Updates From the Desks

Lending Desk: Equities

The second quarter was very volatile for equities as the European debt crisis continued to cause concern among investors. Markets rallied on positive news such as the Portuguese bailout in April and the Greek Parliament's approving austerity measures at the end of June. However, between these periods of optimism, negative news and uncertainty led to a ‘risk’ off scenario, with investors moving into safe havens such as Government bonds and cash. In addition to Europe there were other concerns adding to the uncertainty, including the U.S. debt ceiling stand-off, continued unrest in North Africa and the Middle East, inflation in emerging market countries, concern about the strength of the global economic recovery, and the end of U.S. QE2 in June.

The second quarter was a bad quarter for hedge funds as uncertainty and market volatility led to a difficult trading environment. A sharp rise in correlation between asset classes, made it difficult for stock pickers and for investors to hedge positions. Funds were therefore lacking in conviction and direction, and on the short side, even where a fund had a negative view, they were reluctant to take the risk of expressing that opinion by going short.

Demand to borrow continued to be focused on directional plays and capital raising arbitrage (e.g., rights and convertible bond issuance). Sectors driving lending revenue included financial, alternative energy, retail and technology. The second quarter was the peak European dividend trading period for the year. Performance was mixed due to changes in borrower demand and tax rules. Out of the major markets, France and Sweden traded higher, while others, such as Italy and Switzerland, were lower, and Germany and Finland were flat to 2010. In general, dividend payments were up and several companies that didn’t pay a dividend in 2010 started paying again this year.

In Europe, capital raising by financials as they sought to strengthen balance sheets ahead of European wide stress tests and future Basel III rule changes, was a big driver of borrowing demand. There was also directional demand for financial shares in the European periphery countries off the back of the debt crisis, especially the small to mid cap stocks. The alternative energy sector was also in demand by short sellers as the industry faced the headwinds of reduced Government subsidies and increased competition from Asia.

In Asia Pacific, the technology sector (especially semi conductors), auto, property and construction, and consumer sectors were all in demand. Hong Kong became very active as investors took a negative view on the back of slowing Chinese growth, credit tightening and accounting/corporate governance concerns with certain Chinese companies. Korean and Taiwanese balances were also strong, with the semi conductor space being of particular interest.

U.S. equities experienced an increase in short-selling activity, with IPO stocks attracting particular demand, along with U.S. listed Chinese stocks, again off the back of corporate governance and accounting concerns. Other revenue generating sectors included retail and alternative energy. Fed funds traded at low levels, with reinvestment opportunities constrained due to a lack of collateral. This led to the U.S. equity general collateral (GC) rate being set at zero and even trading negative at times. At the end of the quarter the Russell rebalance caused a lot of volatility in the lending market as clients sold out of securities leaving the index and bought those that were entering.

On the regulatory front, discussions continued between the European Parliament, Council and Commission to try and produce an agreement on rules governing short selling in Europe. Disagreement remains on uncovered short selling of shares, bonds and CDS, plus the powers to be given to European Securities and Markets Authority (ESMA) to monitor and control short selling, versus those of individual member states. Further meetings are not expected until September.

Lending Desk: Fixed Income

Beginning on April 1, Fed Funds, repo rates and other short-term rates decreased because of the new Federal Deposit Insurance Corp (FDIC) assessment fee. The FDIC adjusted the calculations of U.S. banks’ deposit insurance fees to include all liabilities rather than just domestic deposits, which includes excess reserves. Prior to April 1, U.S. Banks could borrow in the Fed Funds or repo market at a level below 25bp and invest this with the Federal Reserve at 25bp (interest on reserves) 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 interest on excess reserves (IOER). Banking entities would engage in repos with cash providers and pay a rebate rate of 10-15bp and then take the cash and leave it on deposit with the Federal Reserve Bank to earn the IOER of .25bp for a spread of 10-15bp.

The U.S. debt ceiling debate is likely to attract most of the focus of the U.S. markets as it nears the August 2 deadline.While there will be numerous headlines and political debates in the time leading up to this date, market participants widely expect the debt ceiling to be raised and for Treasury to continue to honor all of its debt service obligations. Bond markets in the U.S. have in fact rallied to yearly low yields as investors seek the safety of Treasury securities because of weak global economic data and ongoing sovereign debt issues in Europe. The two-year note auction at the end of June had the lowest yield on record for the two year note at .395%. In terms of Treasury coupon issuance, benchmark sizes have remained unchanged on the year while the paydown in Treasury bills that began in late April has continued. The reduction in bills outstanding is only one of the factors that have helped to keep repo rates low. The paydown in bills is expected to continue into the middle of July.

Trading activity continues to be driven by primary dealers’ emphasis on balance sheet allocation. Because of the increased focus on balance sheet, the desk engaged in various short-dated term trades to help maintain liquidity over the quarter-end turn.  These term trades were inclusive of Treasury, Agency and Mortgage Backed securities. As a result, the desk secured term commitments from dealers as early as possible. This quarter-end rates were sharply lower as more cash and less Treasury supply kept rates anchored. Fed Funds opened at a record low 0.02% and Treasury general collateral traded as low as a negative rebate rate as Treasury supply dwindled. The spread between Treasuries, Agencies and Agency MBS widened as Treasury general collateral traded in a range of 0.05% to negative 0.25% and MBS traded in a range of 0.30% to 0.12%. The majority of borrowers were not involved as reducing balance sheet usage remains paramount. The benefits of balance sheet neutral trades and the need to secure longer term financing (as compared to overnight), has led to greater demand for non-cash trades.

The Federal Reserve completed $600 billion in Treasury purchases on June 30 as part of the asset purchase program called QE2. The Fed will continue with the reinvestment of principal payments from agency debt and agency MBS at least into mid-July of this year – a program that had been announced by the FOMC on Augst 10, 2010. Many market participants believe that the Federal Reserve will begin to exit its accomodative monetary policy stance beginning with the cessation of these reinvestments. In fact, Federal Reserve Chairman Ben Bernanke has stated on numeorus occasions that the end of reinvestments would signal a shift to a less accomodative policy stance. Following this, market participants anticipate the Federal Reserve will begin to drain the record amounts of excess reserves through the use of the Term Deposit Facility (TDF) and large-scale Reverse Repos (RRP). While Repos and Reverse Repos have been previously used in the past as a way for the Federal Reserve System to achieve its monetary policy objectives, the TDF is a relatively new policy tool that was introduced in March 2010. Next, the Fed will likely raise the Federal Funds rate, with J.P. Morgan currently projecting the first Federal Funds rate hike in the first quarter of 2013. Finally, the Federal Reserve could conduct outright sales of its GSE Agency and MBS holdings to bring its balance sheet back to historical norms.

Agencies / MBS

As the first half of the year comes to a tumultuous end, agency and agency mortgage-backed collateral continues to trade above treasury collateral, as was the case at the beginning of the year.  Agency collateral traded 1-4bp above treasury collateral while mortgage backed collateral traded 2-5bp above treasury collateral. The world economic situation with several countries’ debt being downgraded has made the reinvest climate a bit precarious at best. The strategy for lending of the asset classes has been difficult to guage and requires restructuring of positions on the open general collateral book almost daily. Balance sheet considerations have become a larger concern for dealers, which challenges month-end and quarter-end positioning. This makes the partnership with our reinvestment desk more important than ever. Towards the end of the quarter, liquidity risk has been alleviated by transacting term loans of general collateral assets especially in the agency and agency mortgage classes.

In an effort to further reduce fails and support liquidity, The Treasury Markets Practices Group (TMPG), at its April 29 meeting, proposed fails charge recommendations for agency and agency mortgage backed securities which are effective February 1, 2012. Securities subject to this charge would include agencies issued by Fannie Mae, Freddie Mac and Federal Home Loan and mortgage backed securities issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. The agency fail charge would be similar to those charges for fails on treasury securities which is a fails charge equal to the greater of 0% and (3% minus the fed funds target rate). Mortgage backed securities fails charge has been modified slightly and will consists of a fails charge equal to the greater of 0% and (2% minus the fed funds target rate).

Corporate Bonds

Corporate bond balances increased over 15% in the second quarter. Issuance was down during the quarter as concerns increased around the sovereign debt crisis in Greece. June was the slowest month for new issuance thus far in 2011. Despite lower new issuance and heightened economic and geopolitical concerns, daily activity was very brisk. Brokers were actively locating and borrowing securities up until the end of the quarter. However, the daily volumes remained high, but duration short. Specials continue to be rerated to rebates closer to general collateral levels. Market participants continued to quickly cover trades and aggressively manage risk positions. Financials (banks and consumer finance companies) remain the sector most in demand. We anticipate balances to drift lower through the summer months on a lighter new issue calendar and on continued concerns about sovereign debt and the global economy.

International

Balances and volumes in the international fixed income book continued to grow; continuing with the theme evident in 2010 and first quarter of 2011. The main drivers were European sovereign specials, a spread between core and peripheral European sovereign issuers and significantly higher volume in the corporate bond book. Borrowing demand for European government bonds remained generally high throughout the quarter. Shorts in peripheral European countries meant that specific issues continued to trade at negative rebates in the repo market. However volumes decreased in Greece, Portugal and Ireland. A continued flight to quality to core Europe meant that the highest quality collateral was in constant demand – leading to increased specials in Germany, especially during May. Overnight general collateral rates continued to be volatile with EONIA setting between 0.531% and 1.549% during the quarter. Volatility was especially pronounced during June. A freeze in the interbank market because of the political crisis in Greece led to rates spiking by 65bp over three days.

Greece will get a vital loan instalment by July 15, saving it from an impending default, while work continues on a second bailout for the struggling country. The Greek parliament responded to EU and IMF demands by passing 28.4 billion euros in budget cuts and tax hikes, and a 50-billion-euro privatization program, despite rioting in the streets of Athens. Greece is now expected to receive 12 billion euros from the euro zone and IMF after finance ministers approved the fifth tranche of aid from last year's 110-billion-euro financial rescue package. However, a final decision on the new aid plan has been left until the involvement of banks and other private creditors has been resolved.

As expected, the ECB raised rates at the April meeting to 1.25% - the first hike in three years. On July 7, President Trichet confirmed that the ECB would again raise rates 25bp to 1.5% and indicated a further hike is likely this year.

U.K. Gilt supply remained abundant with virtually all issues trading as general collateral across all maturities. However, demand to borrow under 10 year maturities meant that most remained fully lent throughout the period. The Bank of England left their benchmark rate on hold at 0.50% while their asset purchase program remained at £200 billion as the majority of the MPC warned that tightening policy now could dampen consumer spending and hamper the recovery.

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 EUR and, to a lesser extent, in USD. The majority of corporate issues trading significantly special were high yield bonds with borrowing demand usually caused by illiquidity.