From the Investment Desk

Market Update

Global credit markets continued to improve in the fourth quarter and were remarkably resilient to the major sovereign credit events, including those in Dubai, Greece and Spain. Although these events have created a cautious and slightly nervous tone amongst investors into year-end, the contagion effect into the wider market has been distinctly muted.

The main indicator of improvement in the credit markets continues to be the steady decline in LIBOR rates as well as broad tightening in leading credit default swap (CDS) indicators. Perhaps the most telling illustration is the spread between one-month and three-month LIBOR. Today the spread, which began the year at 100 basis points, is less than two basis points. The three-month LIBOR rate now stands at 0.25%, a drop of 34 basis points from its June 30 level. Central bank language continues to dictate rates being on hold for a prolonged period. In the most recent Fed minutes, a reiteration of rates on hold for an ‘extended period’ was a dovish signal to the market. We see an excess in investor liquidity remaining, which has brought about inevitable maturity extension.

Continued coordination by central banks to extend various stimulus packages has reached the stimulus packages’ maximum extension. The ECB conducted its final one-year repo tender at a floating rate and the Bank of England extended its Quantitative Easing (QE) measures to £200bn. The market now remains focused on anticipation of gradual and defined exit strategies to be deployed by central banks when clear signals of growth become evident.

Market participants will be carefully analyzing Fed Statements following the conclusion of their meetings as investors anticipate the Fed’s next written communication. The most recent meeting, held December 15-16, delivered another unanimous decision to keep rates on hold. The statement highlighted that economic activity has picked up, that financial markets continue to improve, and that the Fed has noticed “the deterioration of the labour market is abating.” In addition, the minutes noted stable inflation expectations would likely warrant exceptionally low rates for an extended period. The Fed remains on course to exit their support of the mortgage lending and housing markets via the purchase of $1.25 trillion agency mortgage-backed securities and up to $200 billion agency debt by the end of the first quarter of 2010. This slowing pace of purchases continues to allow a smooth transition in these markets.

Chairman Bernanke continues to be cautiously optimistic on the economy and believes that growth would be “sufficient to bring down the unemployment rate, but at a slower pace than we would like.” Some economic data supports the Chairman’s view. Employment data is improving, with the economy adding 25,000 jobs over November and December. Retail sales were up 0.8% in Oct, and industrial production rose 0.5% from September levels. In spite of this we note the unemployment rate still hovering just below 10% leading to concerns by various economic agencies as to the fragility of the recovery.

In contrast to the third quarter, the floating rate market showed signs of emergence with unguaranteed benchmark deals being brought to the market. This has been by way of investor reverse enquiry and excess liquidity or by direct issuer confidence in their funding ability. This has been in addition to government guaranteed product seen in the last quarter.

As expected, year-end was tame with respect to repo pricing. After initial concerns in early November as to a potential scarcity in collateral which could have driven overnight rates lower (even negative), we have seen the reverse occur within the market. We now have an excess of collateral, which has forced overnight repo to trade around the 14 basis point level on an overnight basis. The main reasons for this are redemptions in money funds, large issuance of Treasuries and the Fed announcing tri-party reverse repo tests to enable the Fed to drain excess cash from the system as a means to control where the overnight rate trades in the market.

Strategies and Outlook

The continued improvement in the economy and the financial markets has fostered ongoing discussions with our securities lending clients and allowed J.P. Morgan to revisit our decision during the first quarter to remain within a 95-day investment horizon. At that time, we were purchasing only our most highly rated credits (AA- or more highly rated) in 95 days. Our A-rated investments were limited to tenures ranging from overnight to 65 days. In the current environment, we have increased these tenures on AA- names to 185 days, with our more highly-rated names approved for purchases to nine months and 397 days for AAA names. The A-rated names are now approved from overnight to 95 days. The Investment Desk continues to seek value within these parameters focusing on the one-month to three-month sector, with targeted investing in select credits out to 185 days.

J.P. Morgan continues to monitor liquidity closely, as our recent experience has taught us that, even with improving markets, our best liquidity is achieved through our maturity structure. We manage liquidity in conjunction with the portfolio maturities in the 2-30 day range as well as total liquidity fewer than 95 days. This strategy allows the portfolio to maintain adequate levels of liquidity while also targeting purchases further out the maturity range on our highest-rated credits. The improvement in credit has allowed investors to expand this maturity profile beyond 95 days. In addition to our current fixed-rate strategy, we remain buyers of floating-rate guaranteed issuance, both FDIC guaranteed and other Sovereign guarantees.

The Investment Desk remains cautiously optimistic in our belief that the worst of the credit crisis is behind us. While we have begun to expand our maturity profile, we have not changed our strategy. We remain focused on liquidity, creating an investment product that both supports our clients’ lending activities and allows flexibility to match their individual risk profiles. With the current excess liquidity conditions in play across the United States, U.K. and euro zone economies, we find it difficult to hold any other view than one of continued curve stability with potential room for long end flattening; however, we remain cautious as the market begins to digest rhetoric relating to potential central bank exit strategies.

This improved environment continues to present clients with challenges, but also the opportunity to foster open communication with J.P. Morgan. We look forward to these continued discussions around your program so that we can assess the risks and rewards of your reinvestment portfolio and its importance to your overall securities lending strategy.