuance. Exhibit 14: The FX basis will likely continue to be pressured narrower as the sovereign debt crisis continues to abate 3M EUR/USD FX-OIS basis regressed against 10Y weighted average spread of peripherals (ex Greece) to Germany*; past 1Y; bp

y = -0.18x + 33.2R2 = 74%

-120

-100

-80

-60

-40

-20

0

20

100 200 300 400 500 60010Y w td peri spread (ex Greece); bp

09-Mar-12

* See Exhibit 10 for definition of 10Y weighted peripheral spreads (ex Greece). Exhibit 15: Swaption volatility continued its decline over the past week Change since 2 March 2012 in implied volatility on EUR swaptions; 3M, 2Y and 5Y expiries; bp/day

-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

1Y 2Y 5Y 10Y 30Y

3M 2Y 5Y

Tails

Note: Implieds on 1Y tails are based on the 3s curve


17

resulted in both vega and gamma contributing towards total PnL over the past 3 months.

Going forward, we expect gamma to dominate the total return, as implied volatility is likely to remain sticky at current low levels. Exhibit 17 shows the evolution of rolling 1M gamma and vega PnL.4 As seen, over the past few weeks, gamma has outperformed vega as implied volatility has either remained range-bound or has declined at a slower pace compared to 3 months ago. Going forward, we expect 3Mx10Y implied volatility to flatten out around current levels and therefore do not foresee significant vega contribution. Gamma, on the other hand, is likely to contribute as we target 3M delivered volatility to be at 4bp/day (with risks biased lower) versus a current implied volatility level of 4.6bp/day. This mainly reflects our view that market sentiment remains positive as near term event risks (mainly around Greece) have diminished significantly. Thus, we continue to recommend holding short gamma positions in 3Mx10Y.

Going forward, however, we recommend reducing the delta-hedging frequency on short gamma positions. This mainly reflects our view that swap yields are likely to stay range-bound, as has been the case over the past few weeks (Exhibit 18). Indeed, as Exhibit 19 shows, low-frequency delivered volatility (estimated using, say, 2W changes in swap yields) is lower than high-frequency delivered volatility (estimated using daily changes in swap yields), suggesting that mean reversion in swap yields is large.

We analyse the performance of various delta hedging strategies over the past 3 months. Exhibit 20 shows the average 1M return, SD, and annualised return for various short gamma positions with varying delta-hedging frequencies. We draw the following conclusions from this analysis. First, irrespective of the delta hedging strategy, selling 3Mx10Y would have yielded the highest risk-reward. This vindicates our choice of selling 10Y volatility compared to other tails. Second, hedging once every two weeks would have resulted in superior returns compared to hedging daily. We believe that swap yields are likely to stay range-bound and therefore recommend reducing delta-hedging frequency from daily to once every two weeks.

Another way to benefit from a range-bound environment is by selling unhedged strangles. Indeed, we have

4 We analyze 1M returns on short volatility trades. Specifically, we initiate a short volatility trade every day and hold it over the next 1M.

Exhibit 16: Short gamma positions have been profitable recently, as implied volatility has declined and delivered volatility has been significantly below implied volatility at inception 3Mx10Y implied volatility vs. current 3M delivered volatility of 10Y swaps; bp/day

4

5

6

7

8

01-Dec 20-Dec 09-Jan 29-Jan 18-Feb 09-Mar

Implied v ol

Current 3M deliv ered v ol: 4.3bp/day

Exhibit 17: Given the low level of implieds, we expect gamma to become the dominant driver of total return of short volatility positions; stay short gamma 3Mx10Y Rolling 1M vega and gamma return from selling 3Mx10Y swaption straddles and holding the trade for 1M; bp of notional

-20

0

20

40

60

80

04-Jan 16-Jan 29-Jan 11-Feb 24-Feb 08-Mar

Gamma

Vega

Trade end date

Exhibit 18: Swap yields have moved in a tight range since the first 3Y LTRO… 10Y EUR swap yield; %

2.20

2.30

2.40

2.50

2.60

2.70

2.80

01-Dec 20-Dec 09-Jan 29-Jan 18-Feb 09-Mar

3Y LTRO announcement

First 3Y LTRO


18

recommended selling 109.90/110.50 Jun12 Schatz unhedged strangles (see Global Fixed Income Markets Weekly, 24 February 2012). We remain convinced that yields will remain within a tight range at the front end due to extremely high excess liquidity and an on-hold ECB. Thus, we continue to recommend holding this trade at current total premium of 12cents vs. inception level of 17cents.

Trade Recommendations • Curve: Receive 5Y in 1s/5s/12s level-neutral fly.

Implement 3s/7s/15s OTM bear belly cheapeners. Hold greens/10s weighted steepeners. Hold 2s/5s/10s bull belly richeners, 1s/3s bull flatteners and Jun12/Jun13 Euribor bear flatteners

− Receive €75mm 3Mx5Y (start date 13 June 2012) vs. paying €245.0mm 3Mx1Y (start date 13 June 2012) and €22.6mm 3Mx12Y (start date 13 June 2012) to enter into a level neutral fly (defined as 75% * Yield 5Y - 50% * Yield 1Y - 50% * Yield 12Y) at -55.5bp;

− Buy €100mm 1Mx7Y 2.02% payers (notification date 09 Apr 2012) vs. selling €113.3mm 1Mx3Y 1.26% payers (notification date 09 Apr 2012) and €25.8mm 1Mx15Y 2.68% payers (notification date 09 Apr 2012) to enter into a conditional bear belly cheapeners at 5bp vs. spot level of 2bp and 1M forward level of 3.4bp;

− Stay short 100% risk (€50mn) in 2.345% 3Mx10Y swaps vs. long 66% risk in 27Mx1Y (€311mn) 1.495% swaps to remain in a weighted steepener at 134.5bp vs. entry level of 135.8bp (weighted spread defined as 3Mx10Y – 0.66*27Mx1Y) as a carry-efficient proxy to 2s/10s curve steepener (Global Fixed Income Markets Weekly, 24 February 2012); P/L since inception: -1.3bp of yield;

− Hold longs in €100mn 1.67% 3Mx5Y receivers (notification date 27 April 2012) vs. shorts in 1.135% €122.6mn 3Mx2Y receivers and 2.39% 3Mx10Y €26.4mn receivers to remain in a conditional bull-belly richener in the 2s/5s/10s 50:50 weighted fly at -9.25bp vs. forward level of -11.6bp and spot level of -14.1bp (Global Fixed Income Markets Weekly, 27 January 2012); P/L since inception: +7.7bp of notional;

− Hold longs in €100mn 1.33% 3Mx3Y receivers vs. short €297.7mn 1.25% 3Mx1Y receivers to stay in a conditional bull flattener at 8.0bp vs. spot level of 5.8bp and forward level of 10.9bp (Global Fixed Income Markets Weekly, 6 January 2012); P/L since inception: -7.9bp of notional;

− Continue holding longs in 1000 98.875 Jun12 Euribor puts vs. shorts in 1000 98.75 Jun12 Euribor mid-curve puts to remain into a Jun12/Jun13 Euribor bear flatteners at 12.5bp vs. forward levels of 7bp (Global Fixed Income Markets Weekly, 15 December 2011); P/L since inception: -0.75cents.

• Swap spreads: Hold Jun12 Schatz ASW narrowers

outright and hedged with Jun12 FRA/OIS wideners

− Continue to receive €100mn Schatz CTD expiry-matched swaps and sell 910 110.20 Jun12 Schatz futures to remain in Jun12 Schatz swap-spread

Exhibit 19: …while exhibiting a high degree of mean reversion 3M standard deviation of 1D, 1W, 2W, and 1M changes of 5Y and 10Y swap yields expressed in daily terms*; bp/day

2.0

3.0

4.0

5.0

1 5 10 21

5Y 10Y

# business day s change in sw ap rate

* For example: 10 is calculated as (3M delivered volatility of 10D changes in 10Y swap yield)/sqrt(10). Exhibit 20: We recommend delta-hedging short gamma positions less frequently. Our choice is to sell 3Mx10Y gamma and delta-hedge once every two weeks Statistics on 1M return from selling various straddles with varying hedging frequencies; since 15 Dec 2011; bp of notional

1D 2W Unhedged3Mx2Y

Av g 10 12 10SD 12 14 14

Inf ratio 2.8 2.9 2.53Mx5Y

Av g 24 29 17SD 27 30 22

Inf ratio 3.1 3.3 2.63Mx10Y

Av g 58 70 54SD 64 72 60

Inf ratio 3.1 3.3 3.1


19

narrower at 78.6bp vs. an entry level of 76.3bp (Global Fixed Income Markets Weekly, 24 February 2012). P/L since inception: -2.3bp of yield;

− Continue to receive €100mn Schatz CTD expiry-matched swaps, sell 911 Jun12 Schatz futures, sell 704 Jun12 Euribor futures, and receive €698mn Jun12 IMM EONIA swaps to remain in Jun12 Schatz swap spread narrower hedged for FRA/OIS widener at 41.8bp vs. an entry level of 40bp (Global Fixed Income Markets Weekly, 02 March 2012); P/L since inception: -1.8bp of yield.

• Volatility: Stay short 3Mx10Y EUR swaption

straddles but change delta hedging frequency to once every two weeks. Stay short 109.90/110.50 Jun12 Schatz unhedged strangles. Stay long GBP 2Yx1Y vol vs. GBP 1Yx1Y vol

− Stay short €100mn 2.34% 3Mx10Y EUR swaption straddles (ATMF 2.34%, notification date 24 May 2012, maturity date 28 May 2022) at 4.6bp/day vs. an entry level of 5.1bp/day. This trade requires infrequent delta hedging (once every two weeks) (Global Fixed Income Markets Weekly, 24 February 2012); P/L since inception: +38bp of notional;

− Continue to sell 1000 109.90/110.50 Jun12 Schatz unhedged strangle for 12cents vs. entry level of 17cents (Global Fixed Income Markets Weekly, 24 February 2012); P/L since inception: +5cents;

− Stay long £100mn 1.40% GBP 2Yx1Y straddles (notification date 20 January 2014, maturity date 20 January 2015) vs. short £112mn 1.21% GBP 1Yx1Y straddles (notification date 20 January 2013, maturity date 21 January 2014) at an implied spread of 1.4bp/day (defined as 2Yx1Y – 0.8*1Yx1Y) vs. an entry level of 1.55bp/day (Global Fixed Income Markets Weekly, 20 January 2012); P/L since inception: -2.7bp of notional.

* P/L for open trades calculated using Thursday’s closes.

Closed Trades in 2012 Trade Entry Exit P&L

Long 6Mx6M EONIA 09 Dec 11 06 Jan 12 10.0Long 2Y6Mx6M EONIA 03 Feb 12 24 Feb 12 5.0Long Dec12 EONIA 20 Jan 12 02 Mar 12 1.0CurveGreens/10s weighted steepeners 03 Feb 12 10 Feb 12 0.0

Conditional curve and flies1s/5s bull flatteners 09 Dec 11 06 Jan 12 8.5Mar12 Schatz/Bund bear steepener 20 Jan 12 24 Feb 12 0.0Swap SpreadsMar12 Schatz ASW wideners 15 Dec 11 20 Jan 12 -11.0Mar12 Bund bull wideners 20 Feb 12 24 Feb 12 0.0Options (outright)Short Mar12 Schatz straddles 15 Dec 11 06 Jan 12 10.0Buy 3Mx5Y EUR gamma 04 Nov 11 20 Jan 12 -58.0Short Mar12 Schatz straddles 20 Jan 12 10 Feb 12 7.0Options (relative)Sell Mar12 Schatz vs. mat matched swaption 20 Jan 12 27 Jan 12 8.0Sell 3Mx10Y EUR vs. 3Mx5Y 03 Feb 12 10 Feb 12 -4.0Buy Mar12 Bund vs. mat matched swaption 20 Jan 12 10 Feb 12 18.0Buy Jun12 Bund vs. mat matched swaption 10 Feb 12 02 Mar 12 8.0

Duration

Trade P&L is shown in bp for all trades except option trades, which are shown in bp of notional. Conditional trades are normalised by the PVBP of the underlying * Option Expiry; ** Annualised bp

European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Francis DiamondAC (44-20) 7325-3541 [email protected] J.P. Morgan Securities Ltd.

20

United Kingdom

• 10Y gilt yields ended the week little changed and traded in a very tight 4bp range

• Momentum and technicals suggest staying neutral 10Y duration

• Keep reds/greens swap curve steepener…

• …and for investors looking to express this view in cash space, we think a 4H13/5s14 gilt steepener is the best proxy

• Our curve momentum model suggests the 5s/10s gilt curve is too flat – keep tactical stepeener as a non-directional view

• The 10s/20s/30s fly has been cheapening but we think this can continue given reduced market expectations for any additional QE extensions

• Stay long the belly of the 10s/30s/50s gilt fly – 30Y gilts remain cheap on the curve and the belly of the fly should outperform as the reds/greens curve steepens

• Gilt RV: The belly of the 5s18/4H19/3T20 fly is rich. Take profit on being long the belly of the 5s18/4s22/4Q27 fly. Stay short gilt 4s60 vs. 4Q55 on cash-for-cash basis

• We preview the FY12/13 gilt financing remit and expect an £11bn reduction in gross gilt sales to £168bn…

• …but we see a modest downside risk to this forecast as the treatment of the Royal Mail Pension Fund assets in the national accounts is unclear

• We expect a small increase in short nominal gilt issuance in FY12/13, with medium and long nominal issuance falling

Neutral 10Y duration, stay long the belly of 10s/30s/50s fly 10Y and 30Y gilt yields are essentially unchanged since the last GFIMs, with 5Y yields around 5bp higher, and 10Y gilts trading in a tight 4bp range on the week.

Market sentiment appears to be improving, risky assets continue to perform well and yet this dynamic is really only being reflected at the very front end, where Short

Sterling yields have risen on the week (Exhibit 1), although they remain at very low levels.

Further out, intermediate gilt yields are close to their average levels for the last 3M and as we discussed in the previous GFIMs, we think the range-bound environment will continue. We suspect that investors have a bearish bias on duration given the improving economic backdrop and reduced expectations for further QE, but we think risk appetite remains low and that positions don’t truly reflect this bias. We continue to focus on technical and momentum indicators and we remain neutral on 10Y

Exhibit 1: Back white and front red Short Sterling contracts have underperformed over the last week Change in Short Sterling, FRA/OIS and IMM OIS rates, 2-9 Mar; bp

0

5

10

15

Mar

12

Jun1

2

Sep1

2

Dec1

2

Mar

13

Jun1

3

Sep1

3

Dec1

3

Mar

14

Jun1

4

Sep1

4

Dec1

4

SS FRA/OIS OIS

Exhibit 2: Our momentum model shows a neutral signal for 10Y gilts Momentum model signal* for 10Y benchmark gilt

-0.10

-0.05

0.00

0.05

0.10

Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12

bullish signal at peak

bearish signal at trough

* We first generate a MACD (Moving Average Convergence Divergence) measure. This is calculated as the expected moving average (EMA) of 10Y yields over a 5 day period minus the EMA of 10Y yields over a 25 day period. We then generate a signal measure which is the 10 day EMA of the MACD measure. The rule is defined as the MACD minus the signal


21

duration, but we remove our bearish bias given our momentum model is showing a neutral signal (Exhibit 2).

In the last GFIMs we recommended entering 1Yx1Y/2Yx1Y swap curve steepeners as an attractive way to position for modestly improving sentiment and an increase in term premia in the forward curve. We stick with this medium term reds/greens steepening view. For those investors who are constrained to trading cash gilts, we analyse how to proxy this swap curve steepening view in bond space (Exhibit 3). Overall, the correlation between the gilt curve and reds/greens swap curve has been moderate over the last few months but in general front end cash curve steepeners should provide investors with some broad exposure to a steeper reds/greens swap curve. For choice we prefer a 4H13/5s14 steepener as this has the highest beta and shows the largest dislocation vs. the reds/greens curve. However, we acknowledge that some investors will be unable to take a long position in 4H13 as it has less than one year remaining maturity and may well be excluded from their benchmarks.

We keep our 5s/10s gilt curve stepeener. The 5Y sector of the curve has underperformed and our curve momentum model suggests that the 5s/10s gilt curve is too flat (Exhibit 4). The directionality of 5s/10s with the level of yields has been weak recently and we view this more as a tactical trade rather than a directional view on duration. We target the 115bp level in 1T17/3T21 with a tight stop loss of 100bp (currently 105bp).

Further out we note that the 20Y sector of the gilt curve remains cheap, with forwards in this sector having underperformed since the February QE announcement. In fact, 15Yx5Y gilt forwards (i.e. 5Y gilt yields 15Y forward) now offer the highest yield on the gilt forward curve at around 4.5%. However, we would not recommend fading this cheapness as we think the 20Y sector can underperform further.

Typically, in the absence of QE latent investor demand for 20Y gilts is low compared to 10Y and 30Y gilts. The 10s/20s/30s curve-adjusted fly has generally traded rich during QE periods and cheap during non-QE periods (Exhibit 5). We think QE purchases conducted since October 2011 have led to an artificial richening of the 20Y sector which has now started to correct as the market expects no extension to QE once the current £50bn of purchases have been completed.

We keep our recommendation to be long the belly of the 10s/30s/50s gilt fly. The 30Y sector remains cheap on the curve and we expect to see ultra-long gilt issuance

Exhibit 3: Front end gilt curve steepeners can be viewed as modest proxies for our reds/greens swap curve steepening view Statistics from regressing selected cash gilt spreads against GBP 1Yx1Y/2Yx1Y swap curve over the past 6M, 3M carry and slide for gilt curve steepener; bp unless stated

Beta R-squ Residual 3M C+S4H13/2Q14 0.4 44% -3 -38s13/2Q14 0.3 42% -1 -24H13/5s14 0.8 48% -9 -38s13/5s14 0.7 50% -7 -52Q14/2T15 0.4 29% -7 -25s14/2T15 0.0 0% 0 -12T15/2s16 0.2 32% -3 -3

Exhibit 4: Our gilt curve momentum model suggests 5s/10s is too flat – keep tactical steepener 5s/10s gilt par curve momentum signal vs. 5s/10s par curve

-4

-2

0

2

4

6

Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12

95

105

115

125

1355s/10s curv eMomentum signal

Exhibit 5: We think the 20Y sector can underperform vs.10s/30s if QE finishes in May 10s/20s/30s par gilt fly 50:50 and curve adjusted*; bp

0

10

20

30

40

50

Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12

-15

-10

-5

0

5

1050:50 fly

lev el adjusted

QE2QE1

* residual from regressing 10s/20s/30s fly vs. 10s/30s curve, r-squ: 58%, std error: 4bp


22

early in FY12/13 which should cheapen 50Y gilts. In addition, we note that the 10s/30s/50s fly has shown reasonable directionality with the reds/greens swap curve. Being long the belly is a good proxy for a steeper 1Yx1Y/2Yx1Y swap curve (Exhibit 6) and the fly currently looks some 5bp cheap given the slope of the reds/greens curve.

4H42 auction, gilt RV The DMO will tap gilt 4H42 for £2bn on 15 March, taking the total outstanding to £21.5bn (excluding DMO collateral outstanding is £17.5bn). This bond is now trading as the 30Y benchmark and looks close to fair value on our par curve model. At a macro level we think that the cheapness of the 30Y sector vs. 10s/50s could provide reasonable support for the auction. At a micro level, 4H42 looks a touch cheap on a fly basis vs. neighbouring gilts with the belly of the 4Q40/4H42/4Q46 fly at its cheapest level since the end of January. We think this cheapness may attract some auction interest but we think this RV interest will be limited as the fly has traded in a very tight range over the last 3M. On an ASW basis, 30Y gilts in general offer the highest pick-up vs. LIBOR at around 10-11bp, with 4H42 trading close to its average ASW level for the past 6M.

In the 10Y sector of the curve we note that the belly of the 5s18/4H19/3T20 fly looks rich (Exhibit 7). The fly is non-directional with the level of yields and directionality with the slope of the 5s18s/3T20 curve has been patchy, except during January. The 5s18/3T20 curve steepened sharply following the QE announcement at the February meeting as the BoE shuffled the purchase buckets and bonds in the 3-7Y sector outperformed (as it became the smallest buyback bucket), which resulted in a cheapening of the fly. Gilt 4H19 falls into the 3-7Y purchase bucket for all operations going forward but we think that the fly is already reflecting this dynamic. The BoE holdings of 5s18 are larger than the other two bonds (52% compared to 40% and 23% respectively) but the BoE needs to buy another £4.4bn of this to reach the 70% threshold – something we think is unlikely. We recommend selling the belly of the 5s18/4H19/3T20 fly. Elsewhere, we take profit on our recommendation to be long the belly of the 5s18/4s22/4Q27 fly. We close our recommendation to be long the belly of the 4H19/4T20/3T20 fly.

At the ultra-long end, we keep our recommendation to be short 4s60 vs. 4Q55 on a cash-for -cash basis. The implied forward remains close to its highest level and we

Exhibit 6: The belly of the 10s/30s/50s gilt fly should outperform as the reds/greens swap curve steepens 10s/30s/50s par gilt fly regressed against GBP 1Yx1Y/2Yx1Y swap curve, last 12M; bp

y = -0.24x + 58R2 =65%

20

30

40

50

60

70

0 20 40 60 80 100Reds/greens sw aps; bp

current

Exhibit 7: The belly of the 5s18/4H19/3T20 fly is rich 50:50 fly and 5s19/3T20 curve; bp

-8

-6

-4

-2

0

2

Mar 11 Jun 11 Sep 11 Dec 11 Mar 12

50

55

60

65

70

75

5s18/3T205s18/4H19/3T20

Feb QE

Exhibit 8: We expect a modest decline in gross and net gilt sales for FY12/13 Financing remit breakdown, shaded cells are J.P.Morgan forecasts

£bn FY 10/11 FY 11/12 FY 12/13 FY 13/14

Fiscal (PSNB) 137 127 120 100Financial transaction 6 8 11 13Other -3 0 -3 4Total (CGNCR) 140 135 128 117Redemptions 39 49 53 47Reserv e Financing 6 6 10 10ST Financing adjustment -26 -9 -7 0NS&I 0 3 2 0Roy al Mail PF Adjustment* 0 0 -13 -13Net Financing Requirement 158 178 170 161

T-Bills -1 0 2 2Way s and means 0 0 0 0DMO net cash 6 0 0 0Gross gilt Sales 165 179 168 159Net gilt Sales 126 130 115 112BoE QE gilt purchases 0 115 10 0Gilt issuance net of QE + redemptions*

126 15 105 112

* we estimate the impact of the absorption of the Royal Mal Pension Fund assets into the National Accounts will be split over two fiscal years. However it is possible that the total £25bn benefit is taken in just one fiscal year


23

expect issuance of 4s60 in the first quarter of FY 12/13 (see below).

March Budget and gilt financing remit The Chancellor will present the 2012 Budget on 21 March with the DMO releasing the financing remit for FY12/13 after the end of the Budget speech. At the top level we think that the fiscal outlook will be little changed from the Autumn OBR forecasts, with net borrowing expected to fall to 7.7% of GDP in the next fiscal year, equivalent to £120bn. Over the longer run we think net borrowing will fall to around 4.4% of GDP in FY14/15 with debt/GDP creeping up to 76%.

Investors are starting to focus on the issuance remit and potential gilt market impact and Exhibit 8 outlines our estimates of the financing requirement and gross gilt issuance for FY12/13. The central government net cash requirement (CGNCR) is expected to fall by around £7bn but with redemptions rising by around £4bn this suggests, at a first glance, a £3bn fall in gross gilt issuance (assuming T-Bill issuance is unchanged). However, we expect a slightly larger reduction in gross gilt issuance of £11bn, with gross gilt sales expected to be £168bn in FY12/13.

Sometimes the remit throws up a few surprises in terms of additional or unexpected factors and we highlight three areas of uncertainty in our forecast: 1) Reserve Financing; 2) a short-term financing adjustment, and 3) the inclusion of the Royal Mail Pension Fund assets in the National Accounts. We pencil in a £7bn short-term financing adjustment to take account of an expected overshoot in borrowing in FY11/12 due to better than expected budget outturns, but as the final outcome is not yet known the actual adjustment could be different from our forecast.

The third of these factors, namely in the inclusion of the Royal Mail Pension Fund assets, could potentially have the biggest impact on our issuance forecast. We recently discussed this issue in a briefing email (see UK Inflation markets and the Royal Mail Pension Fund, 8 Mar) but as a recap the Government will be taking the assets of the Royal Mail Pension Fund onto its balance sheet from April 2012, with the liabilities being added to the existing off-balance sheet contingent liabilities of existing public sector pensions. Total assets are around £28bn, with around £2bn of this in cash, and the OBR estimates that the inclusion of these assets net of cash could reduce public sector net borrowing (PSNB) by

around £25bn. The timing of this is uncertain and we are unsure exactly when this would be realized, so we have assumed that half of the £25bn is recognized in FY12/13 and the other half in FY 13/14. However, we acknowledge downside risk to our issuance forecast if we are wrong on the timing.

Exhibit 9 outlines our forecast by sector of the curve. We think the DMO will be reluctant to change the % of issuance by sector by much but we think that short nominal issuance (<7Y) will increase by around 3% as 1) funding at the front end is cheap given low level of spot and forward yield, and 2) we expect MFI and overseas Central Bank demand for gilts to continue. We also expect a slight increase in linker issuance given the very low level of real yields, with medium and long nominal issuance falling by a total of £7bn (3%).

The DMO is likely to focus new bonds in maturities of the curve where the redemption profile is low (Exhibit 10). We would expect any new short maturity bond to be issued with a 2018/19 maturity and any new medium

Exhibit 9: We expect a small increase in the proportion of short nominal gilt issuance for FY12/13 Gilt issuance by maturity bucket, historic and FY12/13 forecast; £bn unless stated

FY 10/11

FY 11/12

FY 12/13

Chg. 12/13 vs.

11/12

FY 10/11

FY 11/12

FY 12/13

Chg. 12/13

vs. 11/12

Short nominal 53 61 61 1 32% 34% 37% 3%Medium nominal 38 40 34 -6 23% 22% 20% -2%Long nominal 41 40 35 -4 25% 22% 21% -1%Linkers 34 39 38 -1 20% 22% 23% 1%Total 166 179 168 0 100% 100% 100% 0%

Exhibit 10: We think that any new gilts will be issued in sectors of the curve where redemptions are low Total gilt redemptions by fiscal year

0

1020

3040

50

6070

80

11/1

212

/13

13/1

414

/14

15/1

616

/17

17/1

818

/19

19/2

020

/21

21/2

222

/23

23/2

424

/25

25/2

6

0.0%

1.0%2.0%

3.0%4.0%

5.0%

6.0%7.0%

8.0%amount, £bn % of total


24

maturity bond to be issued with a 2022-2024 maturity. We expect syndications to continue to be a key method of issuing and think that the DMO could well announce a long nominal syndication to be held in the first quarter of the upcoming fiscal year (i.e. April-Jun). We would favour a reopening 4s60 given the richness of this bond in forward space compared to other ultra-long end gilts.

Trade recommendations • Sell the belly of the 5s18/4H19/3T20 fly (50:50)

Sell £30mn notional of gilt 4.5% Mar19 vs. buying £17mn notional 5s18 and buying £13mn notional of gilt 3.75% Sep20 @ -7.5bp. Target -3.5bp, stop loss @ -9bp.

• Close long the belly of the 4H19/4T20/3T20 fly (50:50) Buy £50mn notional of gilt 4T20 vs. selling £28mn notional of gilt 4H19 and £25mn of gilt 3T20 @ weighted spread of 7.5bp. Target 3bp, stop loss @ 8bp.P/L since inception is -0.5bp (recommended 3 Feb).

• Close long the belly of the 5s18s/4s22/4Q27 (50:50 fly) Buy £50mn nominal of gilt 4s22 vs. selling £38mn nominal of gilt 5s18 and £17mn nominal of gilt 4Q27 at a weighted spread of 15bp. P/L since inception is 3.5bp (recommended 3 Feb).

• Keep reds/greens swap curve steepener Pay £50mn of 2Yx1Y GBP swaps vs. receiving £50.4mn of 1Yx1Y GBP swaps @ 23bp. Target 45bp, stop loss @ 15bp.3M carry and slide is -3bp. P/L since inception is -2bp.

• Stay long belly of 10s/30s/50s gilt fly cash-and-duration neutral fly Buy £40mn of gilt 4Q40 vs. selling £16mn of gilt 3T21 and selling £25mn of gilt 4s60 @ 46bp. Target 30bp, stop loss @ 50bp.P/L since inception is 0bp.

• Keep 5s/10s gilt curve steepener Buy £50mn of gilt 1T17 vs. selling £29.3mn of gilt 3T21 @ 105bp. Target 115bp, stop loss @ 100bp. 3M carry and slide is 0.5bp. P/L since inception is -6bp (recommended 24 Feb).

• Sell 4s60 vs. 4Q55 cash-for-cash Sell £20mn of gilt 4s60 vs. buying £20mn of gilt 4Q55 @ a relative price ratio of 0.964. Target 0.959, stop loss @ 0.9655. P/L since inception is 0c (recommended 24 Feb).

• Sell belly of 3T21/5s25/4T30 fly (50:50) Sell £30mn of gilt 5s25 vs. buying £21mn of gilt 3T21 and £12mn of gilt 4T30 @ -4.0bp. Target -1bp, stop loss @ -7.5bp. P/L since inception is 1bp (recommended 10 Feb).

• Stay long the belly of the 4Q32/4T38/4H42 fly (50:50) Buy £30mn notional of gilt 4T38 vs. selling £19mn notional of gilt 4Q32 and £14mn notional of gilt 4H42 @ weighted spread of 5.0bp. Target 2bp, stop loss @ 7bp. P/L since inception is 0bp (recommended 3 Feb).

• Keep paying 12Mx6M GBP swaps Pay £50mn of 12Mx6M swap @ 1.18. Target 1.30%, stop loss @ 1.05%. 3M carry and slide is -2bp. P/L since inception is 1p (recommended 20 Jan).

• Keep pay belly of 2s/5s/10s GBP swap fly via 3M payers (buy payers on 5Y vs. selling payers on 2Y and 10Y)

− Pay £100mn of 5Y swap vs. receiving £50mn of 2Y swaps and £50mn of 10Y swaps via 3M payer options. Zero cost entry level -22bp, 3M forward -22bp, spot level -26bp.

• Stay short belly of the 4s16/1T17/5s18 fly (50:50) − Sell £50mn of gilt 1T17 vs. buying £25mn of gilt

4s16s and £19mn of gilt 5s18 @ -5.0p. Target -0bp,

2012 closed trades P/L bp unless stated TRADE ENTRY EXIT P/LDURATIONShort 10Yx 5Y forw ard 27-Jan-12 10-Feb-12 138cCURVE5s/30s gilt flattener 15-Dec-11 06-Jan-12 16.010s/30s gilt flattener 20-Jan-12 10-Feb-12 -10.05s/12s sw ap curv e steepener 27-Jan-12 10-Feb-12 7.0RELATIVE VALUELev el- and curv e-adj. long 5s18/4s22/5s25 15-Dec-11 06-Jan-12 2.0Sell 4s16 v s. 1T17 on ASW 16-Sep-11 20-Jan-12 3.0Long lv l. And curv e adj 3s/12s/25s sw ap fly 27-Jan-12 10-Feb-12 4.0Long belly lv l. Adj. 2s/15s/30s sw ap fly 20-Jan-12 24-Feb-12 7.030Y sw ap spread w ideners 03-Feb-12 02-Mar-12 5.0Long belly 4H19/4T20/3T20 03-Feb-12 09-Mar-12 -1.0Long belly 5s18/4s22/4Q27 03-Feb-12 09-Mar-12 3.5INFLATIONReceiv e 2Y RPI 15-Dec-11 10-Feb-12 17.0Long ILG16 06-Jan-12 24-Feb-12 -105p30s/50s RY curv e flattener 10-Feb-12 21-Feb-12 2.0Short belly ILG16/ILG17/ILG22 RY fly 10-Feb-12 24-Feb-12 13.0Long 30Y UK BE v s. 30Y France BE 10-Feb-12 24-Feb-12 10.0Short ILG50 v s. ILG47 cash-for-cash 04-Nov -11 24-Feb-12 110p


25

stop loss @ -6bp. 3M carry and slide 0.5bp. P/L since inception is -0.5bp (recommended 20 Jan).

• Stay short the belly of the 2Q14/2T15/4T15 fly (50:50)

− Sell £30mn of gilt 2T15 vs. buying £21mn of gilt 2Q14 and £12mn of gilt 4T15 @ weighted spread of 2bp. Target 11bp, stop loss @ -0.5bp. P/L since inception is 0bp (recommended 6 Jan).

• Stay long ILG16 BE − Buy £10mn cash of ILG16 vs. selling £29.5mn cash of

gilt 4s16 @ a breakeven spread of 268bp. Target 280bp level, stop loss @ 255bp. P/L since inception is 12bp (recommended on 24 Feb).

• Stay long belly of the ILG22/32/40 real yield cash-and-duration neutral fly

− Buy £15mn of ILG22 vs. selling£6mn of ILG22 and £9mn of ILG40 @ spread of 21bp. Target 12bp, stop loss @ 25bp. P/L since inception is 0bp (recommended on 24 Feb).

US Fixed Income Strategy Global Fixed Income Markets Weekly March 9, 2012 Srini RamaswamyAC (1-212) 834-4573 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC.

26

US Cross Sector

• The risky asset rally took a bit of a breather this week, likely due in part to robust supply

• Supply is a headwind in some markets, keeping us bearish on Treasuries and munis…

• …but in other markets, such as high grade and high yield, supply has been met with strong demand, and we stay overweight

• Weak trade numbers, in conjunction with last week’s disappointing consumption and durable goods orders data, lead us to revise our forecast for 1Q12 growth down from 2.0% to 1.5%

• On the other hand, the February employment report was solid. Given that the Fed’s dual mandate focuses on employment and inflation, not growth, we do not expect the Fed to embark on QE3 at next week’s meeting, and we think the bar for action is higher for the April meeting as well. That said, if QE3 were to eventually occur, it would be supportive of risky assets even if it is implemented on a sterilized basis

• We think the generally supportive macro backdrop and declining tail risks in Europe will continue to outweigh headwinds such as the Middle East and stay overweight risky assets

Market views The risky asset rally took a bit of a breather this week: European sovereign spreads and funding spreads widened, European stocks fell, and credit spreads were mixed (Exhibit 1). The pause in the rally likely partially reflects the heavy supply environment. As we highlighted last week, supply in high grade and high yield have been running at extremely high levels (see also Exhibit 1 in Interest Rate Derivatives), and it has also picked up in markets like munis and CMBS. As Exhibit 2 shows, we expect over $6bn of CMBS to price this month, which would be the most monthly issuance since the primary market reopened in early 2010. In munis, issuance has been increasing steadily over the past four weeks, with this week seeing over $10bn of new supply, which is double the average weekly pace over the first two months of the year.

Although recent supply is likely opportunistic to some extent (driven by low yields and tight spreads) and reflects the strength of issuance markets, supply technicals could nonetheless dampen the rally in some markets. In munis, for instance, elevated supply and the potential for investors to withdraw funds ahead of the upcoming tax season causes us to take a cautious stance

Exhibit 1: The risky asset rally took a bit of a breather this week Current level,* change since 3/2/12, quarter-to-date change, and change over 4Q11 for various market variables

Current Chg from 3/02 QTD chg 4Q11 chgGlobal Equities (level)

S&P 500 1370.9 1.2 113.3 126.2E-STOXX 2516.0 -30.2 199.4 136.9FTSE 100 5887.5 -23.6 315.2 443.8Nikkei 225 9929.7 152.7 1474.4 -244.9

Sovereign par rates (%)2Y US Treasury 0.341 0.053 0.077 -0.03210Y US Treasury 2.099 0.057 0.157 -0.0802Y Germany 0.093 -0.037 -0.009 -0.40610Y Germany 1.917 0.049 0.024 -0.0462Y JGB 0.113 0.011 -0.015 -0.01710Y JGB 0.989 0.014 0.083 -0.089

5Y Sovereign CDS (bp)Spain 396 20 14 -1Portugal 1296 57 117 -36Italy 369 8 -118 13Ireland 618 20 -134 12

Funding spreads (bp)2Y EUR par swap - par gov 't spd 97.3 6.2 -23.7 21.82Y USD par swap - par gov 't spd 23.5 -0.4 -23.1 18.6EUR FRA-OIS spd 38.5 2.9 -32.6 7.7USD FRA-OIS spd 32.8 2.2 -23.0 12.31Y EUR-USD xccy basis -54.2 4.1 45.7 -27.3

CurrenciesEUR/USD 1.312 -0.010 0.020 -0.051USD/CHF 0.919 0.006 -0.024 0.037USD/JPY 81.78 0.15 4.08 0.95JPM Trade-weighted USD 80.83 -0.01 -1.41 0.23

Spreads (bp)30Y CC MBS L-OAS 38.9 -2.8 -7.1 -0.610Y AAA CMBS spd to swaps 220.0 5.0 -55.0 -90.0JULI portfolio spd to Tsy 196.9 4.3 -39.8 -17.6JPM US HY index spd to worst 635.0 12.4 -89.1 -83.9EMBIGLOBAL spd to Tsy 342.5 -5.3 -83.9 -38.6MAGGIE (Euro HG spd to govies) 163.0 -1.5 -64.9 16.6US Financials spd to Tsy 242.2 1.2 -88.5 -3.4Euro Financials spd to gov ies 234.9 -3.7 -117.3 25.110Y AAA muni/Tsy ratio (level) 98% 4.1% 3.4% -15.6%30Y AAA muni/Tsy ratio (level) 104% -1.1% -18.0% 1.6%

CommoditiesGold futures ($/t oz) 1698.70 -23.50 157.80 -74.60Oil futures ($/bbl) 107.40 0.70 8.57 19.63

* 3/8/12 level for Europe and US corporate credit spreads, and the J.P. Morgan trade-weighted USD index; 3/9/12 level for all others.


27

(see Municipals). Moreover, with the bulk of supply now coming in longer-term debt—since the ECB’s LTRO has significantly lowered short-term funding needs for banks (see Short-Term Fixed Income)—duration supply has been substantial. Heavy duration supply keeps us bearish on Treasuries, particularly in light of slowing foreign demand (see Treasuries).

In high grade and high yield, however, heavy supply has been met with strong demand. As Exhibit 3 shows, concessions on new issues have fallen to nearly zero due to robust demand. Given this supportive technical backdrop, we stay overweight both high grade and high yield.

Beyond elevated supply, the macro backdrop is not without headwinds, but we continue to expect positives to dominate negatives. This week’s data point to both a slowing of growth in the first quarter and continued healing of the labor market. Last week we highlighted the downside risk around our 1Q12 growth forecast due to soft consumption and a weak durable goods report. This week’s trade report showed that the trade deficit widened to $52.6bn in January, worse than expected, so we revise down our forecast for 1Q12 GDP growth from 2.0% to 1.5% (see Economics). In addition, the recent rise in energy prices does increase downside risks to growth. On the other hand, Friday’s employment report was solid: total nonfarm payrolls rose 227K in February, with upward revisions to the prior months, and the unemployment rate was unchanged at 8.3%.

What does this all mean for the upcoming FOMC meeting? We think the Fed is highly unlikely to announce additional asset purchases at next week’s meeting. Given that the Fed’s mandate is concerned with inflation and employment, not GDP growth, the slowdown in growth is worrisome, but it is unlikely to cause the Fed to embark on QE3. In addition, we think today’s solid jobs report has raised the bar for action at the April meeting as well (see “Jobs, growth, and the Fed,” Michael Feroli, 3/9/12).

However, as we have highlighted in past publications, the potential for an eventual QE3 remains, and if QE3 occurs, we would expect it to be supportive of risky assets. Furthermore, we would expect further asset purchases to be supportive of risky assets even if purchases are sterilized as has been suggested recently. This is because we find that risky assets have been more correlated with the size of the Fed’s securities holdings rather than the amount of reserves in the banking system.

Under a sterilized asset purchase program, the size of the Fed’s securities holdings will increase, but the total amount of reserves in the banking system would stay the same. In Exhibit 4, we show the partial betas and T-stats for two versions of our stylized model for spreads. Three of the variables remain the same in both versions—the 4-week average of jobless claims to proxy the economy, an average of French bank CDS to proxy the European crisis, and our Middle East crisis index—and then we use either the Fed’s securities holdings or total reserves to proxy QE. As the table shows, the magnitude of the partial betas for the Fed’s securities holdings is larger and statistically significant, while reserves are not generally statistically significant. Thus, if the Fed were to

Exhibit 2: Supply has been very strong in a number of markets recently… Monthly gross issuance of CMBS; $bn

0

1

2

3

4

5

6

7

Jan-

10

Mar

-10

Ma y

-10

Jul-1

0

Sep-

10

Nov-

10

Jan-

11

Mar

-11

Ma y

-11

Jul-1

1

Sep-

11

Nov-

11

Jan-

12

Mar

-12

Priced Expected

Source: Commercial Mortgage Alert

Exhibit 3: …but in high grade, it has been met with very strong demand New issue concessions* (10-day average); bp

0

20

40

60

80

100

120

Oct 07 Feb 09 Jun 10 Nov 11 * Note: Average new issue concession is the running average of the difference between the spread at which a new issue printed and the spread at which corresponding bonds trade in the secondary market. The average is a 10-day running average weighted by the size of the newly issued bond. Source: J.P. Morgan


28

eventually embark on an asset purchase program, whether sterilized or not, we would expect spreads to tighten as a result.

Another factor that we expect to continue to support risky assets is the decline in tail risks around Europe. Thanks to the Greek PSI and the accompanying EU/IMF aid package, near-term risks around Greece have fallen. First, we estimate that Greece’s gross debt burden has fallen by €106bn, with its upcoming interest payments reduced by around 1/3rd and upcoming bond redemptions reduced by around 2/3rds (see Overview, Global Fixed Income Markets Weekly, 3/9/12). Second, the debt restructuring effectively transforms much of Greece’s private debt into official-sector debt, which means less chance of a disruptive default in the near term.

As we have highlighted in the past, declining tail risk has led to increased risk appetite. Indeed, as Exhibit 5 shows, prime money funds increased their exposure to core European banks again in February. Furthermore, we highlight that unlike in January, when increased Eurozone bank exposures were driven more by investments in secured products like ABCP and repo, February’s increases were driven primarily by investments in unsecured products, reflecting improving tone (see Short-Term Fixed Income).

Thus, with tailwinds likely to outweigh the headwinds, we remain largely overweight risky assets. In corporates, we believe that the developments in Europe and the release of the bank stress test results next week should be positive, though ongoing active supply, weaker 1Q12 earnings and the pending Moody’s bank rating actions are offsets. However, we continue to believe that positive technicals will dominate and push spreads tighter over time (see Corporates).

In CMBS and ABS as well, increased supply has been easily absorbed by the market. Within CMBS, new issue single-As remain our top pick, while in ABS, we favor non-prime auto ABS, subordinate benchmark ABS, and USD-denominated foreign ABS.

In emerging markets, the pace of the rally has slowed, but we think a big correction is unlikely and we look for opportunities to add risk. We stay overweight EM sovereigns and corporates, and we trim our year-end EMBIG spread forecast to 325bp from 350bp, and CEMBI target to 350bp from 400bp (see Emerging Markets).

.

Exhibit 4: We find that risky asset spreads have been more correlated to the size of the Fed’s securities holdings than reserves, suggesting that a sterilized asset purchase program should benefit spreads Partial beta and T-stat for two versions of our stylized model for spreads*; spreads are in bp unless otherwise indicated

Beta T-stat Beta T-stat10Y AAA CMBS spd to swaps -0.078 -3.1 -0.025 -1.1JULI portfolio spd to Tsy -0.020 -2.3 -0.013 -1.7JPM US HY index spd to worst -0.084 -3.0 -0.048 -2.0US Financials spd to Tsy -0.031 -2.3 -0.017 -1.4S&P 500 (points) 0.158 5.9 0.117 4.8

Fed sec holdings Reserves

* 2-year regression of spreads or levels versus the 4-week average of jobless claims (000s), French bank CDS** (bp), our Middle East crisis index*** and either the size of the Fed’s securities holdings ($bn) or total reserves in the banking system ($bn); regression uses weekly data. ** Average of 5-year CDS for BNP Paribas, Credit Agricole, and Societe Generale. *** Defined as exp[0.5*(Brent oil prices – 0.1075*S&P + 3.6274*JPM Trade-weighted dollar index + 0.0959*EM stocks -348.34)/4.2]. EM stocks are defined as the weighted average of Brazil, Mexico, Russia, India, China, Hong Kong, Taiwan, Korea, Singapore, Malaysia, Thailand and Indonesia benchmark stock indices in USD terms. Weights determined by market values of the indices (in USD terms) as of year-end 2011. Source: Bloomberg, J.P. Morgan

Exhibit 5: Money market funds increased their exposure to Eurozone banks again in February Monthly change in prime money market fund exposures to Eurozone bank credit; $bn

-100

-50

0

50

100

Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Source: J.P. Morgan estimates, fund holdings reports

US Fixed Income Strategy Global Fixed Income Markets Weekly March 9, 2012 Terry BeltonAC (1-212) 834-4650 Meera Chandan (1-212) 834-4924 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC.

29

US Treasuries

• Valuations are still rich and sponsorship from Japan is likely to weaken in the near term …

• … we maintain our outlook for Treasury rates to increase gradually, still targeting 10-year yields to reach 2.5% by mid-year

• We discuss the impact of sterilization of QE; a $50 bn per month increase in term repo should increase 2-year Treasury rates by 5bp and cheapen 2-year Treasuries versus OIS by 2-3bp

• Increase exposure to well-hedged carry trades; 2s/6s Treasury steepeners hedged with EDM4/EDZ4 Eurodollar flatteners are especially attractive

• Initiate 5s/10s and 5s/30s weighted flatteners

• The latest Flow of Funds release shows demand for fixed income securities (Treasuries, GSE securities, and corporate debt) by international investors fell sharply in 4Q11 while FDI and cash holdings increased

• Tactically position for a steeper 10s/30s TIPS breakeven curve hedged for the nominal curve

Market views Treasury yields rose this week with 2-year yields increasing 4 bp, 5- and 10-year yields increasing 5 bp, and 30-year yields increasing 7 bp. The sell-off occurred as event risk in Europe fell with the completion of the Greek bond swap, while US economic data remained solid. The sell-off leaves 10-year Treasury notes yielding 2.04%, up 17 bp year-to-date, and 2 bp below the highs of the year.

Economic data released this week was solid with nonfarm payrolls increasing 227,000 in February (consensus = 210,000) and upward revisions showing job growth has averaged 245,000 over the past three months. Initial jobless claims data weakened modestly, but still show strength in the labor market with the 4-week average at 355K. The ISM nonmanufacturing survey increased by 0.5pts to 57.3, with the business activity and new orders components reaching their highest levels since February 2011. However, the January trade deficit increased for the third month in a row and came in larger

than expected at $52.6bn, further reinforcing a softening in growth in Q1. As a result, we have lowered our 1Q12 growth forecast to 1.5% from 2% while noting increased downside risks to our 2Q12 growth forecast of 2.5% (see Economics).

Looking ahead, we maintain our outlook for higher Treasury rates, and still target 10-year yields to reach 2.5% by mid-year (Exhibit 1). As discussed in recent weeks, the outlook is driven primarily by 1) rich Treasury valuations, 2) our analysis that suggests the risk premium in forward OIS rates is much too low given the large uncertainty around the Fed’s unemployment rate forecast, and 3) recent data highlighting a clear weakening in China’s sponsorship of Treasuries with China selling 9% of its Treasury holdings in 4Q11. More tactically, as we approach Japanese year-end, we expect sponsorship from Japanese investors to weaken; on average over the last 5 years, Japan has been a net seller of Treasuries during the mid-March to mid-April period.

Exhibit 2: Japan has historically been a net seller of Treasuries during the mid-March to mid-April period 1-month rolling sum of Japan’s net purchases of foreign bonds and notes by residents averaged in the business days around the 1st day in March; $bn

-10

-5

0

5

10

15

20

-50 -40 -30 -20 -10 0 10 20 30 40 50Business days around 1st trading day in March

Source: MoF

Exhibit 1: J.P. Morgan rate forecast %

Actual 1m ahead 2Q12 3Q12 4Q129 Mar 12 9 Apr 12 30 Jun 12 30 Sep 12 31 Dec 12

RatesEffective funds rate 0.11 0.10 0.10 0.10 0.103-mo LIBOR 0.47 0.40 0.45 0.50 0.503-month T-bill (bey) 0.08 0.04 0.02 0.02 0.02

2-yr Treasury 0.32 0.27 0.30 0.30 0.305-yr Treasury 0.90 0.95 1.25 1.25 1.2510-yr Treasury 2.04 2.05 2.50 2.50 2.5030-yr Treasury 3.19 3.15 3.60 3.60 3.60


30

This compares to an average of $15 bn of net buying during February (Exhibit 2). Finally, next week brings heavy duration supply with the Treasury auctioning $66 bn of 3s, 10s, and bonds for a total duration supply of $55 bn in 10-year equivalents.

To be sure, there are important offsets that are likely to keep any rise in rates muted. Demand for fixed income assets from US commercial banks remains strong with US banks buying $64 bn of securities during February or 9 times their average pace during 2011. Moreover, with payrolls behind us without incident, we would expect investors to re-enter carry trades, helping keep rates in their recent trading range. De-risking in front of this month’s payroll release was unusually large, with CFTC data showing speculative investors reduced front-end duration longs by 200,000 10-year futures equivalents in the last few weeks (Exhibit 3). Following the pattern in other periods where de-risking was large, these unwinds are likely to be reversed (Exhibit 4), with investors overweighting the high-carry parts of the yield curve.

The sell-off in the front end this week was helped by a report in the Wall Street Journal that the Fed was considering sterilizing any future asset purchases. This can be done either by conducting reverse repo operations or by offering term deposits to banks with the former having the benefit of placing less of a burden on bank balance sheets (see “Next moves for the Fed,” Michael Feroli, 3/8/12). While the near-term prospects for QE3 appear low, most of the centrist FOMC members have indicated support for further asset purchases if economic

data were to weaken. If QE3 were to occur, we would still place the odds of the Fed sterilizing its purchases at only around 50%. The main benefit would be to minimize an increase in inflation expectations; these rose sharply leading into all three asset purchase programs announced by the Fed that involved an increase in excess reserves. By contrast, inflation expectations fell leading into the Operation Twist when the Fed bought duration without increasing excess reserves (Exhibit 5).

Exhibit 3: Speculative investors derisked ahead of payrolls, reducing front-end duration longs … Rolling 1-month change in net longs held by non-commercial investors in ED, TU and FV contracts; 000s of 10-year contract equivalents

-500-400-300-200-100

0100200300400

2008 2010 2012

Source: CFTC

Exhibit 4: …but these unwinds are likely to be reversed Net longs held by non-commercial investors in ED, TU and FV contracts averaged around periods* in which large de-risking occurred; 000s of 10-year contract equivalents

160180200220240260280300320340

-20 -15 -10 -5 0 5 10 15 20Business days around derisking by spec investors*

* Net longs averaged in the business days around 9/3/10,7/8/11,6/4/10,3/4/11 and 9/2/11. Dates correspond to the 5 largest 1-month declines in net speculative longs (excluding year-end) since 2010.

Exhibit 5: Inflation expectations rose sharply leading into all three QE announcements that involved an increase in excess reserves, but fell leading into Operation Twist 5yx5y inflation swap rates averaged in the business days around QE announcements* and Operation Twist; %

2.4

2.6

2.8

3.0

3.2

3.4

-50 -40 -30 -20 -10 0 10 20 30 40 50

Operation TwistPre Operation Twist

Business days around Fed announcements

* Dates used are 11/25/08, 3/18/09 and 9/21/10 for pre Operation Twist, and 9/21/11 for Operation Twist.


31

The impact of sterilization on front-end rates would depend on whether the Fed uses term deposits or term repo. An increase in term deposits would likely have a very small or no impact on yields as banks are simply moving overnight reserves into reserves with a slightly longer term without directly impacting the supply of collateral in the short-term markets. By contrast, term repo done directly with money market funds would more directly increase the supply of short-term assets available to money funds and be akin to an increase in Treasury bill supply. Based on the historical relationship between bill supply and front-end rates, we estimate a $50 bn per month increase in term repo should increase 2-year Treasury rates by 5 bp (Exhibit 6). To be sure, 2-year Treasury rates are already quite elevated largely because of a seasonal increase in bill supply during February and March. This supply could keep front-end rates elevated for a few more weeks but is likely to reverse in April as bill supply turns sharply negative.

The impact of sterilization on Treasury/OIS spreads is less clear although on balance, we would expect 2-year Treasury-OIS spreads to widen (i.e., Treasuries to cheapen) by 2-3 bp. Historically, a $50 bn increase in monthly bill supply has caused 2-year Treasury-OIS spreads to widen by 4 bp as the increase in front-end supply increases GC repo rates. However, because the Fed can do term repos directly with the GSEs, sterilization will increase OIS by a larger amount than when bill supply increases, as it causes GSEs to move

short-term assets from Fed funds into term repo with the Fed. This switch from Fed funds should be quite attractive to the GSEs as they can increase yield without increasing their credit exposure.

On the yield curve, we recommend increasing exposure to carry trades and find Treasury curve steepeners hedged with Eurodollar curve flatteners attractive. In particular, we recommend 2s/6s Treasury steepeners hedged with a EDM4/EDZ4 Eurodollar flattener (see Trade recommendations). This trade has been weighted to be market-neutral and the entry level is attractive with the weighted spread at its 1-year low (Exhibit 7). The 3-month weighted carry and roll is 5.1bp, and the risk-adjusted carry (i.e. the carry and roll in the trade divided

Exhibit 7: Weighted 2s/6s steepeners hedged with 9th/11th ED flatteners are currently at their 1-year lows 0.33 * 6-year yields – 2-year yields – (0.85 * 11th ED yield – 9th ED yield); %

-0.06

-0.04

-0.02

-0.00

0.02

0.04

0.06

0.08

0.10

Jun 11 Sep 11 Dec 11 Mar 12

Exhibit 6: A $50 bn per month increase in term repo should increase 2-year Treasury rates by 5-6 bp 1-month average of the residual* of 2-year yields to fair value (bp) versus the monthly net issuance of T-bills ($bn)

-20

-15

-10

-5

0

5

10

15

-60 -40 -20 0 20 40 60 80 100Net issuance of Tbills; $bn

Y = 0.1059 X1 - 0.4399R² = 24.62%standard error = 8.1712period = Mar 09,11 - Mar 09,12

* Residual is actual minus fair value where fair value of 2-year Treasury yields (%) estimated as 0.0858 + 0.219 * 5yx5y inflation swap rates (%) + 0.94 * 3mx3m OIS rates (%) – 0.0017*semi-peripheral Europe CDS (bp) – 0.093* J.P. Morgan positions index

Exhibit 8: Look for the long-end of the curve to flatten in coming weeks 0.71 * 30-year yields – 5-year yields and 0.63 * 10-year yields minus 5-year yields averaged in the business days around the last six 30-year auctions; %

1.241.251.261.271.281.291.301.311.321.33

0.3300.3350.3400.3450.3500.3550.3600.3650.3700.3750.380

-8 -6 -4 -2 0 2 4 6 8Business days around the 30-year auction

5s30s5s10s


32

by the 2-year standard deviation of 3-month changes in the weighted trade) is 86%.

We also recommend initiating 5s/10s and 5s/30s weighted flatteners as tactical trades to position for cyclical patterns around supply. The 5s/10s and 5s/30s curves have flattened in the week following 10-year and bond supply in 4 of the last 6 auction cycles (Exhibit 8). Given that both curves are near the steep end of their recent trading range, and that forward OIS is rich, we expect the pattern to repeat itself this cycle, and favor intermediate and long-end flatteners (see Trade Recommendations).

Flow of Funds data The Federal Reserve released Flow of Funds data for 4Q11 this week, providing additional information on the composition of investor demand for Treasuries during the quarter. The following observations are noteworthy from the latest release.

First, the data is consistent with the TIC holdings released last week and shows that foreign sponsorship declined in 4Q11 after increasing in 3Q11 (US Fixed Income Markets Weekly, 3/2/12). As discussed in our previous publication, lower demand was driven by China, which went from buying $16bn per month on average to selling $26bn in 2Q11. Selling was concentrated primarily in 4Q11. China sold $118bn of Treasuries in 4Q alone, or 9% of their Treasury portfolio.

Second, the data suggest a broader reallocation by international investors out of fixed income securities into cash and direct investments during 4Q11. International investors were net sellers of spread product (GSE securities as well as corporate debt) during the quarter while FDI and cash increased significantly (Exhibit 9). Finally, the data did not shed much light on which investors ramped up buying in 4Q11 to make up for the lost demand by international investors. As shown in Exhibit 10, while average monthly net Treasury purchases by broker dealers and money-market funds were $21bn and $10bn higher relative to their longer-term average in 4Q11, the amount of net buying attributed to households (a residual line item used by the Fed to account for gaps in the data) increased by $45bn.

Exhibit 9: International investors shed Treasury holdings in 4Q11, preferring FDI and cash instead Average monthly net buying of various USD financial assets by international investors; $bn

-10

0

10

20

30

40

50

FDI

FF/ R

epo

Tsy

Othe

r

Depo

sits

CP

Equit

ies GSE

Corp

orat

es

Prior 1y avg4Q11

Source: Federal Reserve Z.1

Exhibit 11: The 10s/30s breakeven curve is near historically flat levels… 1-month forward 10s/30s TIPS breakeven curve*; bp

-20

0

20

40

60

80

100

Mar 02 Jul 03 Dec 04 Apr 06 Sep 07 Jan 09 May 10 Oct 11 Note: We look at the 1-month forward curve to remove the impact of near-term carry.

Exhibit 10: The data did not shed much light on which investors ramped up buying in 4Q11 to make up for the lost demand by international investors Average monthly Treasury net purchases by various investor type; $bn

Households 48 3 45Broker dealers 21 0 21International investors 17 42 -25Money market funds 10 0 10Private pension funds 8 11 -4Mutual funds 7 4 3GSEs 2 2 0U.S.-chartered commercial banks 1 2 -1Fed -4 43 -47SLG ex employee retirement funds -4 -2 -2Other 4 4 0Total 110 110 0

4Q11 DifferenceDescription Avg since 2010

Source: Federal Reserve Z.1


33

This line item often gets revised in subsequent quarters as new data is released, and we will look for more information on this front in the coming months.

TIPS Breakevens widened modestly this week as nominal yields rose and oil prices rallied. Despite the Fed selling $1.33bn front-end TIPS on Monday, the breakeven curve ended the week flatter: 5-, 10-, 20- and 30-year breakevens widened by 8bp, 5bp, 6bp, and 6bp, respectively.

We remain bullish on TIPS breakevens given our bearish view on duration and our positive view on risky assets. In addition, carry in long breakeven positions is likely to remain attractive. We expect next week’s CPI report to show a 0.59% increase in headline CPI in February, which implies that 10-year TIPS breakevens will carry positively by 3.3bp in April.

On the curve, we recommend positioning for a steeper 10s/30s breakeven curve. As Exhibit 11 shows, the 10s/30s breakeven curve is near historically flat levels (excluding the 2008-09 crisis), and is at its flattest levels since benchmark 30-year TIPS were reintroduced in February 2010. With the curve close to pancake flat, we think further flattening will likely be limited. In addition, the breakeven curve currently looks too flat relative to the nominal 10s/30s curve and oil prices (Exhibit 12). Furthermore, we think there are two factors that could support a steepening of the 10s/30s breakeven curve over

the very near term. Next week Wednesday, we have both a 30-year nominal bond auction and a Fed purchase operation in TIPS. As Exhibits 13 and 14 show, the 10s/30s breakeven curve (hedged for the nominal curve) has tended to steepen around both these events. Over the past year, the breakeven curve has steepened ahead of a nominal bond auction in 8 out of 12 cycles. In addition, the breakeven curve has steepened around four of the five Fed purchase operations under Operation Twist. This steepening likely reflects the Fed’s strong preference for the long end: under Operation Twist, it has purchased $5.4bn on-the-run and old 30-year TIPS, and none of the

Exhibit 12: …and looks too flat relative to the nominal curve and oil 1-month forward 10s/30s TIPS breakeven curve regressed against 10s/30s nominal curve (bp) and rolling front Brent oil futures contract price ($/bbl); past 1 year; bp

40

45

50

55

60

65

70

75

90 100 110 120 130 140 150

Nominal 10s/30s curve; bp

Y = 0.48(nom 10s/30s curve) - 0.30(oil)-1.86R-sq = 71%

Current

Exhibit 14: …and Fed purchase operations in TIPS Hedged* Jan-21/Feb-41 TIPS breakeven curve averaged around Fed purchase operations; 10/11-2/12; bp

-36

-35

-34

-33

-32

-31

-5 -4 -3 -2 -1 0 1 2 3 4 5Business days around Fed purchase operation

* Hedged for the nominal curve using the 1-year beta partial beta of 1-month forward 10s/30s breakeven curve regressed against 10s/30s nominal curve and oil as of the start of cycle (T-5 date).

Exhibit 13: The 10s/30s breakeven curve has tended to steepen around 30-year nominal auctions… Hedged* Jan-21/Feb-41 TIPS breakeven curve averaged around nominal 30-year bond auctions; 3/11-2/12; bp

-26.0

-25.5

-25.0

-24.5

-24.0

-23.5

-23.0

-10 -5 0 5 10Business days around 30-year nominal auction

* Hedged for the nominal curve using the 1-year beta partial beta of 1-month forward 10s/30s breakeven curve regressed against 10s/30s nominal curve and oil as of the start of cycle (T-10 date).


34

on-the-run/old 10-year TIPS. Thus, we recommend tactically positioning for a steepening of the 10s/30s breakeven curve.

Trade recommendations • Initiate 2s/6s steepeners hedged with 9th/11th

Eurodollar flatteners We recommend increasing exposure to carry trades. This weighted trade carries well (3-month weighted carry and roll at 5.1bp; 2-year standard deviation of 3-month changes of 5.9; risk adjusted carry of 86%) and is at an attractive entry level, with the weighted spread at its 1-year low.

− Buy 100% risk, or $475.6mn notional of T 0.25% Feb-14s (yield: 0.318%; bpv: $196/mn). Sell 33% risk, or $50mn notional of T 2.875% Mar-18s (yield: 1.17%; bpv: $615/mn). Sell 100% risk, or 3,725 EDM4 contracts (price: 99.075). Buy 85% risk, or 3,166 EDZ4 contracts (price: 98.805). Weighted spread is -2.2bp. Three-month weighted carry and roll is 5.1bp.

• Initiate 5s/10s and 5s/30s flatteners The 5s/10s and 5s/30s curves have flattened in the week following 10-year and bond supply in 4 of the last 6 auction cycles. Given that both curves are near the steep end of their recent trading range, and that forward OIS is rich, we expect the pattern to repeat itself this cycle, and favor intermediate and long end flatteners.

− Sell 100% risk, or $148.6mn notional of T 0.875% Jan-17s (yield: 0.889%; bpv: $477/mn). Buy 63% risk, or $50mn notional of T 2% Feb-22s (yield: 2.034%; bpv: $893/mn). Weighted spread is 39.2bp. One-month weighted carry is -0.3bp and roll is -1.1bp.

− Sell 100% risk, or $281.3mn notional of T 0.875% Jan-17s (yield: 0.889%; bpv: $477/mn). Buy 71% risk, or $50mn notional of T 3.125% Feb-42s (yield: 3.185%; bpv: $1905/mn) Weighted spread is 137.2bp. One-month weighted carry is -0.5bp and roll is -2.1bp.

• Tactically position for a steeper 10s/30s breakeven

curve The 10s/30s breakeven curve is near historically flat levels and looks too flat relative to the level of the nominal curve and oil. In addition, the curve is likely to tactically steepen around the upcoming 30-year

nominal bond auction and Fed purchase operation in TIPS. Thus, we recommend positioning for a steepening of the 10s/30s breakeven curve hedged for the level of the nominal curve.

− Sell 100% risk, or $25mn notional of TII 0.125% Jan-22s (yield: -0.250%; bpv: $1016/mn). Buy 100% risk, or $9.7mn notional of TII 0.75% Feb-42s (yield: 0.808%; bpv: $2630/mn). Buy 50% risk, or $14.2mn notional of T 2% Feb-22s (yield: 2.034%; bpv: $893/mn) Sell 50% risk, or $6.7mn notional of T 3.125% Feb-42s (yield: 3.188%; bpv: $1905/mn) Unweighted breakeven curve spread is 9.6bp. Weighted spread is -48.1bp. Two-week carry is -0.8bp and 2-week roll is -0.4bp.

• Stay overweight 4s and 8s versus 6s − Stay overweight 69% risk, or $151.7mn notional of T

3.25% May-16s (yield: 0.742%). Stay underweight 100% risk, or $168.7mn notional of T 2.25% Nov-17s (yield: 1.093%). Stay overweight 40% risk, or $50mn notional of T 3.375% Nov-19s (yield: 1.565%). (US Fixed Income Markets Weekly, 3/2/12). P/L since inception: -1.0bp of yield.

• Stay in 2s/7s steepeners hedged with reds/ greens

flatteners − Stay overweight 100% risk, or $170.1mn notional of T

0.25% Feb-14s (yield: 0.320%). Stay underweight 98% risk, or $50mn notional of T 1.375% Feb-19s (yield: 1.426%). Stay underweight 98% risk, or 1,327 EDM3 contracts (price: 99.375). Stay overweight 100% risk, or 1,354 EDZ4 contracts (price: 98.80). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: -1.4bp of yield.

• Maintain exposure to belly cheapening trades − Stay overweight 94% risk, or $307.1mn notional of T

0.25% Feb-15s (yield: 0.445%). Stay underweight 100% risk, or $157.4mn notional of T 2.75% Feb-18s (yield: 1.147%). Stay overweight 42% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.583%). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: -2.0bp of yield.

− Stay overweight 75% risk, or $191.7mn notional of T 0.25% Jan-15s (yield: 0.433%). Stay underweight 100% risk, or $112.8mn notional of T 1.25% Jan-19s (yield: 1.409%).


35

Stay overweight 54% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.583%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -6.7bp of yield.

• Stay underweight May-38s versus May-37s − Stay overweight 100% risk, or $48.9mn notional of T

5% May-37s (yield: 3.031%). Stay underweight 100% risk, or $50mn notional of T 4.5% May-38s (yield: 3.063%). (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: +0.3bp of yield.

• Stay underweight on-the-run 10s versus triple olds − Stay underweight 100% risk, or $50.6mn notional of

2% Feb-22s (yield: 2.036%). Stay overweight 100% risk, or $50mn notional of T 3.125% May-21s (yield: 1.877%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -0.8bp of yield.

• Stay in weighted 2s/3s steepeners − Stay overweight 100% risk, or $219.8mn notional of T

0.125% Dec-13s (yield: 0.315%). Stay underweight 70% risk, or $100mn notional of T 0.25% Jan-15s (yield: 0.433%). (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -1.8bp of yield.

• Stay in weighted 4s/25s steepeners hedged with

reds/10s flatteners − Stay overweight 96% risk, or $156.8mn notional of T

2.125% Feb-16s (yield: 0.67%). Stay underweight 78% risk, or $25mn notional of T 4.75% Feb-37s (yield: 3.033%). Stay overweight 100% risk, or $76.4mn notional of T 2% Nov-21s (yield: 1.996%). Stay underweight 100% risk, or 2,732 EDM3 contracts (price: 99.375). (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -5.0bp of yield.

• Stay overweight 6.5% Nov-26s versus a weighted barbell of Aug-23s/Feb-31s

− Stay underweight 62% risk, or $39mn notional of T 6.25% Aug-23s (yield: 2.173%). Stay overweight 100% risk, or $50mn notional of T 6.5% Nov-26s (yield: 2.566%). Stay underweight 38% risk, or $16.5mn notional of T 5.375% Feb-31s (yield: 2.805%). (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: -2.7bp of yield.

• Stay underweight Apr-14 TIPS versus Jan-14 TIPS − Stay long 100% risk, or $25mn notional of TII 2%

Jan-14s (yield: -1.937%); Stay short 100% risk, or $25.4mn notional of TII 1.25% Apr-14s (yield: -2.022%); (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: +3.3bp of yield.

Closed trades in 2012 P/L reported in bp of yield unless otherwise indicated TRADE ENTRY EXIT P/LNominal Treasuries10-year duration shorts 01/20/12 02/10/12 -11.1

CurveUnderweight 4s versus 3s and 7s 12/09/11 01/06/12 0.9Buy 2.375% Jun-18s versus 1.875% Oct-17s 10/14/11 01/06/12 -2.87s/30s flatteners 01/06/12 01/27/12 -14.2Buy Nov-21 Cs versus Ps 09/23/11 01/06/12 -0.24s/6s steepeners vs. reds/greens flatteners 01/06/12 01/27/12 3.07s/30s flatteners 02/10/12 02/24/12 3.53s/7s flatteners 02/12/12 02/24/12 8.5

Misc.Sell 2s versus OIS 12/09/11 01/06/12 0.8Buy 5s versus OIS 01/06/12 02/04/12 5.0Sell 2-year Treasuries vs. JGBs swapped into USD 08/12/11 02/10/12 44.0Buy the March CTD Bond basis 12/09/11 02/24/12 1/32nds

TIPSSell 5-year TIPS on a breakeven basis 12/16/11 01/20/12 -12.3

US Fixed Income Strategy Global Fixed Income Markets Weekly March 9, 2012 Srini RamaswamyAC (1-212) 834-4573 Praveen Korapaty (1-212) 834-3092 Alberto Iglesias (1-212) 834-5116 J.P. Morgan Securities LLC.

36

US Interest Rate Derivatives

• Stay biased towards narrower intermediate maturity swap spreads hedged for FRA-OIS, and maintain outright wideners in the 30-year sector

• With today’s payrolls report validating the recent improving trend in labor markets, the upside risk to the Fed’s projected path of the funds rate remains in focus. Positioning for an eventual renormalization of the yield curve is thus an attractive theme; however, given the considerable uncertainty around timing, such trades will need to exhibit several important characteristics—positive carry, relatively little exposure to outright yield levels locally, attractive entry levels relative to the recent trading range, as well as significant upside in the event of a renormalization. We identify several trades that exhibit these characteristics …

• … initiate Reds/10Y swap curve steepeners hedged with weighted 2Y/Blues flatteners

• We recommend short gamma positions in the 10-year sector; returns from even actively delta-hedged gamma positions are likely to exhibit directional exposure to yield levels, but hedged for rates, selling 3Mx10Y delta-hedged straddles is likely to prove profitable

• The opposite is true at the front end—buy 3Mx2Y swaption straddles hedged with a weighted long in 2-year swaps

Swaps Swap spreads are largely unchanged over the past week, with front-end spreads modestly wider and back-end spreads slightly narrower. For instance, maturity matched swap spreads are 0.5bp wider in the 2-year sector relative to week-ago levels, but 1-1.5bp narrower in the 10- to 30-year sector.

Issuance activity remains strong; month-to-date issuance in March has been near $45bn, in excess of last year’s run-rate, after an above-average issuance month in February. In all, the pace of overall fixed-rate issuance remains quite strong (Exhibit 1); however, with non-financial firms dominating recent issuance (who tend to swap smaller fractions of overall issuance), swapping activity is likely more modest but still an important factor

pressuring intermediate spreads narrower in coming months.

Beyond issuance-related technicals, the broader macro backdrop continues to point to a stable outlook for swap spreads overall. Funding stresses stemming from the European crisis have now largely moderated, auguring stability in FRA-OIS spreads in the near term; budget deficit expectations remain relatively stable, trending narrower only very slowly and remaining near $1Tn; Treasury coupon issuance sizes have remained unchanged since late 2010; and there is little reason to expect a near-term rise in Fed tightening expectations. Thus, the bigger picture remains one of relatively rangebound spreads.

Given such a context, our strategy in swap spreads remains centered around taking advantage of cheap/rich valuations, as well as opportunities that arise due to seasonal trends (while being careful to hedge out other risk factors). In that vein, we remain biased towards wider long-end swap spreads (with 30-year spreads continuing to appear narrow versus fair value), and we recommend staying biased towards narrower 10-year swap spreads (due to our expectations of rising issuance and related swapping activity, as outlined earlier), hedged with FRA-OIS wideners.

Exhibit 1: Corporate issuance remains elevated Monthly total fixed rate long term issuance; $bn

0

20

40

60

80

100

Mar

07Ju

n 07

Sep 0

7De

c 07

Mar

08Ju

n 08

Sep 0

8De

c 08

Mar

09Ju

n 09

Sep 0

9De

c 09

Mar

10Ju

n 10

Sep 1

0De

c 10

Mar

11Ju

n 11

Sep 1

1De

c 11


37

At the front end of the curve, risks to spreads remain balanced and we stay neutral. On the one hand, the threat of bank downgrades remains a potential source of upside pressure. This, however, is balanced by the fact that central banks (and the ECB in particular) stand ready to provide liquidity to the banking system. Also, on the margin, this week’s indications that the Fed could possibly sterilize its reserve creation in any future asset purchase programs (likely via reverse repos) are also supportive of narrower swap spreads. Should such sterilization occur (and in the form of reverse repos), this would essentially have the effect of a large (albeit temporary) increase in T-bill supply, at the expense of reduced issuance in longer tenors. Our Treasury strategists estimate that 2-year Treasury-OIS spreads could cheapen by 2-3bp, suggesting that front-end swap spreads could be biased narrower by a similar amount. To be sure, we do not see this as imminent going into next week’s FOMC meeting; it is however, a new possibility that has come into focus this week, with (on the margin) a narrowing influence on front-end spreads. Given offsetting influences in this sector, we therefore remain neutral on front-end swap spreads.

Swap yield curve renormalization In the past few months, since the Fed began publishing its forecast for the funds rate (specifically suggesting a stable funds rate well into late 2014), swap yield levels and the curve have settled into a new regime, with yield levels lower, the curve flatter, and relative volatilities between different sectors shifting as rates have fallen closer to the zero barrier. More recently, risks have emerged to the Fed’s projections of a stable funds rate, at least for forward horizons such as late 2014. The sharp decline in the unemployment rate (which has fallen 0.7%-age points in the last nine months or so) highlights this risk. As our Treasury strategists have pointed out, even assuming a stable participation rate going forward, there is still material risk of a lower unemployment rate (relative to the Fed’s baseline forecast) at a 2-year forward horizon, implying upside risk to the Fed’s own projections of the appropriate funds rate at such a horizon. To be clear, we are not forecasting a material decline in the unemployment rate or any Fed tightening in the near term. However, as we have noted often in recent weeks, risks of such an outcome remain underpriced into forwards. Even though Dec-2014 forward OIS rates have risen off their recent lows, they remain well below their 6-month-ago levels (Exhibit 2), despite the significant decline in labor market slack since then.

Looking ahead in the medium term, a renormalization of the yield curve is likely if future employment reports

Exhibit 3: Several trades offer attractive ways to position for a renormalization of the yield curve to pre-August levels … Weighted spreads with no current exposure* to 3Mx2Y swap rates, current carry and entry level**, average in the past 6 months and in the 6 months prior to 7/29/2011 and prior exposure to 3Mx2Y rates

Trade Weights Recent Prior Difference-3Mx10Y/+REDS/+BLUES/-3Mx2Y -1/1/0.485/-1.113 0.6 1.49 1.88 0.40 0.06 -0.44-3Mx5Y/+BLUES/-2Yx5Y/-3Mx2Y -0.105/1/-1/-0.275 1.0 0.81 1.01 0.20 0.16 -0.33+BLUES/-1Yx5Y/-2Yx5Y/-3Mx2Y 1/-0.09/-1/-0.299 1.0 0.84 1.05 0.21 0.18 -0.33-3Mx5Y/+BLUES/-1Yx5Y/+3Mx2Y -0.309/1/-1/0.115 1.2 0.34 0.39 0.04 0.07 -0.32

+BLUES/-2Yx5Y/-3Mx2Y 0.929/-1/-0.302 0.8 0.81 1.01 0.21 0.17 -0.32+BLUES/-1Yx5Y/+3Mx2Y 0.791/-1/0.036 0.7 0.33 0.40 0.07 0.10 -0.32

-3Mx7Y/+BLUES/-2Yx5Y/-3Mx2Y -0.096/1/-1/-0.306 1.0 0.86 1.08 0.21 0.17 -0.31+GREENS/+BLUES/-2Yx10Y/-3Mx2Y 1/0.178/-1/-1.083 1.0 2.15 2.56 0.40 0.02 -0.24

-3Mx7Y/+BLUES/-1Yx5Y/-3Mx2Y -1/1/-0.33/-0.03 1.7 0.70 0.78 0.08 0.05 -0.16-3Mx7Y/+BLUES/-3Mx2Y -1/0.739/-0.042 1.4 0.59 0.65 0.06 0.02 -0.12-3Mx10Y/+2Yx2Y/-3Mx2Y -1/0.897/-0.514 1.6 1.37 1.58 0.21 0.00 -0.11

Carry (bp)

Prior exposure to 2Y rates

Entry level z-score

Weighted spread avg (%)

* Exposure is defined as the 6-month beta of weekly changes between weighted spread and 3Mx2Y swap yield. ** 6-month z-score of weighted spread.

Exhibit 2: Even though forward OIS rates have rebounded from recent lows, they remain well below pre-August levels 1-month OIS rate at a 12/31/2014 forward horizon; %

0.50.60.70.80.91.01.11.21.31.41.5

Nov 11 Jan 12 Mar 12

Forward OIS rate; %

Exhibit 4: … such as Reds/10Y steepeners, hedged with weighted 2Y/Blues flatteners 3Mx10Y minus 1Yx1Y + 1.11*3Mx2Y minus 0.485*3Yx1Y swap yields, average in the past 6 months and in the 6 months prior to 7/29/2011; %

1.3

1.4

1.5

1.6

1.7

1.8

1.9

2.0

Jun 11 Sep 11 Dec 11 Mar 12

Recent average

Prior average


38

validate the recent trend, and/or if the Fed modifies its language to refer to downside risks to the unemployment rate or the data-dependent nature of its funds rate projections. Given today’s strong employment report and the upcoming FOMC meeting, a focus on such a renormalization in the yield curve is likely the right theme at the present time.

Positioning for such a renormalization can however be tricky. Outright shorts at the front end are not particularly attractive, given that the Fed’s near-term policy is likely to be very stable, and the timing of any Fed action/communication change is very uncertain. Thus, any trade designed to position for a yield curve renormalization should ideally possess the following characteristics. First, it should exhibit relative little directional exposure to front-end yield levels in the current rangebound yield environment, in light of the above discussion. Second, the trade should have close to zero, or even positive carry; this is essential to being able to hold the trade for a prolonged period of time until eventual renormalization. Third, the weighted yield spread corresponding to the trade should have exhibited little directional exposure to front-end yields in the months prior to August 2011—this would indicate stability of the risk weightings used in the trade. Fourth, the entry level on the trade should be favorable, in normalized terms relative to the average levels in recent months. Last but not least, the weighted yield spread corresponding to the trade–which would have been roughly mean-reverting prior to August 2011 as well as in the months since–should have experienced a discrete shift of significant magnitude in its average, a consequence of the regime shift triggered by the Fed’s communications policy since August 2011. In the event of yield curve renormalization, we may reasonably assume that the mean would shift back to its pre-August levels, thereby providing the rationale for trade.

Exhibit 3 provides a list of several trades that meet the above mentioned criteria, and Exhibit 4 illustrates the characteristics of one of the those trades. As can be seen, in the case of a Reds/10Y steepener hedged with a weighted 2Y/Blues flattener, the weighted yield spread has been relatively mean-reverting both prior to August 2011 as well as recently, albeit around different means in the two regimes. In addition to its flat-to-modestly-positive carry, a yield curve renormalization would likely cause the mean to shift back up by about 40bp, making this trade an attractive way to position for a potential change in yield curve regime. Therefore, we now recommend initiating Reds/10s steepeners, hedged with a

1.11:0.48 weighted 3Mx2Y/Blues flattener (see Trade recommendations).

Options Implied volatilities were generally unchanged for the week, rising before the payrolls report on Friday, and falling in the aftermath. For instance, 3Mx10Y implied volatility ended the week lower by 0.1bp/day over the prior week, having been up before payrolls, and then dropping 0.2bp/day on Friday. Implied volatilities on longer expiries, as well as shorter tails, were relatively more stable over the week. Realized volatility fell across the volatility grid, causing short volatility positions to outperform (Exhibit 5).

Looking ahead, with the payrolls report now behind us, we now turn bearish on short expiry volatility in the 10-year sector, but recommend adding a pay-fixed swap to hedge the directional nature of short gamma positions.

Exhibit 6: Normal volatilities have become highly directional with rates 3Mx10Y implied volatility (bp/day) versus level of 3Mx10Y rate (%)

5.25.35.45.55.65.75.85.96.06.16.2

1.95

2.00

2.05

2.10

2.15

2.20

2.25

2.30

12 Jan 26 Jan 09 Feb 23 Feb 08 Mar

3Mx10Y implied volatility3Mx10Y rate

Exhibit 5: Short volatility positions were profitable this past week P/L* from short straddles in various options instruments since 3/2/12 and current levels of volatility; bp of notional**

Return Return

Theta Adj** Gamma PL Vega PLCurrent

Implied VolCurrent

Realized Vol6M2Y 1 6 0.2 0.3 2.4 2.26M5Y 3 7 1.3 1.4 4.3 4.06M10Y 7 7 4.0 2.7 5.8 4.46M30Y 22 9 3.3 18.4 6.0 4.8Front FV 2 7 -9.9 12.3 3.9 3.7Front TY 14 16 18.7 -4.9 5.6 4.5Front US 40 21 18.4 22.0 6.3 4.8 * Returns calculated using the J.P. Morgan Volatility Index, which assumes daily delta rebalancing and zero transaction costs. Options are re-struck at the start of each month. ** Adjusted to a theta-neutral amount of 6Mx10Y swaptions.


39

Our model for look-ahead delta-hedged returns from short 3Mx10Y straddle positions is currently projecting attractive returns from selling gamma in this sector (around 40bp of notional, which is nearly twice the standard error of the model); however, the model also uses contemporaneous yield levels as a factor, meaning that if yields were to rise over the next month, short gamma positions could suffer a loss as a result.

Why do daily-delta-hedged returns from short gamma positions still exhibit directional exposure? In part this is because the compressive effect of the zero boundary causes yields to become more lognormal at low yield levels, which is evidenced by the directional nature of ATMF 3Mx10Y implied volatility (Exhibit 6). Using lognormal deltas for delta-hedging (rather than normal deltas, which we use for analysis) could mitigate this effect, but not fully. Even fixed-strike implied volatilities show directional exposure, which is partly a reflection of the fact that the market’s option coverage needs are themselves asymmetric, with greater option demand at higher yield levels.

In sum, in the current regime, returns from short-expiry positions are likely to remain highly directional, which poses a risk to short gamma positions; such positions, however, are likely to be profitable if rates remain rangebound, which remains highly likely in the near term. Therefore, to take advantage of the likely attractiveness of selling gamma, while also guarding against the prospect of higher yields, we recommend selling 3Mx10Y swaption straddles, hedged with a pay-fixed swap (see Trade recommendations).

In the 2-year and 5-year sector as well, the directional exposure of delta-hedged volatility positions to yields is similarly high. This is seen, for instance, in the high (and statistically very significant) coefficients on the yield factor that we estimate in our model for look-ahead delta-hedged returns from short gamma positions in these sectors (Exhibit 7). Indeed, because of the lower level of front-end yields, volatility returns on these tails tend to have a stronger and more statistically significant dependence on rates. Interestingly, assuming relatively rangebound yields, our model suggests that long positions in 3Mx2Y volatility are now likely to be profitable.

While the magnitude of the projected return on long gamma positions in the 3Mx2Y sector is relatively modest (slightly less than the standard error of the model), such long gamma positions at the front end are

nonetheless attractive for the following reasons. First, if our model forecast is correct, long delta-hedged straddles at the front end would result in a positive carry position net of estimated delta hedging costs and the carry on the swap hedge, which is attractive given the backdrop of rangebound front-end yields. Second, as also seen in Exhibit 7, these positions are likely to offer exposure to positive economic surprises. Third, as we discuss in earlier sections, an eventual renormalization in the yield curve would likely cause front-end implied volatility to shift upwards as well. Therefore, at the front end of the curve, we now recommend buying 3Mx2Y swaption straddles on a delta-hedged basis, with a receive-fixed swap against it to hedge the likely directional exposure of returns from this trade (see Trade recommendations).

Trade recommendations • Initiate Reds / 10Y steepeners hedged with

weighted 2Y / Blues flatteners This trade provides an attractive way to position for a possible renormalization of the yield curve to a pre-August 2011 regime–a likely outcome if future employment reports continue the strong trend. It exhibits little directionality currently and carries modestly positive, and the weighted spread corresponding to this trade is likely to revert sharply higher if and when the yield curve eventually normalizes.

Exhibit 7: Returns on long gamma positions on shorter tails show greater sensitivity to level of rates, as well as economic surprises 1-month return forecast for delta-hedged long-straddles*; bp of notional

3Mx5Y ModelCoefficient T-statistic

3Mx5Y implied vol (bp/day) -26.7 -13.5 4.02EASI index 0.54 5.7 -16.7

JP Morgan postions index 71.46 12.1 0.143mx5y rate level (%) 50.20 11.9 1.26

Intercept 41 5.7Long straddle returns (bp of notional) -3

R2

Std Error3Mx2Y Model

Coefficient T-statistic3Mx2Y implied vol (bp/day) -13.3 -21.3 2.22

EASI index 0.11 4.1 -16.73mx2y rate level (%) 56.9 20.3 0.62

Intercept 1.15 0.7Long straddle returns (bp of notional) 5

R2

Std Error

18-month model

62%22.5

18-month model

61%7.0

Current value

Current value

* Returns calculated using the J.P. Morgan Volatility Index, which assumes daily delta rebalancing and zero transaction costs. Options are re-struck at the start of each month.


40

− Initiate a 1Yx1Y/3Mx10Y swap curve steepener hedged with a weighted 3Mx2Y/3Yx1Y curve flattener (1.11/0.485 weights) at a weighted yield spread (defined as 3Mx10Y minus 1Yx1Y + 1.11*3Mx2Y minus 0.485*3Yx1Y) of -145.5bp. 3M carry and slide on this trade is approximately 0.4bp.

• Sell delta-hedged 3Mx10Y swaption straddles

layered with a duration short Ten-year tails have been relatively sticky over the past few months, and given levels of drivers of realized vol in this sector, selling gamma is likely to result in positive returns. However, given the directionality of vol returns with rates, we recommend overlaying a short duration position to offset the risk of a move higher in rates.

− Sell $100mn notional of 3Mx10Y swaption straddles (notification date 6/11/2012, maturity date 6/13/2022, ATMF and strike 2.189%, premium 329bp) versus paying fixed in $10.7mn notional of a 3Mx10Y forward starting swap (swap start date 6/13/2012, swap end date 6/13/2022). This trade requires frequent delta rebalancing.

• Buy delta-hedged 3Mx2Y swaption straddles

layered with a duration long Long gamma positions in the 2-year sector offer a relatively inexpensive asymmetric way to position for positive economic surprises. The directionality of this position with rates requires a long duration overlay, which generates positive carry.

− Buy $100mn notional of 3Mx2Y swaption straddles (notification date 6/11/2012, maturity date 6/13/2014, ATMF and strike 0.620%, premium 29.3bp) versus receiving fixed in $28.6mn notional of a 3Mx2Y forward starting swap (swap start date 6/13/2012, swap end date 6/13/2014). This trade requires frequent delta rebalancing.

• Continue to pay in 3.25% June 16 spreads versus

receiving in 3.25% July 16 maturity matched swap spreads

− Stay long $100mn notional of 3-1/4% June 16 and continue to pay fixed in $105.3 notional of a 06/30/2016 swap; stay short $98mn notional of 3-1/4% of July 16 and continue to receive fixed in $103.5mn notional of a 7/31/2016 swap (US Fixed Income Markets Weekly, 03/02/12). P/L since inception: profit of 0.7bp of yield.

• Maintain belly cheapening position in a sell-off on the EDU3/7Y/25Y butterfly using ED midcurve puts and payer swaptions

− Stay long $100mn notional of 6Mx7Y payer swaptions (notification 09/14/12, maturity 09/18/19, strike 1.797%), stay short 1598 0EU2 99.375 puts (midcurve option expiry 09/14/12, EDU3 strike 99.375), and stay short $22.3mn notional of 6Mx25Y receiver swaptions (notification 09/14/12, maturity 09/18/37, strike 2.845%). (US Fixed Income Markets Weekly, 03/02/12). P/L since inception: loss of 1.4bp of yield.

• Continue to receive in 10-year swap spreads

hedged with 20% risk in September FRA-OIS wideners

− Continue to receive in $100mn notional of 2% Feb 22 maturity matched swap spreads (stay short $100mn notional of 2% Feb 22s, and continue to receive fixed in $96.2mn notional of a 2/15/2022 swap), and continue paying 20% of the risk (or $18035/bp) in September 2012 3M FRA-OIS spreads (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 0.1bp of yield.

• Maintain 30-year swap spreads wideners − Continue to pay in 4.75% of Feb 2041 spreads (stay

long $100mn notional of the 4.75% of Feb 2041, and continue to pay fixed in $110.3mn notional of a 02/15/2041 swap). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 1.3bp of yield.

• Maintain 5-year swap spread wideners in a rally − Stay long 1,000 FVM2 123.25 calls (FVM2 @ 123-

04, strike 123.25, expiry 5/25/2012) and stay short $129mn notional of a 05/25/12x8/31/16 receiver swaption (notification 05/25/12, swap start date 07/05/12, maturity 8/31/16, strike 1.073%, ATMF 1.098%) (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 2bp of yield.

• Stay long 3Mx1Y payer spreads − Stay long $100mn notional of a 0.506%/0.756%

3Mx1Y payer swaption spread (1:1 weighted, notification 5/10/2012, maturity 5/14/2013, ATMF 0.506%; buy the ATMF strike and sell the A+.25 strike) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 1.4bp of yield.

• Maintain belly cheapening position on the 1-year

forward 2s/5s/10s swap butterfly − Continue to pay fixed in $100mn notional of a 1Yx5Y

forward starting swap (swap start date 02/14/2013,


41

swap end date 02/14/2018, yield 1.513%), continue to receive fixed in $138.3mn notional of a 1Yx2Y forward starting swap (swap start date 02/14/2013, swap end date 02/17/2015, yield 0.734%) and continue to receive fixed in $29.6mn notional of a 1Yx10Y forward starting swap (swap start date 02/14/2013, swap end date 02/14/2023, yield 2.354%) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 2.9bp of yield.

• Maintain conditional 2s/30s steepeners via 3-month

expiry options, versus selling 3-month expiry caps on the 2s/30s CMS curve

− Stay long $50mn notional 3Mx30Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2042, ATMF and strike 2.883%) versus staying short $500mn notional 3Mx2Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2014, ATMF and strike 0.5275%); also stay short $998.5mn notional of 3-month expiry 1-look caps on the 2s/30s CMS curve (end date 5/8/2012, ATMF CMS 10s/30s yield spread and strike at 239.7bp) (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: profit of 0.8bp of yield.

• Maintain 30-year matched maturity swap spread

wideners, hedged with 5-year swap spread wideners and the 5s/30s Treasury yield curve

− Stay long $50mn notional of 3.125% of Nov 2041s and pay fixed in $51.6mn notional of a 11/15/2041 swap; also, stay long $95mn notional of 0.875% of Jan 2017s and continue to pay fixed in $67.4mn notional of a 01/31/2017 swap (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: loss of 2.9bp of yield.

• Continue to receive fixed in the belly of a 3-month

forward weighted 5s/10s/30s swap butterfly − Continue to receive fixed in $100mn notional of a

3Mx10Y forward starting swap (swap start date 04/24/2012, swap end date 04/25/2022) and continue paying fixed in $133mn notional of a 3Mx5Y forward starting swap (swap start date 04/24/2012, swap end date 04/24/2017) and paying fixed in $21.9mn notional of a 3Mx30Y forward starting swap (swap start date 04/24/2012, swap end date 04/24/2042) (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: profit of 1.6bp of yield.

• Maintain synthetic conditional trade by selling 10s/30s YCSO caps versus 10Y receiver swaptions

− Sell $500mn notional (i.e., $50K/bp forward DV01) of single-look 6-month caps on the 10s/30s swap curve (end date 6/11/12, strike and ATMF 10s/30s CMS yield spread at 60.1bp) versus buying $21.3mn notional of 6Mx10Y receiver swaptions (notification date 06/11/12, maturity date 06/13/22, ATMF and strike 2.335) (US Fixed Income Markets Weekly, 12/09/11). P/L since inception: loss of 0.5bp of yield.

• Stay long 6Mx30Y versus 6Mx10Y swaption

straddles − Stay long $43.7mn notional of 6Mx30Y swaption

straddles (notification date 8/24/2012, maturity date 08/29/2042, ATMF and strike 2.849%) and stay short $100mn notional of 6Mx10Y swaption straddles (notification date 8/24/2012, maturity date 8/30/2022, ATMF and strike 2.220%) (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 3.7abp.

• Stay short 6M single-look CMS curve straddles on

the 2s/10s swap curve − Stay short $250mn notional of 6-month curve

straddles on the 2s/10s CMS curve (end date 09/06/2012, ATMF CMS 2s/10s yield spread and strike at 1.64%) (US Fixed Income Markets Weekly, 03/02/12). P/L since inception: profit of 0.8abp.

Closed trades in 2012 P/L reported in bp of yield for swap spread, yield curve and miscellaneous trades, and in annualized bp of volatility for option trades, unless otherwise specified Trade Entry Exit P/LSwap spreads10-year swp sprd widener 01/06/12 1/20 (1.8)Front end swap spread wideners via options 01/06/12 2/3 (4.4)Pay Aug 20 vs Feb 20 sprds (hedged) 01/20/12 2/3 1.7Yield curve Entry Exit P/L5s/10s swp sprd crv steepeners 11/04/11 2/3 (3.5)3m fwd 1s/15s crv flatteners via rec swptns 01/06/12 2/3 (16.1)Buy belly of EDZ2/EDZ3/EDZ4 bfly 01/20/12 3/2 (9.9)Buy wtd WN calendar sprd PL in 32nds 02/10/12 3/2 1.9Options relative value Entry Exit P/LSell 10s/30s YCSO vs 6Mx2Y swptn strddls 10/28/11 1/27 18.2Buy 6Mx5Y vs 9Mx5Y swptn strddls 01/20/12 2/10 (0.6)

Japan Rates Research Global Fixed Income Markets Weekly March 9, 2012 Takafumi Yamawaki (81-3) 6736-1748 Yuya Yamashita, CFA (81-3) 6736-1493 JPMorgan Securities Japan Co., Ltd.

42

Japan

• The benchmark 10Y JGB yields remained almost unchanged this week. The curve continued to steepen

• The low and stable JGB yields appear at odds with the rally in equities since the beginning of this year, but such divergence is also seen in the US and European markets. One explanation for this is the monetary easing worldwide

• Support from the BoJ’s monetary easing helped the 5Y sector remain rich on the curve despite supply pressure from this week’s auctions

• The super-long sectors were heavy, and the JGB curve continued to steepen, partly backed by the steepening of the swap curve

• We maintain our neutral view on JGBs. The BoJ’s purchase is expected to support JGBs, while any downside in yields should be limited unless the BoJ introduces more easing measures

• The BoJ will hold the Monetary Policy Meeting (MPM) on 12 and 13 March. Our economic research team expects no change in policy at this meeting

• Potential downside in 5Y yields may be 5bps or so even if additional monetary easing measures are introduced

Overview

The benchmark 10Y JGB yields remained almost unchanged this week, but the curve continued to steepen. Early in the week, German Bunds and US Treasury yields declined on uncertainty around the Greek PSI, but rebounded later as the media reported high participation in the Greek debt exchange. The heightened expectations of strong US payroll numbers may have been responsible for the mid-week rebound in US Treasury yields. The range of the yields, however, was relatively tight in a wait-and-see mode ahead of the Greek debt exchange participation deadline and outcome, and US non-farm payroll numbers. Lacking external drivers, the JGB market was range-bound. The results of the two auctions in the 30Y and 5Y JGBs were firm, but these auctions too followed the recent pattern of heavy upside after strong auction results. The futures sector led the rally in up-to-10Y JGBs, while the super-long sectors were

modestly sold off, resulting in a twist-steepening of the curve (Exhibit 1). The 10Y sector in the middle of the curve remained almost unchanged.

The low and stable JGB yields appear at odds with the rally in equities since the beginning of this year (Exhibit 2), but such divergence is also seen in the US and European markets. One explanation is the global monetary easing, i.e., the abundant liquidity supporting both debt and equity markets.

The BoJ’s monetary easing continued to support the intermediate sectors. The 5s/10s curve is steep relative the yield level, indicating that the 5Y sector remained rich (Exhibit 3). The richness could be explained by the following reasons. First, the supply and demand balance

Exhibit 1: The futures sector led the rally in up-to-10Y JGBs while the super-long sectors were modestly sold off. The 10Y sector in the middle of the curve was almost unchanged this week. JGB yield change over this week; bp

-2

-1

0

1

2

1 2 3 4 5 6 7 8 910 12 15 20 25 30 40Maturity

Source: Bloomberg, J.P. Morgan Exhibit 2: The low and stable JGB yields appear at odds with the rally in equities since the beginning of this year, but such divergence is also seen in the US and European markets. One explanation is monetary easing implemented globally 10Y JGB yield and Nikkei 225 Index since 2011; % Yen

8000

8500

9000

9500

10000

10500

11000

11500

0.90 0.95 1.00 1.05 1.10 1.15 1.20 1.25 1.30 1.35 1.40

Jan '11 Apr '11 Jul '11 Oct '11 Jan '12

10Y JGB Yield (LHS)

Nikkei (RHS)

Source: Bloomberg, J.P. Morgan


43

in short-term sectors is tight on the back of the BoJ’s expanded JGB purchase. The low and stable short-term yields stabilise the intermediate sectors. Second, the intermediate sectors appear to be pricing in additional easing measures such as a further upsizing of the BoJ’s JGB purchase under the Asset Purchase Program (APP) or extension of the maturity of JGBs eligible under the programme. Third, investors may be switching positions out of longer sectors into shorter ones, given the bearish factors that have recently emerged. The issuance amount of 10Y and 20Y sectors will be increased by JPY100bn each on a monthly basis, starting April. Some market participants think the BoJ’s current and potential future monetary easing may heighten inflation expectations. A reversal of the risk-off mode may continue after the Greek debt exchange sees sufficiently high participation.

The super-long sectors were heavy, and the JGB curve continued to steepen, partly backed by the steepening of the swap curve. The pace of the steepening in the swap curve looks too quick, but it has been largely in line with the rise in the AUD/JPY FX rate (Exhibit 4). The recent rally in the Nikkei and the depreciation of the JPY could have driven dealers’ exotic/hybrid risk-hedging.

Another factor for the steepening in the JGB curve may be concerns about the increase in issuance in the 10Y and 20Y sectors from April 2011. However, it may not be valid as an explanation for the steepening in the JGB 10s/20s curve as the two sectors have the same amount of issuance increase (JPY 100bln per month). Exhibit 5 shows the JGB 10s/20s curve vs. 10Y JGB yields since 2011. There was a shift in the yield directionality of the JGB 10s/20s curve around September 2011, and the 20Y has remained rich since then. The steepening of the curve may partly be a reversal of this richness.

We maintain our neutral view on JGBs. The yields will likely remain range-bound in the near term. The BoJ’s purchase is expected to support the short-to-intermediate sectors, and the stability of the shorter sectors could spill over to longer sectors. Meanwhile, any further downside in intermediate yields should be limited unless the BoJ introduces more easing measures. Our economic research team expects additional easing measures to be introduced, but not until April 2012 (see below). The 10Y sector appears to have more room for upside from a relative value and carry perspective. Nevertheless, the steepening bias of the curve, if it continues, could limit the downshift in 10Y yields.

Exhibit 3: The 5s/10s curve is steep relative to the yield level, indicating that the 5Y sector remained rich JGB 5s/10s curve since April 2011; bp

6062646668707274767880

0.90 1.00 1.10 1.20 1.30 1.4010Y JGB Yield (%)

Exhibit 4: The steepening of the swap curve has been largely in line with the rise in the AUD/JPY FX rate Swap 10s/30s spreads and AUD/JPY FX since 2011; bp Yen

70

75

80

85

90

95

70

75

80

85

90

95


Swap 10-30 (LHS)

AUDJPY (RHS)

Source: Bloomberg, J.P. Morgan Exhibit 5: There was a shift in the yield directionality of the JGB 10s/20s curve around September 2011 and the 20Y remained rich since then. The steepening of the curve may be partly a reversal of this richness. JGB 10s/20s curve vs. 10Y JGB yields; bp

65

70

75

80

85

90

0.90 1.00 1.10 1.20 1.30 1.4010Y JGB Yield (%)

January 2011 - August 2011

Since September 2011

Current


44

The MoF’s Balance of Payment data shows that the non-seasonal adjusted current account balance for January 2012 marked JPY -437bn, the largest deficit since 1985. The weakness in the trade balance, which was the major reason for the current account deficit, may be exaggerated by such factors as seasonality, the floods in Thailand and the Chinese New Year. After a seasonal adjustment, the January current account balance showed a surplus of JPY115.6bn. The current account balance also turned into a deficit in January 2009 after the Lehman shock, but soon recovered and continued to show a surplus over 2009 and 2010. Therefore, the impact on the market should not be large until it is confirmed that the current account balance constantly runs a deficit.

There has been no notable progress on the discussion on the consumption tax rate hike. Our main scenario is that the consumption tax rate will be hiked sooner or later. It is widely thought that both the ruling party (the Democratic Party of Japan, DPJ) and the biggest opposition party (the Liberal Democratic Party, LDP) basically agree on the consumption tax rate hike. The focus now appears to be on the conflicts within the DPJ. Ex-DPJ leader Ichiro Ozawa opposes the tax hike. Some views that the conflict between Prime Minister Yoshihiko Noda and Ozawa will delay the submission of the bill or, in a worst-case scenario, may lead to the disintegration of the party, evoking the possibility of another ‘Ozawa Shock’. However, we think another Ozawa-shock scenario is unlikely because factions and members opposing the tax hike are a minority within the DPJ.

BoJ Monetary Policy Meeting

The BoJ will hold the Monetary Policy Meeting on 12 and 13 March. Our economic research team envisages the following steps as a main scenario (see BoJ preview: BoJ to hint further easing, 8 March 2012):

• 13 March: BoJ Governor Masaaki Shirakawa changes the wording at the press conference to indicate the BoJ’s commitment towards further monetary easing

• 27 April: The Bank extends the maturity of JGBs eligible for the BoJ’s APP to 5 years from 2 years, and, possibly, increases the JGB purchase to JPY29tn in the APP by extending the deadline for achieving the target amount to June 2013 from the current December 2012 (this may be postponed to May or June 2012).

Exhibit 6: The MoF’s Balance of Payment data shows that the non-seasonally-adjusted current account balance for January 2012 marked a deficit of JPY 437 billion. Non-seasonally-adjusted current account balance since 2006; JPY bln

-1000-500

0500

100015002000250030003500

Jan '06 Jan '07 Jan '08 Jan '09 Jan '10 Jan '11 Jan '12

Source: MoF, J.P.Morgan Exhibit 7: The flattening in the 2s/5s curve since the previous MTM was largely in line with the yield directionality realized since 2011 JGB 2s/5s curve vs. 2Y yields since 2011; bp

y = 116.02x + 5.2151R² = 0.7986

15

20

25

30

35

40

0.10 0.15 0.20 0.25

2s/5s

curv

e

2Y JGB yield (%)

Source: Bloomberg, J.P.Morgan Exhibit 8: The 2s/5s curve flattened by more than implied by the directionality last summer, probably pricing in a possibility of a cut in the IOER JGB 2s/5s curve since 2011; bp

15

20

25

30

35

40


2s/5s spread

current

Source: Bloomberg, J.P.Morgan


45

• 2H 2012: The Bank increases the JGB purchase to JPY39tn in APP.

2Y and 5Y yields have declined 1.4bp and 3.8bp, respectively, since the last MPM held in February 2012. The flattening in the 2s/5s curve was largely in line with the yield directionality realised since 2011 (Exhibit 7). This fact indicates that further downside in 5Y yields, and accordingly in longer yields, would be limited as long as the APP buys up-to-2Y JGBs without introducing more drastic easing measures.

Last summer, there was a period when the curve flattened more than what was implied by the directionality, probably because the market priced in the possibility of a cut in the IOER (Exhibit 8). A cut in the IOER, however, is very unlikely, considering the fact that banks currently must pay annual deposit insurance fee of 8.4bp, which is only 1.6bp lower than the level of the IOER. The Fed also discussed the option but has not introduced it, given the uncertainty about its potential impact on the economy. It would be no surprise if the BoJ has similar concerns. In addition, given that a cut in the IOER is seen as one of the most drastic measures the Bank can take, last summer’s flattening may indicate a potential downside in 5Y yields. Looking at the moves last summer, potential downside in 5Y yields may be 5bp or so, even if additional measures are introduced

Recommended trades

• Maintain neutral stance on duration • Maintain JGB steepeners (such as 8s/30s) • Maintain paying 10Y swap via 5s/10s/20s butterfly • Maintain JGB 5s/8s flattener • Maintain FX LIBOR basis 1s/5s steepener • Maintain weighted 20s/30s swap spread curve

flattener • Maintain paying 3x2 forward swap with long JGB

futures • Maintain long 7Y JGB via weighted 5s/7s/10s

butterfly

European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Aditya ChordiaAC (44-20) 7777-9841 [email protected] J.P. Morgan Securities Ltd.

46

Interest rate forecasts Euro area 09-Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 United States 09-Mar-12 Jun-12 Sep-12 Dec-12 Mar-13Refi rate 1.00 0.75 0.75 0.75 0.75 Fed funds 0 - 0.25 0 - 0.25 0 - 0.25 0 - 0.25 0 - 0.25Euribor 3M 0.89 0.65 0.65 0.70 0.75 Libor 3M 0.48 0.45 0.50 0.50 0.50

2Y 0.15 0.20 0.20 0.20 0.20 2Y 0.31 0.30 0.30 0.30 0.305Y 0.77 1.00 0.90 0.90 0.85 5Y 0.90 1.25 1.25 1.25 1.2510Y 1.79 2.15 2.00 1.95 1.90 10Y 2.04 2.50 2.50 2.50 2.5030Y 2.44 2.85 2.70 2.65 2.60 30Y 3.21 3.60 3.60 3.60 3.602s/10s 164 195 180 175 170 2s/10s 173 220 220 220 22010s/30s 65 70 70 70 70 10s/30s 116 110 110 110 1102s/30s 229 265 250 245 240 2s/30s 289 330 330 330 3302Y 91 70 75 80 85 2Y 25 31 32 24 245Y 74 50 55 60 65 5Y 24 31 33 28 2810Y 44 30 35 40 45 10Y 7 11 12 7 730Y 8 5 5 10 10 30Y -30 -25 -22 -22 -22

United Kingdom 09-Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 AustraliaBase rate 0.50 0.50 0.50 0.50 0.50 Cash rate 4.25 4.25 4.00 4.00 4.00Libor 3M 1.04 1.05 1.00 1.00 1.00 Govt curve 10Y 4.10 4.30 4.25 4.20 4.30

2Y 0.43 0.50 0.50 0.50 0.505Y 1.02 1.10 1.10 1.10 1.10 New Zealand10Y 2.07 2.20 2.10 2.10 2.10 Cash rate 2.50 2.50 2.75 3.00 3.2530Y 3.22 3.15 3.15 3.15 3.15 Govt curve 10Y 4.10 4.40 4.30 4.20 4.402s/10s 164 170 160 160 16010s/30s 114 95 105 105 1052s/30s 279 265 265 265 2652Y 80 80 80 80 805Y 52 60 60 60 6010Y 25 25 20 20 2030Y -11 -10 -15 -15 -15

JapanO/N call rate 0.05 0.05 0.05 0.05 0.05

2Y 0.11 0.12 0.13 0.13 0.135Y 0.30 0.40 0.35 0.35 0.4010Y 0.99 1.15 1.05 1.05 1.1520Y 1.77 1.80 1.80 1.85 1.9530Y 1.96 2.00 2.00 2.05 2.152s/10s 88 103 92 92 10210s/30s 97 85 95 100 1002s/30s 185 188 187 192 202

Govt curve

Swap spreads

Govt curve

Swap spreads

Govt curve

Govt curve

Swap spreads


47

Recent curve movements

Govt. curve 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago2Y 0.15 0.16 0.24 0.27 0.32 0.43 0.39 0.38 0.42 0.385Y 0.77 0.78 0.84 0.96 1.04 1.02 0.96 0.96 1.10 0.9110Y 1.79 1.80 1.88 2.03 2.15 2.07 2.06 2.07 2.24 2.1630Y 2.44 2.42 2.47 2.67 2.66 3.22 3.22 3.24 3.38 3.242s/5s 61 62 60 70 72 59 57 58 69 532s/10s 164 164 164 177 182 164 167 169 183 17810s/30s 65 62 59 64 52 114 116 118 114 107

Swap curve 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago2Y 1.07 1.04 1.15 1.18 1.40 1.24 1.17 1.26 1.24 1.315Y 1.52 1.50 1.58 1.66 1.95 1.58 1.52 1.57 1.64 1.6110Y 2.25 2.22 2.30 2.43 2.66 2.39 2.37 2.39 2.52 2.4530Y 2.53 2.49 2.56 2.68 2.73 3.12 3.12 3.13 3.24 3.162s/5s 45 46 42 49 55 34 35 31 40 312s/10s 118 118 115 125 125 115 120 113 128 11510s/30s 28 27 26 25 7 73 75 74 72 70

Swap spreads 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago2Y 91 86 88 85 108 80 77 86 79 885Y 74 71 73 70 86 52 53 58 52 6410Y 44 40 40 37 51 25 24 26 21 2530Y 8 6 8 0 6 -11 -11 -12 -15 -92s/5s -18 -15 -15 -15 -22 -28 -24 -28 -27 -242s/10s -48 -46 -49 -47 -57 -55 -53 -60 -58 -6310s/30s -35 -33 -32 -37 -45 -36 -35 -38 -37 -34

EUR GBP

Govt. curve 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago2Y 0.31 0.28 0.31 0.27 0.22 0.11 0.11 0.11 0.12 0.135Y 0.90 0.85 0.89 0.86 0.88 0.30 0.30 0.31 0.35 0.3510Y 2.04 1.98 1.97 2.05 2.05 0.99 0.99 0.97 0.99 1.0130Y 3.21 3.11 3.10 3.20 3.10 1.96 1.94 1.94 1.93 1.922s/5s 58 57 58 59 66 19 19 20 23 222s/10s 173 171 166 178 183 88 88 87 87 8810s/30s 116 113 112 115 105 97 95 97 94 91

Swap curve 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago2Y 0.57 0.53 0.62 0.54 0.64 0.34 0.34 0.34 0.36 0.385Y 1.15 1.11 1.17 1.13 1.25 0.46 0.47 0.46 0.48 0.4810Y 2.13 2.07 2.08 2.13 2.18 1.02 1.01 1.00 1.00 1.0030Y 2.90 2.82 2.80 2.88 2.78 1.90 1.89 1.87 1.84 1.782s/5s 58 58 55 59 61 12 12 12 12 112s/10s 155 154 146 159 154 67 67 66 65 6210s/30s 77 74 72 76 60 89 88 87 83 78

Swap spreads 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago2Y 25 25 30 27 41 23 23 24 24 255Y 24 25 28 26 35 16 15 15 13 1210Y 7 8 10 8 12 3 3 1 0 -130Y -30 -29 -30 -31 -31 -6 -6 -8 -11 -162s/5s -1 0 -3 -1 -6 -7 -8 -9 -11 -122s/10s -18 -17 -20 -18 -30 -20 -20 -23 -24 -2610s/30s -37 -37 -39 -39 -43 -9 -9 -9 -11 -15

USD JPY


48

Recent sovereign cash spread movements Spread to Germany; bp

09-Mar-12 1W ago 2W ago 1M ago 3M ago 1Y min 1Y max 1Y avg 1Y SD 1Y z-scoreAustria 58 54 55 52 85 9 139 47 31 0.4Belgium 110 106 132 126 292 32 469 147 89 -0.5Finland 19 20 22 21 18 4 51 17 10 0.2France 46 40 47 34 88 4 150 47 33 -0.1Netherlands 22 17 17 12 37 3 70 17 13 0.2Ireland 434 424 382 392 836 380 2164 831 305 -1.3Italy 200 198 290 275 558 83 713 313 158 -0.7Portugal 1486 1476 1414 1569 1529 493 2216 1335 345 0.4Spain 197 186 218 216 415 102 548 264 95 -0.7Wtd. peri. spread* 289 281 342 345 590 153 737 387 137 -0.7

09-Mar-12 1W ago 2W ago 1M ago 3M ago 1Y min 1Y max 1Y avg 1Y SD 1Y z-scoreAustria 100 102 108 100 151 30 219 87 48 0.3Belgium 164 160 183 158 297 84 433 198 74 -0.5Finland 49 55 55 54 73 6 93 43 22 0.2France 94 91 101 77 120 21 187 75 40 0.4Netherlands 49 47 49 45 61 6 83 38 18 0.4Ireland 443 441 426 440 756 416 1509 756 223 -1.4Italy 302 288 369 340 563 102 675 347 151 -0.3Portugal 1544 1539 1421 1509 1418 572 2079 1193 290 1.2Spain 285 277 293 287 413 155 495 305 76 -0.3Wtd. peri. spread* 381 369 416 402 587 181 670 410 123 -0.2

09-Mar-12 1W ago 2W ago 1M ago 3M ago 1Y min 1Y max 1Y avg 1Y SD 1Y z-scoreAustria 98 103 104 96 118 31 189 84 39 0.4Belgium 168 171 186 160 240 72 357 179 62 -0.2Finland 50 50 51 49 61 24 80 45 12 0.3France 107 107 115 93 113 30 188 84 38 0.6Netherlands 45 40 42 40 43 22 65 38 9 0.4Ireland 515 513 509 494 660 494 1142 681 130 -1.3Italy 314 321 357 341 460 125 575 331 126 -0.1Portugal 1178 1157 1056 1075 1050 458 1406 943 190 1.3Spain 318 307 313 311 388 170 500 310 71 0.2Wtd. peri. spread* 378 387 403 394 495 188 566 387 104 0.0

09-Mar-12 1W ago 2W ago 1M ago 3M ago 1Y min 1Y max 1Y avg 1Y SD 1Y z-scoreAustria 87 86 87 71 96 28 158 65 30 0.7Belgium 153 160 168 143 197 75 297 157 48 -0.1Finland - - - - - - - - - -France 115 116 116 96 109 32 199 83 39 0.9Netherlands 15 12 14 10 8 6 15 10 2 1.5Ireland - - - - - - - - - -Italy 314 316 345 333 412 153 515 320 100 0.0Portugal 816 798 757 765 661 295 919 583 143 1.6Spain 329 318 326 318 368 185 448 303 62 0.5Wtd. peri. spread* 502 353 372 362 418 173 500 336 91 0.2

10Y

30Y

2Y

5Y

*Weighted peripheral spread computed against Germany for Ireland, Portugal, Italy and Spain (weighted by the size of their outstanding bond market). 30Y does not contain Ireland and Finland.


49

Recent sovereign CDS spread movements CDS spread*; bp

08-Mar-12 1W ago 2W ago 1M ago 3M ago 1Y min 1Y max 1Y avg 1Y SD 1Y z-scoreUS 29 29 29 29 29 21 50 36 11 -0.7UK 23 24 28 30 52 21 58 37 12 -1.2Germany 28 27 33 34 50 10 62 31 16 -0.2Austria 109 102 112 110 134 20 174 81 49 0.6Belgium 181 175 210 189 294 62 382 192 84 -0.1Finland 32 33 33 33 32 12 45 28 10 0.4France 119 111 130 122 155 29 180 97 49 0.5Netherlands 51 47 52 51 61 10 75 36 20 0.7Ireland 633 597 656 662 892 597 1606 917 183 -1.5Italy 324 329 384 365 575 71 627 333 173 -0.1Portugal 1756 1683 1580 1712 1579 530 2306 1315 403 1.1Spain 350 318 357 344 419 142 473 315 87 0.4Wtd. peri. spread** 433 422 463 457 612 148 657 418 154 0.1

08-Mar-12 1W ago 2W ago 1M ago 3M ago 1Y min 1Y max 1Y avg 1Y SD 1Y z-scoreUS 40 40 40 40 40 40 65 51 10 -1.1UK 63 66 72 76 92 47 104 76 15 -0.9Germany 77 75 81 85 102 36 120 74 25 0.1Austria 165 155 170 168 183 50 243 130 56 0.6Belgium 232 222 244 223 320 115 408 232 71 0.0Finland 64 65 66 66 64 24 90 56 19 0.4France 179 166 190 178 211 63 252 149 56 0.5Netherlands 99 92 102 100 109 28 146 78 34 0.6Ireland 615 580 580 566 701 510 1199 716 110 -0.9Italy 372 355 400 394 535 125 583 353 144 0.1Portugal 1200 1151 1080 1170 1111 525 1522 965 223 1.1Spain 400 355 376 365 435 197 488 345 71 0.8Wtd. peri. spread** 442 415 445 443 553 189 595 407 121 0.3

2Y

5Y

* 25bp running coupon used for Finland, France, Germany, Netherlands and US. 100bp running coupon used for UK, Austria, Belgium, Greece, Ireland, Italy, Portugal and Spain. Spreads for all the countries except US are in $ CDS and for US it is in € CDS. **Weighted peripheral spread computed as CDS spread of Ireland, Portugal, Italy and Spain, weighted by the size of their outstanding bond market.


50

Euro area conventional bond* and bank debt** redemptions €bn

Sov. Banks Sov. Banks Sov. Banks Sov. Banks Sov. Banks Sov. Banks Sov. BanksMar-12***** 1 2 4 0 0 0 0 4 19 12 0 3 24 21

Apr-12 0 2 0 0 0 1 18 6 16 3 0 10 34 22May-12 0 2 0 2 0 0 0 2 0 2 0 4 0 12Jun-12 0 1 0 1 0 1 0 5 19 9 0 2 19 20Jul-12 10 1 0 0 0 0 28 13 27 10 15 2 81 25Aug-12 0 0 1 1 1 1 0 0 0 5 0 3 2 10Sep-12 0 2 11 0 6 0 12 5 21 11 0 2 50 21Oct-12 0 1 0 3 0 0 19 9 16 9 0 1 35 23Nov-12 1 1 0 1 0 0 0 1 0 5 0 1 1 9Dec-12 0 2 7 0 0 0 5 3 17 3 0 1 29 9Jan-13 0 0 0 2 0 0 22 14 24 18 16 9 61 42Feb-13 0 1 0 7 0 1 0 3 0 12 0 3 0 26Mar-13 0 2 13 6 0 0 0 11 18 11 0 5 31 36Total 13 15 37 24 7 4 105 77 177 110 31 47 368 276

Sov. Banks Sov. Banks Sov. Banks Sov. Banks Sov. Banks Sov. BanksMar-12***** - 2 0 2 0 5 0 1 0 9 0 18

Apr-12 - 0 0 3 27 2 0 0 12 15 39 21May-12 - 0 0 0 1 6 0 1 0 10 1 17Jun-12 - 1 0 2 2 3 10 2 0 25 12 33Jul-12 - 1 0 0 17 2 1 2 13 8 31 12Aug-12 - 1 0 0 12 2 0 0 0 3 12 5Sep-12 - 2 0 0 11 4 0 0 2 7 13 12Oct-12 - 1 0 1 20 6 0 0 20 5 40 12Nov-12 - 1 0 3 13 4 0 0 0 10 13 18Dec-12 - 0 0 0 30 10 1 0 0 5 32 15Jan-13 - 1 0 1 0 3 0 0 14 11 14 16Feb-13 - 1 0 2 21 10 0 2 0 7 21 22Mar-13 - 0 0 1 0 6 0 0 0 9 0 16Total - 10 0 15 154 63 13 9 62 122 229 219

Austria Belgium

Greece Ireland

Netherlands Core Euro-area***

Peri. Euro-area****

Finland

Portugal Spain

France Germany

Italy

* Marketable bonds include: conventionals, linkers, floaters zero coupons and international bonds. ** Maturities in all currencies and jurisdictions and include secured, unsecured and securitised issuance, including MTNs but excluding short-term (maturity of less than one year) and self-funded deals (deals where there is only one bookrunner and it is also the issuer). The data also include any government guaranteed issuance by the banks but no direct issuance by government or government sponsored institutions. *** Austria, Belgium, Finland, France, Germany and Netherlands. **** Greece, Ireland, Italy, Portugal, Spain. ***** For the remaining part of the month. Source: J. P. Morgan, Dealogic


51

Event risk/election calendar

Event risk Month Day Date Country/Region EventMarch 2012 Mon 12 Euro area Eurogroup meeting (17 finance ministers)

Mon 12 Greece Ex pected settlement of Greek PSI for domestic law bondsTue 13 Euro area Ecofin meeting (27 finance ministers) Sun 18 Greece PASOK v otes on a new leader to replace Papandreou

Tue-Thu 27-29 Greece Bond holder meeting dates for foreign law bonds in the Greek PSIApril 2012 ?? Greece Greece parliamentary elections

Wed 4 Euro area ECB rate announcementThu 5 UK BoE rate announcementWed 11 Greece Ex pected settlement of Greek PSI for foreign law bonds

Fri-Sun 20-22 IMF/World Bank IMF/World Bank spring meeting in WashingtonSun 22 France French Presidential election (round 1)

May 2012 Thu 3 Euro area ECB rate announcementSun 6 France French Presidential election (round 2)Sun 6 Germany State elections, Schlesw ig-HolsteinThu 10 UK BoE rate announcementMon 14 Euro area Eurogroup meeting (17 finance ministers)

Tue-Tue 15-22 G8 G8 summit in ChicagoWed 16 UK BoE Quarterly Inflation ReportFri 25 Euro area EU Council Meeting (EU heads of state)

June 2012 Wed 6 Euro area ECB rate announcementThu 7 UK BoE rate announcementSun 10 France French legislativ e election (round 1)Sun 17 Euro area French legislativ e election (round 2)Mon 18 Euro area Eurogroup meeting (17 finance ministers) Tue 19 Euro area Ecofin meeting (27 finance ministers)

Thu-Fri 28-29 Euro area EU Council Meeting (EU heads of state)

Election calendar Period Date Month Election in2012 ?? Greece

22 April France2013 - - Austria

- - Germany- - Italy

2014 - - Belgium- - Netherlands

2015 - - FinlandPortugal

- - Spain2016 - - Ireland


52

Euro area fact sheet / SMP purchases

Euro-area fact sheet GDP GDP growth Inflation* Budget balance^ Prim. Balance Gross debt Curr. acc. bal. GDPpc Unempl. (€bn) (oya, %) (oya, %) (% of GDP) (% of GDP) (% of GDP) (% of GDP) (EU=100) rate (%)2012 2012 2012 2012 2012 2012 2012 2012 Latest

Austria 310 0.7 2.4 -3.1 -0.3 73 2.8 124 4.0Belgium 382 -0.1 2.7 -4.6 -1.3 99 2.1 116 7.4Finland 198 0.8 3.0 -0.7 0.5 52 0.0 123 7.5France 2,028 0.4 2.2 -5.3 -2.5 89 -3.3 104 10.0Germany 2,623 0.6 1.9 -1.0 1.3 81 4.4 108 5.8Greece 212 -4.4 -0.5 -7.0 1.0 198 -7.9 63 19.9Ireland 159 0.5 1.6 -8.6 -4.3 118 1.5 119 14.8Italy 1,617 -1.3 2.9 -2.3 3.1 121 -3.0 90 9.2Netherlands 623 -0.9 2.0 -3.1 -1.2 65 7.0 126 5.0Portugal 169 -3.3 3.3 -4.5 0.8 111 -5.0 54 14.8Spain 1,094 -1.0 1.3 -5.9 -3.5 74 -3.0 80 23.3GDP-weighted avg 9,415 -0.3 2.1 -3.4 -0.2 91 0.0 101 8.0US 15,495** 1.5 1.9 -8.5 -5.4 105*** -3.1 - 8.3UK 1,566** 0.6 2.9 -7.8 -4.6 89 -0.9 - 8.4

* HICP; National index if not available **Local currency *** IMF Estimate ^ Net lending (+) or net borrowing (-) Source: EC European Economic Interim Forecast Feb-12, EC European Economic Forecast, Autumn 2011, IMF, Eurostat and ILO

Sovereign ratings

Austria AA+ NEG Aaa NEG AAABelgium AA NEG Aa3 NEG AA NEGCy prus BB+ NEG Baa3 NEG* BBB- NEGFinland AAA NEG Aaa AAAFrance AA+ NEG Aaa NEG AAA NEGGermany AAA Aaa AAAGreece SD Ca DEV RDIreland BBB+ NEG Ba1 NEG BBB+ NEGItaly BBB+ NEG A3 NEG A- NEGNetherlands AAA NEG Aaa AAAPortugal BB NEG Ba3 NEG BB+ NEGSlov akia A A2 NEG A+Slov enia A+ NEG A2 NEG A NEGSpain A NEG A3 NEG A NEG

S&P Moody's Fitch

“*” represents under watch; grey highlight: below IG; Outlook:NEG - negative outlook, POS – positive outlook, DEV - developing outlook and blank represents stable outlook Notes: 1 – Rules for a country to be excluded from its index: 1) J.P. Morgan's EMU IG index requires any 1 of 3 credit ratings (S&P's, Moody’s, Fitch) to be below IG. 2) Barclays Capital requires 2 of the above 3 credit ratings to be below IG. 3) Citigroup requires both S&P and Moody’s rating to be below IG. 2 – Markit iBoxx uses an average rating methodology (S&P, Moody’s and Fitch) for a country's exclusion. Source: Bloomberg

SMP purchases

First Last First LastWeekly

(€bn)

Amount matured

(€bn)

Amount offered for

sterilization (€bn)

22-Feb 28-Feb 27-Feb 02-Mar 0.0 0.0 219.515-Feb 21-Feb 20-Feb 24-Feb 0.0 0.0 219.508-Feb 14-Feb 13-Feb 17-Feb 0.0 0.0 219.501-Feb 07-Feb 06-Feb 10-Feb 0.1 0.0 219.525-Jan 31-Jan 30-Jan 03-Feb 0.1 0.0 219.0

224.9 6.8 219.0

Trade date Settlement date

Cumulativ e amount till 24 Jan 2012 Note: Every Tuesday ECB sterilizes SMP purchases during the period between the Wednesday two weeks back (first trade date) and the Tuesday of the previous week (last trade date). This is equivalent to SMP purchases which settle on Monday (first settlement date) to Friday of the previous week (last settlement date). The ECB started buying Italian and Spanish bonds on Monday, 8 August 2011. Source: ECB

European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Pavan WadhwaAC (44-20) 7777-3370 [email protected] J.P. Morgan Securities Ltd.

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56

Global Market Movers 12 March 13 March 14 March 15 March 16 March

Germany 0900 CPI final Feb Italy 1000 GDP final 4Q Japan 0850 Private machinery orders Jan

1.0%m/m, sa 0850 Corporate goods prices Feb

0.5%oya 1400 Consumer sentiment Feb

40.5, DI BoJ Monetary Policy Meeting United States 1400 Federal budget Feb Auction 3-year note $32 bn

Germany 1100 ZEW bus. survey Mar France 0730 CPI Feb

2.3 %oya, nsa Italy 1000 CPI final Feb

3.3 %oya, nsa Spain 0900 CPI final Feb

2.0 %oya, nsa Netherlands Auction DSL Apr15 Japan 0850 Tertiary sector activity index

-0.5%m/m, sa BoJ Monetary Policy Meeting and

statement 1530 BoJ governor Shirakawa’s

press conference United Kingdom 0001 RICS HPI Feb 0930 Trade balance Jan 0930 DCLG HPI Jan United States 0730 NFIB survey Feb 0830 Retail sales Feb 1.1% Ex auto 0.7% 1000 Business inventories Jan 0.6% 1000 JOLTS Jan FOMC meeting Auction 10-year note (r) $21 bn

Euro area 1100 HICP final Feb

2.7 %oya, nsa 1100 Industrial production Jan

0.1%m/m, sa Italy Auction BTP Mar15 and Sep19 Japan 0850 Business outlook survey1Q 1330 IP final Jan 1400 BoJ monthly economic report Auction 3-month bill United Kingdom 0930 Labor market statistics Feb Claimant count 5 k,ch,m/m,sa Average Earnings Jan ILO Unemployment Rate Jan 8.4 % sa United States 0830 Import prices Feb 0.5% 0830 Current account 4Q Auction 30-year bond (r) $13 bn 0900 Chairman Bernanke speaks in

Nashville, TN

Euro area 1000 ECB monthly bulletin 1100 Employment 4Q Netherlands 0930 Industrial production Jan France Auction OAT Apr14 & Oct14 and BTAN Feb16

& Feb17 Spain Auction Bono Jan15, Apr16 & Jul18 Japan Auction 1-year note Auction 20-year bond United Kingdom Auction 2042 United States 0830 Initial claims w/e prior Sat 355,000 0830 PPI Feb 0.6% Core 0.2% 0830 Empire State survey Mar 17.5 0900 TIC data Jan 1000 Philadelphia Fed survey Mar 11.0 Announce 10-year TIPS (r) $13 bn

Euro area 1100 Foreign trade Jan Italy 1000 Foreign trade Jan Japan 0850 Construction spending Jan 0850 Minutes of Feb 13-14 BoJ

Monetary Policy Meeting United States 0830 CPI Feb 0.5% Core 0.18% 0915 Industrial production Feb 0.6% Manufacturing 0.4% Capacity utilization 78.9% 0955 Consumer sentiment Mar

preliminary 76.0 1500 Chicago Fed President Evans

speaks on monetary policy in Frankfurt

19 March 20 March 21 March 22 March 23 March

Euro area 1000 BoP Jan Italy 1100 Industrial new orders Jan Japan Auction 2-month bill United States 1000 NAHB survey Mar

Germany 0800 PPI Feb Netherlands 0930 CBS cons. conf. Mar Spain Trade balance Jan United Kingdom 0930 CPI Feb 1100 CBI industrial trends Mar United States 0830 Housing starts Feb 1245 Chairman Bernanke speaks in

Washington, D.C. 1730 Minneapolis Fed President

Kocherlakota speaks in St. Louis

Germany Auction Schatz Mar14 Japan 1330 All sector activity index Jan United Kingdom 0930 UK Spring Budget MPC minutes

Mar 0930 Public sector finances Feb United States 1000 Existing home sales Feb

Euro area 1000 PMI flash Mar

Mfg, services, composite 1100 Industrial new orders Jan 1600 EC cons. conf. prelim Mar France 0900 PMI flash Mar

Mfg, services, composite Germany 0930 PMI flash Mar

Mfg, services, composite Japan 0830 Reuters Tankan Mar 0850 Trade balance Feb 1110 BoJ board member Morimoto’s

address in Hyogo prefecture Netherlands 0930 GDP final 4Q United Kingdom 0930 Retail sales Feb Auction IL 2042 United States 0830 Initial claims w/e prior Sat 1000 FHFA HPI Jan 1000 Leading indicators Feb Auction 10-year TIPS (r) $13 bn Announce 2-year note $35 bn Announce 5-year note $35 bn Announce 7-year note $29 bn 1245 Chairman Bernanke speaks in Washington, D.C. 2000 St. Louis Fed President Bullard

speaks in Hong Kong

France 0845 INSEE bus. conf. Mar Spain 0900 PPI Feb Japan 0850 Flow of funds 4Q Auction 3-month bill United Kingdom 0930 BBA mortgage lending Feb United States 1000 New home sales Feb 1430 Atlanta Fed President Lockhart speaks in Washington, D.C.

Selective list as of 09 March. Forecasts are m/m, nsa, unless stated & times are local. Telephone your J.P. Morgan representative for an update/more details. Highlighted data are scheduled for release on or after the date shown. Times shown are local. .

JP Morgan - Global Fixed Income Markets Weekly - March 9 2012

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