From the Investment Desk

Market Update

The headlines have been dominated throughout the second quarter by stories relating to the concerns in the euro-zone countries.  The focus has been primarily on Greece, but has also spread to Ireland, Portugal, Italy and Spain.  The concerns lead to an unprecedented bailout package in mid-May that was put together by the ECB with support from the IMF and governments in the region. This bailout followed an aid package that was designed solely for Greece.  The broader package includes 440bn euros worth of government-backed loan guarantees and bilateral loans provided by euro-zone members through the development of a special purpose funding vehicle, an expansion of an existing balance of payments facility supported by EU members worth 60bn euros and 220bn euros in IMF support.  All told the package would be nearly one trillion dollars.  The work in the region is far from done as the difficult fiscal austerity measures must continue to be enacted so that these governments are able to stand on their own in the future.

J.P. Morgan continues to monitor exposures in the euro-zone countries.  We have never invested in Greece debt, we removed Ireland from our approved list in February 2009, and we took action to allow our exposures to Portuguese banks to roll off beginning in February 2010 allowing our exposures to mature before Portugal was downgraded.  Additionally in April 2010 we began to monitor our exposures to Spanish and Italian banks and allowed these exposures to mature.  As we come to the end of the second quarter we have seen a majority of this exposure mature with the remaining maturing in July and August.   

The focus in early Q3 will be on the maturing on the ECB’s 440bn tender program that was put into place last summer.  This program provided liquidity to banks in the region at a rate of 1% with a pledge of collateral securities.  This one year program will be replaced with a 3-month maturity program also at a rate of 1% and supplemented with the 1-week tender program.  This is not as attractive as 1-year financing at the same level and it is our expectation that participants will continue to focus on issuance in the broader markets and that use of the facility will be primarily by banks that are not able to access the capital markets.  We expect this to lead to volatility in short-end interest rates early in the quarter as banks sort out their use of the 3-month and 1-week tender programs while also testing access to funding in the market.

We have begun to see signs of this access to funding in the market during June.  The floating rate market began to show renewed signs of the strength we saw in Q4 2009 and Q1 2010.  After being relatively quiet early in Q2 as the market sorted out the euro-zone worries we have witnessed the markets resilience and creativity.  The issuance of the month during June was putable structures with step-up coupons.  These structures respond to the needs of investors, notably 2a-7 money-market funds by giving them the 7 day liquidity that they need under the revised 2a-7 rules, and also issuers who have been unable to tap the markets for funding.  The issuers are offering attractive levels but in a structure where the investor needs to hold the security to its final maturity date and not put the security back to the issuer early.  The coupon steps up each month that the investor continues to hold the security.  If the investor holds until the final maturity they will receive an attractive yield and the issuer receives the funding they were initially looking for in the 6-month or 1-year period.  The investor has the further benefit of the put should any concerns arise around the issuers credit, while the issuer bears the risk that when they need funding the most, during a crisis, they will likely lose it due to uncertainty.  There has been approximately $20bn issued during June and this has lead to issuers also being able to access the markets in straight fixed rate issuance as well as better rated issuers accessing the markets in structures with longer put dates, 1-month to 60-days.

With the market’s focus predominantly on the euro-zone there has been less focus on the timing of the Fed’s exit strategy.  The Fed has concluded their asset purchases and has completed the reintroduction of the Supplementary Financing Bills (SFP) through a series of weekly auctions of $25bn 56-day maturity bills, taking the program to $200bn.   Additionally the Fed has authorized five small value offerings of their Term Deposit Facility (TDF) and offered the first 2 during June.  They consisted of a $1bn 14 day offering on June 14th and a $2bn 28-day offering on June 28th. The third planned test of the TDF facility will take place in mid-July and will entail an offering to 84 days.  The additional two tests may be planned later in the summer.  The SFP and TDF along with the reverse repo facility tested earlier in the year, remain the primary weapons in the Fed’s toolbox for the active removal of reserves. 

The crisis in Europe has taken some focus off of the Fed’s monetary policy statements as it seems to be a foregone conclusion that the Fed is on hold for the foreseeable future given the broader global concerns.  We continue to monitor the Fed as well as the health of the global economy and concerns that the recovery may stall and we will have a double-dip recession.

Outlook and Strategy

The Investment Desk believed as we exited Q1 that our focus would be on the continually improving global economy and that the efforts of the Fed and the ECB to remove liquidity would be our primary concern.  The news of the euro-zone shifted that belief and we were faced with days to rival those of the toughest times during the credit-crisis.  During the crisis we maintained our focus on liquidity as the secondary market was non-existent.  As market conditions improved we felt that our portfolio liquidity would allow the program the flexibility to respond to higher market interest rates and the corresponding higher funding costs as the Fed and ECB began their withdrawal of reserves from the market. Instead our liquidity allowed the Desk to respond to the latest chapter in the credit crisis as our more worrisome credits matured.  This constant focus on building and maintaining liquidity through our maturity structure continues to serve the program well.  We manage liquidity in conjunction with the portfolio maturities in the 2-30 day range as well as total liquidity less than 95 days. This strategy allows the portfolio to maintain adequate levels of liquidity to respond to daily market conditions and ensures that the portfolio is able to respond quickly when market volatility returns.

The portfolio investment activity remains concentrated in maturities that are 95 days and less.  As the market calms we may target 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 1-month LIBOR our preferred index.  The desk continues to monitor the new issuance and structures in the floater market and we have purchased a floater with a 60-day put although we have not purchased any issuance to date with 7-day puts.  We remain defensive as we move through the summer months and assess the volatility in the markets and the reaction to the extreme measures put in place to stabilize the euro-zone.  We will continue to monitor our Spanish and Italian bank names and their access to market funding with the potential to reenter these markets as stability of funding returns.  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.

We continue to experience new challenges throughout this market cycle and expect that this will continue in Q3 and beyond as we deal first with global concerns and further along with the exit of the Fed and the ECB that has been so greatly anticipated.  The Desk welcomes the continued opportunity that these times provide to foster open communication between J.P. Morgan and our client base.  The Desk looks forward to continued discussions around your program as we assess the risks and rewards of your reinvestment portfolio and its importance to your overall securities lending strategy.

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