From the Fixed Income Desk

Treasuries, Agencies and MBS

The last quarter of 2012 provided answers to many of the questions that will shape the market in 2013. As intended, the Fed's Operation Twist was completed by year's end; however the Fed will continue to maintain its ultra easy monetary policy stance. In September, the Fed announced an historic plan to purchase $40 billion of mortgage-backed securities per month in an open-ended approach that would continue until the labor market improves. Moreover, at its last meeting of the year, the Fed said it will keep its stated target rate at 0.0% to 0.25% and also buy $45 billion of Treasuries per month as long as unemployment remains above 6.5% and inflation for 1-2 years ahead is expected to be no more than 2.5%.

Finally, overall balance sheet considerations remain a large concern for dealers, which continues to challenge utilization for these asset classes. This trend is expected to continue into the next year. Funding needs from REITS continue to put pressure on mortgage backed securities term rates, which remain inflated across the curve.

Corporates

Borrowers of corporate bonds pared risk throughout the fourth quarter, continuing
a trend that began after Labor Day. National elections, the fiscal cliff, Hurricane Sandy, and strong performance by corporate bonds kept market participants protecting profits for the duration of the quarter. The new issue calendar remained heavy throughout the fourth quarter as issuers took advantage of excellent technicals.

Investors had plenty of cash to put to work and the majority of new issues immediately began trading at a premium. As corporate bonds rallied, traders were quick to cover shorts and borrows were quickly closed.

International

Balances in the international fixed income lending book fell slightly throughout the fourth quarter of 2012, and were significantly off the highs seen at the end of 2011 – mainly as a result of improving market sentiment in the Eurozone – leading to less specials in Euro sovereign repo markets. Volumes picked up significantly, however, as dealers micro-managed balance sheets, resulting in shorter loan tenures.

Looking Ahead

Looking ahead to 2013, we believe Treasury rebate rates will decline significantly from the recent highs reached in 2012 as market dynamics change. J.P. Morgan has forecast Treasury General Collateral rates to decline from the mid-upper 20s potentially to the mid-teens by the end of the year. Some of the main drivers pushing rates lower will be the aforementioned Fed purchases (removing supply from the market), increasing the Fed's balance sheet and increasing demand for high-quality collateral, such as Treasuries, with the expiration of the Transaction Account Guarantee Program (TAG) and with various financial regulations coming into effect.

We anticipate strong demand for corporate bonds in 2013. After several years of strong performance, issuance could be lighter this year, increasing demand for secondary corporate bonds.

In addition, if spreads start to widen, market participants and traders will likely be ready to establish new trades and short corporate bonds, creating demand from borrowers.
Turning to Europe, German Chancellor Angela Merkel said the economic environment will be more difficult in 2013 than 2012, and that the sovereign debt crisis is "far from over," though progress has been made. However, financial market tensions have abated after the ECB unveiled its Outright Monetary Transactions bond- buying plan in September. As a result, we expect sovereign repo markets to trade with narrow spreads between issuers going forward. In addition, with Greek Prime Minister Antonis Samaras delivering on austerity commitments, and euro region leaders showing determination to keep the bloc intact, economists have scaled back their predictions of Greece's euro exit.