From the Investment Desk

Market Update

As the end of Q2 approached, investors began returning to the market as funding was provided to many issuers through creative floating-rate structures. The market focus as Q3 dawned was on the results of the stress-tests that were performed on several euro-zone banks. The anticipation of these results was enough to continue the positive tone in the short-end of the market as investors continued their return. LIBOR rates reversed course during the quarter as the spread between 3-month and 1-month LIBOR went from nineteen basis points on the first of July to less than four basis points by quarter-end. This flattening of the yield curve was a stark representation of the state of the market. Issuers continued to experience the renewed access to investors that was started by the first foray into the floating rate structures. Further, the release of the stress-test results lead to credits being reapproved as well as credit lines being extended on already approved names.

After closely monitoring our euro-zone exposures during Q2, and with the anticipated release of the stress-test results and the corresponding maturity of our last exposures to Spanish and Italian banks, we began to reassess our stance on these credits during Q3. We ultimately resumed our investing in select Spanish and Italian banks as our maturities came due, focusing initially on maturities in the 1-month area.

Throughout the early months of 2010 the market had been focused on the Federal Reserve’s exit strategy and the tools they would use to drain reserves from the system. The Federal Reserve reintroduced their Supplementary Financing Bills (SFP), and successfully tested their reverse-repo facility and the Term Deposit Facility (TDF) before the end of Q2. The SFP and TDF along with the reverse repo facility remain the primary weapons in the Federal Reserve’s toolbox for the active removal of reserves. During the euro-zone crisis it became apparent that this toolbox would not be needed for quite some time. Focus has returned to the Federal Reserve’s statements however as the health of the global economy and concerns that the recovery may stall lead to expectations of a double dip recession. These concerns have brought renewed interest in the FOMC statement with expectations not of an exit but rather a renewal of quantitative easing. In their statement following the September 21, 2010 meeting, the FOMC specifically mentioned that “measures of underlying inflation are currently at levels somewhat below” what they judge to be consistent with their “mandate to promote maximum employment and price stability”. Further, they state they are prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate. This statement has lead to anticipation of future details following the November meeting. There are many opinions on the size and pace of the Federal Reserve’s next move, but most center on the purchase of US Treasury securities. The impact of the FOMC actions will become clearer as details are provided to the market.

Outlook and Strategy

2010 has challenged the Investment Desk with varied twists and turns. Early in the year the global economy was improving and the focus was on the removal of excess liquidity from the market by both the Federal Reserve and the ECB. The concerns that presented themselves in the euro-zone during Q2 shifted that belief, and the removal of excess liquidity was the last thing on market participants’ mind. As concerns were put aside early in Q3 and investors returned, the focus shifted to a stalling global recovery that now leaves us waiting for signs of renewed quantitative easing, with thoughts that the Federal Reserve will not raise rates until 2012. Our strategy throughout this tumultuous year remains focused on liquidity. This focus has allowed us to maneuver the changing landscape and quickly respond to market conditions. Throughout the market environment of the past few years the Desk has witnessed the value portfolio liquidity plays in allowing us to address any challenge. The focus on building and maintaining liquidity through our maturity structure, with portfolio maturities in the 2-30 day range as well as total liquidity less than 95 days continues to serve the program well.
 
The portfolio investment activity remains concentrated in maturities that are within 95 days. We have utilized select credits out to 185 days in the fixed rate market when value opportunities present themselves. In addition to our fixed rate strategy, we remain buyers of floating rate issuance with our interest expanding to other indices as the activity in the floating rate market continues to be strong. Our preferred index has been 1 month LIBOR and we are now adding Fed Effective rate floaters to the portfolio. These floaters reset daily and present value in a market where LIBOR rates have fallen as dramatically as we have seen over the past few months time. The Desk’s aim is to create an investment product that supports our clients’ lending activities and is responsive to the market environment, while matching their individual risk profiles.

The Desk believes that global concerns remain and will continue to challenge the markets in the future as the global economy recovers. We welcome the 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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