From the Investment Desk

Market Update

The tone of the credit markets continued to improve during the first quarter, particularly at the short-end, despite Greece being in the headlines on a daily basis.  The strengthening environment has sparked renewed debate around the timing of the exit strategies of the Fed and the ECB. In addition to the removal of reserves from the market, focus has continued on the pace of monetary policy decisions throughout 2010.

The primary focus of short-end market participants has been around the timing of the Fed’s exit strategy as we near the expiration of credit easing.  The Fed’s asset purchases have slowed ahead of this date and attention has turned to the tools the Fed will utilize to drain reserves from the market. We envision the strategy as having two components, both an active and a passive withdrawal of reserves.

The first signs of the active exit strategy became apparent late in Q4 2009 when the Fed tested their reverse repo facility with the Primary Dealer community. The market continues to expect the expansion of this facility to include US Agency mortgage collateral, perhaps in the second quarter. Additionally, the Fed announced the expansion of the counterparties eligible to participate in the program to include certain money market funds. The inclusion of these counterparties will allow the Fed to drain an estimated $400bn of reserves. There are two additional parts of the active strategy:  the reintroduction of the Supplementary Financing Bills (SFP) and the Term Deposit Facility (TDF). The SFP bills will allow the Fed to drain an additional $200bn in reserves. The SFP bills have been auctioned weekly in $25bn increments with a 56-day maturity. This will allow the Fed to achieve the growth to $200bn in eight weekly auctions and then roll the program forward when the first issuance matures. The final piece of the active drain, the TDF, will offer interest bearing term deposits to eligible institutions through an auction process. These two additional pieces will enable the Fed’s active draining of liquidity to reach approximately $800bn.

The passive strategy will be achieved through the maturity of securities that are currently on the Fed’s balance sheet. The Fed expects that roughly $200bn of its mortgage holdings will mature or pay down by the end of 2011. Additionally, they have roughly $140bn in Treasury maturities in the same time frame. The combination of these two strategies will allow the Fed to drain roughly $1.15tn in reserves by the end of 2011.

Although the repo markets have had initial difficulty digesting the additional SFP issuance, we don’t anticipate the full effects of the reserve draining to ensue before late Q2 2010, when the Fed begins their reverse repo program in earnest. This timing would also correspond with the maturity of the ECB’s tender program in early July.

Beyond the timing of the exit strategy, market participants are also closely monitoring the Fed’s monetary policy statements with particular focus on the language that rates will stay low for an “extended period” of time. Following their March 16th meeting, the Fed left this language in place and noted the end of the asset purchase program. They also noted that “the labor market is stabilizing” in contrast to the January directive that “deterioration in the labor market is abating.”  Further they attributed depressed levels of consumer spending  to “high unemployment” as opposed to January’s “weak labor market.”  J.P. Morgan continues to expect no change in the target rate before 2011, although the desk believes that the target will be established at .25%, shifting from the 0-.25% current target as part of the removal of reserves and the end of quantitative easing.

As markets focus on the exit strategy, we have begun to see short-end market rates begin to rise. After hitting a low of .24875% in February, 3-month LIBOR has recently set at levels that we have not seen since the end of Q3 2009. The spread between 1-month and 3-month LIBOR, which stood at 100 basis points in early 2009 and dropped below 2 basis points in the first quarter, has begun to widen and now stands above 4 basis points. This steepening of the money-market curve will continue as the Fed exits and anticipation mounts for a shift in monetary policy.

The floating rate market continues to strengthen, in an ongoing but modest rally since Q4 2009. The market has seen issuance from the banking sector in maturities ranging from 6 months to 3 years. Issuers in the insurance sector, including Met Life, were able to tap the market as well, and we saw new corporate issuance from Berkshire Hathaway, PepsiCo and Toyota, among others. Additionally, we have seen continued active issuance from the US Agencies and will continue to look for opportunities in this market

Outlook and Strategy

The Investment Desk outlook and strategy has subtly shifted from the market concerns during the height of the credit crisis to the current efforts of the Fed and the ECB to remove liquidity from the market. During the crisis, we maintained our focus on liquidity as the secondary market was non-existent. Today, our liquidity strategy takes on a different, but no less important, focus. As the Fed and the ECB continue to drain reserves from the market, we anticipate that overnight funding levels will rise more quickly than short-term investment rates. The portfolio liquidity will allow the program the flexibility to respond to higher market interest rates and the corresponding higher funding costs in the form of rebates. J.P. Morgan continues to create liquidity through our maturity structure. We manage liquidity in conjunction with the portfolio maturities in the 2-30 day range, as well as total liquidity at fewer than 95 days. This strategy allows the portfolio to maintain adequate levels of liquidity to respond to daily market conditions, while also allowing the portfolio to respond quickly in a rising rate environment.

Although we continue to believe the credit market environment has improved and have expanded our investment tenors, our portfolio activity has recently been concentrated in maturities that are 95 days and fewer with targeted investing in select credits out to 185 days when the Desk sees opportunities that present value. In addition to our fixed-rate strategy, we remain buyers of floating-rate issuance, with the 1-month LIBOR being our preferred index. We are maintaining a defensive posture as the early stages of the central bank exit strategies begin. The Desk’s aim is to create an investment product that supports our client’s lending activities and is responsive to the market environment, while matching their individual risk profiles.

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