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Highlights
Outlook and Strategy
The focus on the euro-zone continued into the first quarter of 2011. Global credit concerns were exacerbated with the earthquake in Japan and lack of information regarding a potential nuclear disaster. The floating rate market remained active as new issuance was close to $90 billion in the US markets. It is important to note that the maturity profile is expanding in the floating rate market as there has already been 1.5 times the issuance in 3-year maturities than we saw for all of 2010. Further, the maturity extension of credits has been largely in the non euro-zone issuers, mainly Canadian and Australian Banks. LIBOR rates remained steady throughout the quarter with the highs being reached in mid-February. The 1-month rates began to fall in the last days of March, steepening the curve relative to the longer periods. Our strategy throughout the quarter remained focused on liquidity. This focus allowed the desk to quickly respond to market conditions and manage the ever challenging month-end and quarter-end periods.
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. 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. In addition to our fixed-rate strategy, we remain buyers of floating-rate issuance. Our preferred index remains the LIBOR indices, preferably 1-month. The desk has broadened interest to other indices beyond LIBOR, primarily the Fed Effective rate although given the steady decline in overnight rates as a result of QE2 and the retirement of the SFP bills we will monitor the spreads that we can attain on these investments. 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.
Looking forward the Desk will focus on the on-going effects of QE2 and the retirement of the SFP program. In addition, April 1 commenced the beginning of the FDIC assessment period and its impacts on rates in the short-end of the market. We continue to be concerned with US fiscal policy as it relates to the debt ceiling and fiscal austerity. The issues seem to be coming to a head and will need to be addressed to remove concerns around the debt sustainability in the United States, a topic once thought unthinkable. We would expect renewed focus on the Fed and their interest rate decisions given increasing concerns around headline inflation numbers and the foregone conclusion that the ECB will hike rates early in Q2. The economic numbers remain a mixed bag for the Fed as the housing market continues to show poor performance and the employment reports fail to build strong momentum. As the second quarter draws to a close we anticipate speculation around how the Fed will begin the process of removing all of the excess cash that it has helped to place into the system. We would expect a reintroduction of the SFP program as debt ceiling concerns are addressed and ongoing discussion around the other tools at the Fed’s disposal, namely reverse-repos and the Term Deposit Facility. The removal of reserves from the system and speed at which the process will commence is of paramount importance to our near term strategy. As reserves leave the system overnight rates will rise quickly. This rise in overnight rates will have an immediate negative impact on the distribution side of the lending book in the form of higher rebates, with the positive effect felt more slowly in the form of higher investment book yields. This relationship will be closely monitored throughout the coming months. 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.
Equity markets ended the quarter higher, with the most notable exception being Japan. The market rally over previous months has led to a reduction in short selling, as hedge funds increase their long exposure and are wary of adding short positions in a market where momentum is driving share prices higher. The market rally has been primarily driven by QE2 and improving economic data in the U.S., continued strength of the Asian economies, view the EU debt crisis will get resolved, and good company earnings. However despite the market pick up, risks still remain. These include an escalation of the European sovereign debt crisis, regulatory uncertainty, instability in North Africa and the Middle East (especially its impact on oil prices), and the Japanese earthquake/tsunami/nuclear crisis.
Demand continues to be driven by directional plays and capital raising arbitrage, e.g. rights and convertible bond issuance (can also lead to directional trades). The following sectors are driving revenue for directional: financial, alternative energy and technology (especially semiconductor). Looking closer at the sectors, Spanish, Portuguese and Italian banks have been the financial stocks most in demand. In the alternative energy sector, German solar power companies have been heavily lent (especially as funds shorted into a share price rally caused by the Japanese nuclear incident), and in technology, semi-conductor stocks, especially in Korea and Taiwan, have been in demand. M&A activity continues to be light, with Australia being our most active market, as high commodity prices spur deal activity. Borrowers continue to ‘internalize’ borrowing, having become much more efficient at covering shorts from internal positions, rather than from agent lenders. This varies by borrower, but can be as high as 50% of their shorts getting covered this way.
Q1 was the start of the European dividend season. Demand has been volatile relative to previous years. Markets trading down this year include Italy and Switzerland, whereas those trading up include France and Sweden. In general dividend payments are up on 2010, and a number of companies that did not pay a dividend in 2010 restarted in 2011 (e.g., Daimler of Germany and Swedbank of Sweden).
Money continues to flow into hedge funds, whose total assets under management are approaching their peaks. In contrast to 2010 in which money flowed into the larger funds, we have started to see more investor interest in smaller start ups thus far in 2011. We believe this will be positive for the industry, as it diversifies demand. Strategies that have performed well this quarter include convertible arbitrage, equity long short, event driven and macro.
On the regulatory side, the European Parliament has agreed on its position on short selling. Key areas of concern remain, namely: 1) restrictions on naked CDs 2) requirement to ‘reserve’ stock prior to short selling 3) marking of short sale orders. Positive progress made on: 1) public disclosure moved to anonymous 2) buy-in rules not to be included in the legislation. The European Council also has draft legislation, which they need to finalize and reconcile to the Parliament’s (so we expect further negotiation/horse trading, etc), after which everything has to be agreed by member states. At the time of writing the Commission was struggling to agree a common position.
Going Forward
Q2 will be the peak of the European dividend season. Most of the positions have been traded in Q1, but the revenue will peak in April and May.
We expect to see continued high levels of capital raising, particularly amongst financials as they prepare for Basel III.
Regulation will continue to be a concern as the European short selling legislation continues to play out, with the Parliament and the Commission trying to reconcile differing views into one rule book.
We hope for a more stable environment, with less macro shocks and less market volatility, creating a market more suited to stock pickers, which will help drive short demand.
2010 was a year in which rates slowly inched higher and then tapered off as year-end approached. That trend continued as the New Year began and it became evident that the Federal Reserve Bank was unlikely to remove its economic stimulus. During Q1 and into April, the repo and short term interest rate markets were impacted by the following:
Beginning in early November 2010, The Federal Reserve Bank under the Large Scale Asset Purchase program, commonly referred to as QE2, removed a steady supply of Treasury collateral from the market. Also, as we approached the U.S. debt ceiling, the Treasury began to wind- down the Supplementary Financing Program (SFP), allowing $195bn in bills to mature. Both the Treasury purchases by the Federal Reserve Bank and the SFP wind-down have led to an increase in banking reserves, which has caused short term rates, such as Federal Funds and Treasury funding to trade lower. U.S. Treasury repo rebates have declined on average 7-8bps. Specials are minimal and are limited to current issues. Trading activity continues to be driven by primary dealers’ emphasis on balance sheet allocation. In preparation for quarter-end where balances are volatile, the desk engaged in various short-dated term trades to help maintain liquidity over the quarter-end turn. Unlike the past two quarter-ends where rebate rates spiked higher, this quarter-end was sharply lower as more cash and less Treasury supply kept rates anchored. Ultimately, Treasury collateral averaged 0.16% and MBS averaged 0.24% on 3/31. Demand for non-cash collateral trades continue to increase as borrowers source balance sheet neutral trades. Financing rates for the agency and agency mortgage-backed asset classes continue to price at a premium to treasury collateral within a range of 2-4 basis points for the majority of the first quarter. There has been an increased demand for agency short coverings, albeit with limited dept.
Corporate bond balances rose only slightly during the first quarter. Events in Egypt and the rest of the Middle East, followed by the tragedy in Japan, led to an increase in risk-averse behavior among market participants. Many risk takers moved to the sidelines, covering short positions and reducing long positions. Through most of March, daily activity remained robust with little impact on balances. Demand remains the greatest for issues in the financial sector, followed by the communications sector and the consumer non-cyclical sector. We anticipate that balances will continue to grow into the second quarter as traders become more comfortable with geopolitical risks and begin taking on more risk.
April 1 was the beginning of the new FDIC Assessment Fee. Deposit Institutions will be charged for deposit insurance based on their assets less tangible equity instead of deposits. This follows a final rule approved by the FDIC. As a result repo rates, as well as other short term rates, traded with a downward bias. Treasury repo traded as low as 0-5bps and for some cases with a negative handle. It is surmised that this was an unintended consequence of the new assesment. Prior to April 1, U.S. banks could borrow in the Fed Funds or repo market at a level below 25bps and invest this with the Federal Reserve at 25bps interest on excess reserve (IOER) and lock in the spread. Since these liabilities were not insured, no FDIC assessment was involved. For some time now there have been banking entities that have taken advantage of the spread between Repo and the IOER. Banking entities would engage in repos with cash providers and pay a rebate of 10-15bps. Take the cash and leave it on deposit with the Federal Reserve Bank to earn the IOER spread of .25bps; netting 10-15bps. Until banks gain certainty of what their new assessment fee will be, this 10-15bp trade before the new assessment fee doesn't make sense. Banks will need to determine their new hurdle. It is estimated that around 50-70B of this trade was removed from the market: thus leading to the low range of rates evident during the first week in April.
In the current environment U.S. treasury repo market is extremely volatile and subject to unexplainable moves. However, for the remainder of Q2 we expect U.S. treasury repo rates to continue to trade low at the pre-quarter end levels of 8-12bps and possibly lower as the FRB continues with QE2. As a result we expect increased demand for U.S. Tresuries general collateral to continue.
Lastly, on February 2, 2011, the New York Federal Reserve Bank added two more primary dealers to the list of Primary Government Securities Dealers. Both, MF Global Inc. and SG Americas Securities, LLC. have been added to the list to bring the number of primary dealers transacting with the New York Fed to 20.
In terms of the outlook for 2011, low repo and other short term rates, induced by the new FDIC assessment fee and the Fed’s ongoing Treasury purchases (QE2) will persist in the near term. Demand for non-cash collateral trades will continue to increase as borrowers source balance sheet neutral trades. Corporate bond balances will continue to grow as traders become more comfortable with geopolitical risks and begin taking on more risk.
International
Following the strong growth we saw throughout 2010, balances and volumes in the international fixed income book continued to increase and reached new all time highs towards the end of the first quarter. The main drivers were German specials, a spread between European sovereign issuers and more intrinsic value in the corporate bond book.
Borrowing demand for all European government bonds remained high throughout the quarter. Shorts in peripheral European countries meant that specific issues continued to trade at higher spreads in the repo market, while a flight to quality to core Europe meant that the highest quality collateral was in demand. Which lead to increased demand for Germany, France and The Netherlands. Overnight general collateral rates continued to be volatile with EONIA setting between 0.347% and 1.318% during February. March was a more stable period.The ECB left its benchmark interest rate at 1% even as inflation breaches its 2% limit. The sovereign debt ratings of Spain, Greece and Portugal were all downgraded during March. However, Spanish 5 year CDs were much lower during the quarter (349 at the beginning of January vs. 216 at the end of March) indicating that the market is viewing the Spanish situation as very different to that in Portugal.
U.K. Gilt supply remained abundant with virtually all issues trading as general collateral across all maturities.
Activity in the credit markets remained high and intrinsic value remained strong but the average spread was affected week to week by the volatile overnight cash rates in USD and EUR. The majority of corporate issues trading significantly special were high yield bonds with borrowing demand usually caused by illiquidity.
Looking toward the rest of 2011, as the volatility continues in the European markets we expect the flight to quality trade to persist with the demand for Germany, France and the Netherlands remaining constant along with continued demand for specific issues in the peripherals.
