JP Morgan - Global Fixed Income Markets Weekly - March 9 2012

European Rates Strategy
J.P. Morgan Securities Ltd. March 9, 2012
Global Fixed Income Markets Weekly

Overview Pavan Wadhwa, Kedran Panageas CACs have been invoked on Greek domestic-law bonds, and Greece has received 60% participation on its foreign law bonds, suggesting at least 96% of the total eligible universe of bonds will be restructured. This will reduce Greeces net debt burden by 30% of GDP. Greeces upcoming interest payments will be reduced by 1/3rd, and upcoming bond redemptions by 2/3rds; official sector ownership of Greek debt will increase from 37% pre-PSI to over 60% post-PSI. This reduces the chance of a second private-sector default. We remain in risk-on trades. Euro Pavan Wadhwa, Fabio Bassi, Gianluca Salford Euro area growth has historically surprised to the downside, and inflation to the upside. Stay tactically short duration. 20Y German bonds are cheap to 30Y. Stay long peripherals and implement 4s/10s Italian curve flatteners. Underperformance of Spain vs. Italy is due to technical and fundamental factors. Sell DSL Jul20 vs. RFGB Apr20. Hold weighted greens/10Y steepeners and receive 5Y in the 1s/5s/12s level-neutral fly. We favour 1s/3s and 1s/5s bull flatteners, and recommend 3s/7s/15s OTM bear belly cheapeners. We target 2Y b/m swap spreads at 75bp; hold June Schatz swap spread narrowers both outright and hedged-with June FRA/OIS basis wideners. Stay bearish 3Mx10Y swaption gamma but delta hedge less frequently. Hold shorts in Jun12 Schatz unhedged strangles. UK Francis Diamond Momentum and techicals suggest staying neutral duration. Keep reds/greens swap curve steepener, or 4H13/5s14 gilt curve steepener. The 5s/10s gilt curve is too flat keep tactical stepeener. Stay long the belly of the 10s/30s/50s gilt fly. We preview the FY12/13 gilt financing remit, and expect an 11bn reduction in gross gilt sales to 168bn. We expect a small increase in short nominal gilt issuance in FY12/13, and a decline in medium and long nominal issuance. US Terry Belton, Srini Ramaswamy Stay bearish on duration over the medium term. Remain in 30Y swap spread widener and 10Y swap spread narrower hedged with FRA/OIS widener. Turn bearish on gamma and sell 3Mx10Y straddles. Japan Takafumi Yamawaki, Yuya Yamashita Stay neutral on duration and hold JGB curve steepeners. The BoJs purchase is expected to support JGBs, but any downside in yields should be limited unless the BoJ introduces more easing measures.
Pavan WadhwaAC
(44-20) 7777-3370 pavan.wadhwa@jpmorgan.com
Fabio Bassi
(44-20) 7325-8615 fabio.bassi@jpmorgan.com
Contents
Overview Euro Cash European Derivatives United Kingdom US Cross Sector US Treasuries US Interest Rate Derivatives Japan . Interest rate forecasts Recent curve movements Recent sov cash spread movements Recent sov CDS spread movements Sov & bank redemptions Event risk calendar Euro-area fact sheet / SMP Purchases Global Market Movers 46 47 48 49 50 51 52 56 2 7 12 20 26 29 36 42
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J.P. Morgan Securities Ltd.
See page 54 for analyst certification and important disclosures.
European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Pavan WadhwaAC (44-20) 7777-3370 Kedran Panageas (44-20) 7777-0326 J.P. Morgan Securities Ltd.
Overview
Greece received enough participation to invoke CACs on its domestic-law bonds; 60% of foreign law bondholders tendered as well. suggesting that at least 96% of the total eligible universe of bonds will be restructured, slightly better than the IMF target of 95% A 96% participation rate allows Greece to reduce its net debt burden by 68bn, or around 30% of GDP The domestic-law exchange will be settled Monday 12 March; the foreign-law exchange extends through late March and will settle in April PSI reduces the near-term market relevance of Greece in two ways: First, the magnitude of the issue posed by Greece has shrunk: Greeces upcoming interest payments are reduced by 1/3rd, and upcoming bond redemptions are reduced by 2/3rds Second, PSI increases the official ownership share of Greek debt from around 37% pre-PSI to over 60% post-PSI (growing to nearly 75% by 2020) while the official share of upcoming bond redemptions over the next 3 years is even higher (95%) due to ECB SMP holdings Successful PSI and high official sector exposure reduce the chance of a disruptive private-sector default We remain in risk-on trades. Yields, front-end swap spreads, and tenor basis have retraced the least since mid-2011 Ambitious austerity measures and Greek election rhetoric may eventually lead to fiscal slippage and friction with the Troika, creating mediumterm risk
Exhibit 1: Greece received enough participation to use CACs on its domestic-law bonds, and 60% of foreign law bonds have been tendered as well. At least 96% of the total eligible universe of bonds will be restructured, slightly better than the IMF target of 95%
Greek debt exchange participation rates; bn without CACs with CACs* Domestic Foreign* Total Domestic Foreign* Total Tendered 158 13 172 184 13 197 Total 184 22 206 184 22 206 % 86% 61% 83% 100% 61% 96% * The deadline for participation from foreign-law bonds is in late March. We expect revocations of previously submitted instructions for foreign-law bonds to be minimal. Also, CACs may be applied across individual foreign-law issues, boosting the total. Note: The IMF assumed 95% PSI participation in their 15 Feb 2012 debt sustainability analysis. Source: Greek Finance Ministry, IMF
action clauses (CACs) on domestic-law bonds. This brings the overall participation rate to 96% (Exhibit 1), which is above the IMFs target of 95%, as laid out in the IMFs latest debt sustainability analysis (DSA) from 15 Feb. We expect the formalities to be concluded early next week, with the domestic-law exchange settling Monday 12 March. The new Greek bonds are already trading in the when-issued market. The invocation of CACs triggered a CDS credit event (as determined by ISDA late Friday) and an auction will be held to settle Greek CDS on Monday 19 March. The foreign-law exchange is still ongoing, and foreignlaw bondholders have until late March to respond (Exhibit 2). Each specific issue has a separate bondholders meeting scheduled for the last week of March; investors can submit participation instructions up to Friday 23 March or can vote at their respective meetings (occurring between 27-29 March). We expect that on Friday 30 March Greece will tally the foreign-law responses and announce their intentions. Because the CACs are issue-specific rather than aggregate, Greece will likely accept all voluntary tenders and apply CACs where the particular voting thresholds have been met, on a bond-by-bond basis. In theory, the foreign-law participation rate could go up or down from here. It could go up in two ways: first, more positive responses could be received, and second, Greece has decided to pursue the use of CACs on a set of bonds which were previously exchange-only.1 On the
1 These bonds are mostly small private placements issued by stateowned entities. They tally 6.7bn but the reported voluntary participation was already close to 6.4bn. The settle date was initially 12 March. Now that Greece will pursue CACs, the participation deadline will be extended and the settle date has been pushed to 11 April. However, participation instructions that have already been submitted cannot be revoked.
Mission PSI: (almost) accomplished

Last Thursday was the deadline for Greek bondholders to submit participation instructions for the Greek debt exchange. On Friday Greece announced a participation rate around 84%, in line with our expectations. They also announced that they would indeed invoke collective
2
Exhibit 2: A 96% participation rate allows Greece to reduce its net debt burden by 68bn, or around 30% of GDP. The domestic-law exchange will be formally approved and settled early next week; the foreign-law exchange extends through late March and will settle in April
Bonds targeted in the Greek debt exchange, reported participation rates and consequent debt reduction benefit to Greece
Group (1) (2) (3) (4) Total Bond Type Governing Law Domestic Domestic exch-only* Foreign Foreign (Swiss)** Amount bn % 177 7 21 0.5 206 86% 3% 10% 0% 100% Participation Thu 8 Mar TBD*** Key deadlines Revocation Wed 7 Mar Settlement Mon 12 Mar Collective action clauses (CACs) Debt Reduction (bn) To be used? Threshold Participation Gross Net^ Yes (aggregate across issues) Likely (aggregate across issues) Partial (by issue) Possibly (single issue) 66% TBD*** 66% - 75% na 100% 100% 61% 61% 96% 95 4 7 0.2 106 57^ 4 7 0.2 68
Wed 7 Mar*** Wed 11 Apr*** Wed 11 Apr Wed 11 Apr
Fri 23 Mar, mtngs Tue- two days Thu 27-29 Mar before mtng Fri 23 Mar, mtng Wed 28 Mar --
* A small group of domestic-law bonds was targeted in a separate offering memorandum. These are primarily private placements from state-owned enterprises Hellenic Railways, Athens Urban Transport Organisation, and Hellenic Defense. Initially these bonds were to be exchanged only (i.e. no use of CACs)***. ** The Swiss-denominated bond was targeted in a separate offering memorandum due to Swiss legal requirements. *** Initially the bond offer to Group (2) was to exchange only and settlement was anticipated for 12 March. However, the Greek Finance Ministry announced on 9 March that they would delay settlement in order to pursue the use of CACs. The participation deadline and the voting threshold will be clarified when the new offering memorandum is sent out. Settlement is delayed to 11 April. Previously submitted participation instructions cannot be revoked on Group (2). Greek will pursue the use of CACs on Group (2). These will likely be in the form of aggregate CACs (voting across issues), and since the vast majority of these bonds have already tendered (6.4bn out of 6.7bn), CACS should be successfully invoked. Voting threshold to allow the use of CACs. For domestic-law bonds, the threshold is defined as a percentage of those voting. Foreign-law bonds are mixed, but most frequently the voting threshold is defined as a percentage of total outstanding principal. This occurs in the case of 2/3rds of the total principal, predominantly Greek Republic international bonds (14bn). The remaining 1/3rd (7bn, predominantly railway bonds) have thresholds defined as a percentage of those voting. ^ Net debt reduction is defined as the debt reduction after exchange-related bank and social security fund recapitalization (23bn and 15bn, respectively). Source: Greek Finance Ministry, Bloomberg
other hand, participation could go down if investors revoke their previously submitted instructions. Instructions can generally be revoked up to two days prior to the bondholders meetings (although note, current participation for the above-mentioned set of bonds cannot be revoked). In general, we expect revocations to be minimal, and for the overall participation rate to continue to inch higher. This is because the risk of a later Greek default or debt restructuring is high, and a subsequent writedown is likely to be on worse than current terms (discussed further below). The current level of participation is enough to reduce Greeces gross debt burden by 106bn. After subtracting exchange-related recapitalization expenses of 23bn for banks and 15bn for social security funds, the net debt reduction is 68bn (Exhibit 2), around 30% of GDP. This is a substantial reduction but is still modest in the scale of Greeces overall debt burden (Exhibit 3). Furthermore, we expect continued fiscal slippage amounting to around 20bn over the next three years.2 Greeces high debt burden and challenging fiscal targets will keep it in the longer-term spotlights.
Exhibit 3: PSI reduces the near-term market relevance of Greece in two ways. First, Greeces upcoming interest payments are reduced by around 1/3rd, and upcoming bond redemptions are reduced by around 2/3rds
Estimated Greek debt burden before and after PSI Period Post-PSI Pre-PSI
Chg -32% -36% -41% -43% -20 -25 -64 -56
Current Total Debt (% of GDP) Interest Ex pense (bn) Bond redemptions* (bn) end-2012 end-2015 end-2020 2012 - 2015 2016 - 2020 2012 - 2015 2016 - 2020
131% 157% 154% 124% 48 72 38 21
163% 193% 195% 167% 68 98 102 77
* Does not include T-bills and official loans Note: we assume economic, interest rate and fiscal scenarios based on the IMFs latest DSA from 15 Feb 2012. PSI profile and participation rates are based on 9 March press release from the Greek Finance Ministry. Source: Bloomberg, IMF, Greece, J.P.Morgan
2 See Challenges facing the second Greek package, Nicola Mai, 9 March 2012
However, the PSI and the accompanying EU/IMF aid package do reduce Greeces near-term market relevance, for two key reasons. First, obviously the magnitude of upcoming liabilities has been reduced. For instance, we estimate that the face value haircut reduces Greeces upcoming interest payments by around 1/3rd, and the haircut and maturity extension reduce upcoming bond redemptions by around 2/3rds (Exhibit 3).
3
Second, the debt restructuring effectively transforms much of Greeces private debt into official-sector debt (by granting EFSF sweeteners in the exchange, providing bank recapitalization funds, etc.). This high official sector exposure means less chance of a disruptive private sector default in the near-term. For instance, we estimate the following: The official ownership share of Greek debt will grow from around 37% currently to over 60% after the PSI exercise is concluded, and will grow to nearly 75% in subsequent years (Exhibit 4). There is considerable scope to restructure official sector debt via maturity extensions, interest rate reductions, ECB profit-sharing, etc. Around 95% of upcoming maturities over the next few years will be bonds owned by the ECB or various national central banks (Exhibit 4).3 EU governments wont want the ECB to realise a loss, and private sector maturities will be minimal due to the 10-30Y maturity extension on exchanged bonds. For small issues/holdouts that mature over the next 3-6 months, it may be preferable to pay out at par rather than risk a hard default. Similarly, around 3/4ths of upcoming Greek interest payments will go to the official sector due to the ECB/NCB owned bonds and large stock of official sector loans (Exhibit 5). The escrow account and the EFSF co-financing arrangement will lower near-term payment risk for new Greek bonds, to a certain extent.
Exhibit 4: Second, PSI increases the official ownership share of Greek debt from around 37% to over 60% (growing to nearly 75% by 2022). Given the large amount of ECB SMP holdings, the official sector share of upcoming Greek redemptions is even higher, at around 95% excluding T-bills
Estimated official sector ownership of Greek debt and share* of private debt maturities post-PSI; %
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2011 2013 2015 PSI
ECB/NCB % of priv ate debt maturities (ex c bills)**
Official % of total debt stock
2017
2019
2023
2027
2029
* We show the 3Y moving average of the share of upcoming maturities beginning in 2014. ** Private debt maturities exclude T-bills and private loans which we assume are rolled each year. Note: PSI profile and participation rates are based on 9 March press release from the Greek Finance Ministry. Source: Bloomberg, IMF, Greece, J.P.Morgan
Exhibit 5: Similarly, around 3/4ths of upcoming Greek interest payments will go to the official sector. High official sector exposure means less chance of a disruptive default in the near-term
Estimated interest costs for Greece post-PSI; bn Priv ate / ECB/N Official
Official/ Total 77% 76% 72% 69% 48 72 73 79
Period 2012 - 2015 2016 - 2020 2021 - 2025 2026 - 2030
Market Debt 11 17 21 25
CBs 8 4 1 0
Loans Total 29 51 51 54
Over the medium-term, we are less sanguine on Greeces prospects. In April or May they will likely hold elections, which will produce heated anti-austerity rhetoric and potentially a less cooperative government. Also, in the summer large-scale public sector layoffs are supposed to begin. In all likelihood Greece will slip on reform targets such as these, which will become evident fairly soon. As fiscal slippage mounts and the bill to the official sector grows (yet again), there is likely to be pressure for a 2nd restructuring or a hard default. Any subsequent private-sector debt restructuring is likely to target holdouts from the current exchange and will likely offer worse terms. Furthermore, even if Greek private sector obligations are considerably reduced by the current PSI, Greece remains relevant in its implications for the path that other Eurozone peripherals such as
3 Note: we exclude bills and private loans from this analysis, as we assume they will be rolled by domestic investors.
Note: we assume economic, interest rate and fiscal scenarios based on the IMFs latest DSA from 15 Feb 2012. PSI profile and participation rates are based on 9 March press release from the Greek Finance Ministry. Source: Bloomberg, IMF, Greece, J.P.Morgan
Portugal and Ireland may take, and in whether frictions with the official sector could eventually lead to a Eurozone exit. Nevertheless, the above factors are unlikely to play out over the near term, and thus we continue to hold risk-on trades. In particular, Exhibit 6 highlights the performance of various asset classes since mid-2011 when the EU sovereign crisis began escalating to its most extreme phase. Most assets have retraced about 2/3rds of their move since then. Yields, front-end swap spreads, EUR/USD, and tenor basis have retraced the least. As
such, we remain short duration in Germany and hold peripheral spread narrowers (see Euro Cash). Also, we hold 2Y swap spread narrowers (see Derivatives).
Trade recommendations
Duration In Euro, hold short duration in 10Y Bunds; In UK, turn neutral on duration. Curve In Euro, have a steepening bias on curve; In UK, hold 5s/10s gilt steepeners.
Exhibit 6: and we remain in risk-on trades over the near term. Yields, front-end swap spreads, EUR/USD and tenor basis have retraced the least since mid-2011
Current level of various assets vs. peak crisis level since mid-2011 and % retracement* from peak;
Sector
Asset German 10Y US 10Y
08 Mar 12 Extreme 01 Jul 11 1.80 2.01 2.07 4.99 5.02 288 378 91 30 -52 132 574 1366 2514 5860 107 1684 1.33 1.69 1.71 1.96 7.53 7.10 741 560 115 31 -91 209 879 1099 1995 4944 76 1889 1.27 3.03 3.20 3.39 4.87 5.38 256 273 55 14 -25 103 384 1340 2876 5990 95 1503 1.45
Extreme - Current Initial Extreme -1.34 -1.48 -1.43 2.66 1.72 485 288 59 16 -65 106 495 -240 -881 -1045 -19 386 -0.18 0.11 0.30 0.11 -2.54 -2.07 -452 -182 -23 -1 39 -77 -305 267 519 915 31 -205 0.06
% Retracement* 8% 20% 8% 95% 121% 93% 63% 39% 4% 60% 73% 62% 111% 59% 88% 160% 53% 33% 65%
b/m yields (%)
UK 10Y Italy 10Y Spain 10Y Wtd*** periph 2Y spread to Germany, ex-Greece Wtd*** periph 10Y spread to Germany, ex-Greece 2Y b/m swap spread
Spreads (bp)
2Y 3s/6s 2Y FX basis Itraxx EUR HY CDS S&P500 EUR Stoxx 50 FTSE100
Equity Indices (pts)
Crude Oil Commodities / FX Gold ($) EUR/USD Average * Retracement defined as (current extreme level) / (initial - extreme level)
Exhibit 7: Birds eye view of our major trade recommendations by currency

Duration Curve Euro area Short 10Y Steepening bias Weighted greens/10s steepener 1s/3s bull flattener UK Neutral Pay 12Mx6M in swaps Reds/greens steepener 5s/10s steepener Long 10s/30s/50s gilts fly Neutral Neutral Neutral Neutral Long ILG16 b/e US Bearish bias Neutral Japan Neutral 8s/30s steepener 5s/8s flattener Long 7Y JGB in 5s/7s/10s wtd. fly Pay 10Y in 5s/10s/20s swap wtd fly 1s/5s FX basis steepener 20s/30s wtd. steepener Neutral Neutral Neutral
Swap spreads
Jun12 Schatz narrower Jun12 Schatz narrower hedged with Jun12 FRA/OIS widener Swap spread curve Neutral Gamma Vega Inflation Short Schatz unhedged strangle Short 3Mx10Y straddle w/infrequent hedging Neutral Pay 5Yx10Y HICP (rec. fixed) Rec. 10Y French CPI vs. Euro HICP swaps Long BTANi16, OBLi13 & OATei15 b/e 4s/10s Italy flattener Long 2Y Belgium vs. Germany Long 5Y Italy vs. France Sell protection in 3Y Spain CDS Short 2Y Italy CDS-cash basis
30Y widener 10Y narrower hedged with FRA/OIS widener Sell 3Mx10Y Bearish Bullish bias
Cross-market
European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Gianluca SalfordAC (44-20) 7325-4334 Aditya Chordia (44-20) 7777-9841 J.P. Morgan Securities Ltd.
Euro Cash
The ECB press conference highlighted a chronic problem in the Euro area region: there is a tendency for growth to surprise on the downside and inflation on the upside German bond yields are expensive vs. fair value, and we keep a tactical short duration On the German curve, we find 20Y bonds cheap vs. 30Y, especially boxed vs. swaps We remain cautiously positioned for a further compression of sovereign spreads, but our level of conviction is declining After the Greek exchange, the focus will shift to Portugal. The macro adjustment is very challenging, but whether the PSI is replicated over the next few years is a political decision The underperformance of Spain vs. Italy is due to technical and fundamental factors. Despite the fact that we have assigned similar medium-term risk to both countries, we believe that Italys outperformance in the medium term can continue On the Italian curve, we recommend 4s/10s flatteners We recommend selling the DSL Jul20 vs. the RFGB Apr20 on valuations and relative headline risk Supply next week: around 20bn with new 3Y Italy
Exhibit 1: Even before the sovereign crisis, it was typical of the Euro area to disappoint on growth
Realised minus forecasts made 1Y and 2Y back of Euro area GDP growth; %y/y
2 1 0 -1 -2 -3 -4 -5 -6 -7 2000
Realised - 2Y back fcst
Realised - 1Y back fcst
2002
2004
2006
2008
2010
Source: Consensus Economics
Exhibit 2: and still experience higher-than-expected inflation

2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 2000 2002 2004 2006 2008 2010 Realised - 2Y back fcst Realised - 1Y back fcst
Realised minus forecasts made 1Y and 2Y back of Euro area HICP inflation; %oya
Source: Consensus Economics
Exhibit 3: 20Y Bunds are cheap, making the 20s/30s swap spread curve very steep
Bund Jul42 swap spread minus Bund Jan31 swap spread; bp
Same story but less conviction

The tug of war between improving market sentiment and ample liquidity left German yields broadly unchanged on the week and not far from the historical record lows across maturities. Even the ECB press conference sent conflicting messages: on the one hand, Draghi closed the door on further short-term easing as inflation forecasts were revised higher with upward risks; on the other hand, the growth outlook continues to deteriorate. Unfortunately, it was typical of the Euro area, even before the sovereign crisis, to disappoint on growth whilst experiencing higher-than-expected inflation (Exhibit 1 and 2), the worst possible combination for a region with fiscal and competitiveness problems. Higher inflation at the margin favours debtors vs. creditors, but
0 -2 -4 -6 -8 -10 -12 -14 -16 -18 -20 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12
makes the competitiveness problem worse, especially if the euro remains strong. We, therefore, remain sceptical about the macro prospects for the region and peripherals in particular, but do not base our tactical recommendations on it. We still recommend short-duration exposure on valuations. On the client side, many investors seem to have a token short-duration exposure but positions are light according to our client survey. On the curve, we continue to see bearish steepening/bullish flattening going forward. From an RV point of view, 2019 and 2020 Bunds remain slightly expensive, as discussed last week, and we highlight the cheapness of the 20Y sector of the German curve: the swap spread curve between 20Y and 30Y is trading close to zero, suggesting limited downside (Exhibit 3), especially given the shape of the other segments.
Exhibit 4: Portugals private sector debt is an additional problem compared to Greece

Household, corporate and general government debt/GDP; 2010
350 300 250 200 150 100 50 0
Household
Corporate
General gov ernment
Greece
Source: Eurostat
Portugal
Intra-EMU
Despite some intra-week noise related to the Greek PSI, intra-EMU spreads have not moved much on a weekly basis. For choice, we remain cautiously positioned for a further compression of spreads, but our level of conviction is declining as the LTRO impact fades, spread compression makes valuations less attractive and next weeks supply might find some resistance. Portugal and Spain continued to suffer, whereas 10Y Italy was the best performing sector. After a successful resolution of the Greek exchange, it is natural to look at the next candidate for a debt restructuring. We have covered Portugal in the past (see Overview, 27 January 2012, and IMF assessment of Portugal looks consistent with no near term PSI by Nicola Mai, 2 March 2012). We essentially see Portugal as a country with problems similar to Greece (namely, too much debt and lack of competitiveness), but with two important differences one positive and one negative. On the positive side, the political and social support to the Troika programme is considerably higher than in Greece; however, on the negative side, the enormous amount of private sector debt (Exhibit 4) is an additional problem compared to Greece. We are sceptical about Portugals ability to hit fiscal targets without experiencing years of recession, and talks about a second package might start as early as 3Q12. Whether bond holders will be asked to provide some support (maybe in the mild form of maturity extensions) will be a political decision. Therefore, we are reluctant to express strong views on Portuguese bonds.
Exhibit 5: The 1Y and 3Y sectors on the Spanish curve are trading rich vs. Italy, but the 2Y sector is trading cheap
Spanish bonds vs. the interpolated Italian curve; bp
20 15 10 5 0 -5 -10 -15 -20 2013
Spain cheap
Spain rich 2014 2015 2016
Spains outperformance vs. Germany essentially halted a month ago, allowing Italian bonds to catch up across the curve. Italys outperformance vs. Spain is due to a combination of technical factors and fundamentals. Spanish banks started purchasing domestic government bonds earlier than Italian ones and their market support anecdotally has greatly diminished recently, especially in the secondary market. At the same time, the aggressive frontloading by the Spanish Treasury also might have weighed on the Spanish bonds. From a fundamental point of view, the technocratic Italian government has stabilised markets and won international praise (in line with the experience 20 years ago, see Global Fixed Income Markets Weekly, 29 November 2011), and the probability that the experience will continue after the 2013 elections is rising. On the Spanish side, despite the
Exhibit 6: The BTP 4% Feb37 is trading expensive vs. BTP 5% Aug34

Residual from regressing BTP 4% Feb37 BTP 5% Aug34 yield spread against BTP 5% Aug34*; since January 2011; bp
approval of draconian labour reforms, the attention is on the public spat over the 2012 deficit/GDP target and on local governments. In our sovereign risk framework published in the 2012 Outlook, Italy and Spain shared a similar score, although the strengths and weaknesses were quite different. In a nutshell, we believe that Spain is more competitive in the medium term, but the shortterm rebalancing is more profound, with higher execution risk. We, therefore, expect Italys outperformance vs. Spain to continue in the short term. Exhibit 5 shows Spanish bonds vs. the interpolated Italian curve, with interesting dislocations at the short end of the curve: 1Y and 3Y Spain is expensive vs. Italy, but 2Y is cheap. On the Italian curve, after the strong performance the 5Y 5Y forward is better valued: we replace a long in the forward with a 4s/10s BTP curve flattener and recommend closing the 10s/15s steepener. The recent market normalisation has only partially involved lowhigh-coupon trades at the long end. We still find that the BTP 4% Feb37 is expensive, given the level of yields vs. the 5% Aug34 (Exhibit 6). Among core countries, we recommend investors buy the RFGB Apr20 vs. the DSL Jul21 at an attractive yield pickup compared to other parts of the curve (Exhibit 7). The recent Dutch macro and political developments are not fully reflected in the current spreads, in our view. On the Dutch curve, we believe the new 20Y DSL issued last week is 2-3bp cheap.
20 15 10 5 0 -5 -10 -15 -20 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12
* BTP Feb37 BTP Aug34 = -9.7*(BTP Aug34) + 97.6*(BTP Aug34)^2 250.7; Rsquared 87%
Exhibit 7: The RFGB Apr20 vs. the DSL Jul21 provides attractive yield pickup compared to other parts of the curve
Dutch and Finnish bonds vs. the interpolated German curve; bp
75
Finland
Netherlands
Finland cheap 50
25
Issuance/News
Next weeks conventional bond issuance is expected to be very heavy (Exhibit 8), greater than 20bn. The supply will be skewed towards the short-to-medium sector. On the T-bill side, peripheral supply will come from Italy (on Tuesday). On Tuesday, the Netherlands will issue 2.5-3.5bn of the 3Y benchmark DSL Apr15, likely around 3.0bn. The DSL Apr15 is trading close to its richest levels relative to the surrounding bonds since its creation in early January 2012. As discussed above, we find the 710Y sector on the Dutch curve expensive relative to the Finnish curve and recommend buying RFGB Apr20 vs. the DSL Jul21. On Wednesday, Italy will issue 4-5bn of a new 3Y benchmark, BTP 2.5% Mar15 and 0.5-1bn of the BTP Sep19. Contrary to the previous benchmark, the 6% Nov14 the new bond will be issued with a low coupon in line with surroundings making it more appealing. We look at the existing 5Y and 10Y benchmarks to estimate
0 2012 2017 2022 2027 2032 2037
Exhibit 8: The Euro area bond redemption and tentative conventional issuance calendar until the end of March 2012
Euro area marketable bond* redemption by settlement date and conventional bond issuance calendar; official announcements and J.P. Morgan forecast; peripheral supply highlighted in grey; bn
Date Issuer Short Apr15 Mar15 Jan15 3.0 5.0 Sep19 1.0 Medium Long Ultralong Bond red. (by set. date)
13-Mar Netherlands 14-Mar 15-Mar 15-Mar 16-Mar 20-Mar 21-Mar 26-Mar 28-Mar 29-Mar Italy France Spain Germany Greece Germany Belgium Belgium Italy
Apr14, Oct14 3.0 Feb16, Feb17 5.0 1.0 Apr16, Jul18 2.5 19.0 14.4 Mar14 5.0 1.0 3.0 1.0 3.0 34.5 37.7 1.0 4.3
Total for March
*Marketable bonds include conventionals, linkers, floaters and zero coupons.
the benchmark discount for the Mar15. For the BTP May17 the discount on the BTP curve is 11bp, whereas it is 13bp for the Sep22. We expect the new bond to trade around 1bp cheap to the Apr15, equivalent to a benchmark discount of 9bp on the curve. The Sep19 is optically trading a touch expensive on the BTP curve, but the Mar19/Sep19/Mar20 fly is directional to the level of interest rates (Exhibit 9). On Thursday, France will issue 7.5-8.5bn of the offthe-runs OAT Apr14, OAT Oct14 and BTAN Feb16, and the 5Y benchmark BTAN Feb17. We expect around 1bn each of the OAT Apr14 and BTAN Feb16, 2bn of the OAT Oct14 and 4bn of the BTAN Feb17. The offthe-runs OAT Apr14 and BTAN Feb16 are trading fair on the interpolated French curve and also cross-market. The OAT Oct14 is trading close to its richest levels relative to the surrounding BTANs over the past two years (Exhibit 10). The BTAN Feb17 was issued rich relative to the surrounding bonds in mid-February and has cheapened since then, currently trading at an asw pickup of around 2bp. Historical 5Y benchmarks on average came at an asw pickup of 2-3bp and remained in that range for a few months following their creation. We expect the BTAN Feb17 to follow the historical trend and remain range-bound (at an asw pickup of 2-3bp) in the near future. Also on Thursday, Spain will tap the off-the-runs Bono Jan15, Bono Apr16 and Bono Jul18; the issuance size ranges will be announced on Monday. Spain is not tapping any of the benchmark bonds at the mid-month auction, which might be consistent with a slowdown in its issuance pace after front-loading aggressively since the start of 2012. We expect around 3.5bn to be issued: around 1bn each of Bono Jan15 and Apr16, and 1.5bn of Bono Jul18. The Bono Jan15 and Bono Jul18 are trading rich on the interpolated Spanish curve, whereas the Bono Apr16 is trading close to fair. Cross market, the Bono Jan15 is expensive vs. Italy, whereas the Bono Apr16 and Jul18 are trading close to fair vs. Italy.
Exhibit 9: The BTP Mar19/Sep19/Mar20 fly is directional to the level of rates

50:50 BTP Mar19/Sep19/Mar20 fly vs. BTP Sep19; since Jan2011
10 8 6 4 2 0 -2 -4 -6 -8 4.00
Current
5.00
6.00 BTP Sep19; %
7.00
8.00
Exhibit 10: The OAT Oct14 is trading close to its richest levels relative to the surrounding BTANs
BTAN Jul14/OAT Oct14/BTAN Jan15 50:50 barbell; bp
-2
-4 Mar-10 Aug-10 Dec-10 May -11 Oct-11 Mar-12
Close BTP 10s/15s Italy steepener Close long 25mn BTP Sep22 vs. short 22mn BTP Mar26 @ 25bp. P&L since inception (2 March): 5bp. Keep Bono Jul32-Jan37 flattener Keep long 25mn of Bono Jan37 and short 23.5mn of Bono Jul32 @ -1.5bp. 3M carry and slide: -2bp. P&L since inception (2 March): -.05bp Keep short 10Y Bund Keep short 100mn of Bund Jan22 @ 1.795%. 3M carry and slide: -10bp. P&L since inception (24 February): -9.5bp. Keep long 5Y Italy vs. France Keep long 25mn BTP May17 vs. short 19.8mn OAT Oct17 @ 191bp. 3M carry and slide: 14bp. P&L since inception (24 February): 59bp.
Open 4s/10s BTP flattener Open long 25mn of BTP Sep22 vs short 50mn of BTP Aug16 @ 165bp. 3M carry and slide: -6bp. Close long Italy 5Yx5Y Close long 25mn of BTP Sep22 @ 5.00%. Close short 25mn of BTP Feb17 @ 3.55%. P&L since inception (5Y leg equivalent, 2 March): 27bp.
10
Keep long 2Y Belgium vs. Germany Keep long 25mn OLO Mar14 vs. short 26mn Schatz Mar14 @ 113bp. 3M carry and slide: 21bp. P&L since inception (2 March): -3bp. Keep short protection on 3Y Spain CDS Keep short protection on $25mn Spain 3Y CDS protection @ 376bp. 3M carry and slide: 30bp. P&L since inception (3 February): -42bp. Keep BTP Dec13 vs. selling maturity-matched CDS protection Keep short 25mn of BTP Dec13 @ 1.94% and short $32mn of Dec13 CDS protection on Italy @ 320bp. 3M carry and slide: +5bp. P&L since inception (20 January): -45bp.
Trades closed in 2012

TRADE DURATION Short 10Y Bund Jan22 CURVE 5s/10s flattener v s. beta adj. 2s/30s steepener 3s/10s flattener COUNTRY SELECTION/RELATIVE VALUE Short 25Y Italy v s. Spain Long 8Y Austria v s. Germany and Spain Short 3Y Spain v s. Germany Italy 5s/10s flattener Long Bund Jan21 v s. RFGB Apr21 Long BTP Nov 23 v s. Aug23 Long 10Y Spain v s. Italy Short BTP May 31 v s/ BTP Aug23 and Sep40 Bono Jul19-Jul26 flattener Long Italy 5Yx 5Y 10s/15s Italy steepener CDS Sell protection on 2Y Italy CDS Spain 5s/10s CDS flattener 20-Jan-12 03-Feb-12 105 10-Feb-12 24-Feb-12 0 11-Nov -11 06-Jan-12 06-Jan-12 20-Jan-12 21 9 09-Dec-11 20-Jan-12 03-Feb-12 10-Feb-12 3 -2 27-Jan-12 10-Feb-12 6 ENTRY EXIT P&L
09-Dec-11 20-Jan-12 -132 06-Jan-12 03-Feb-12 -56 06-Jan-12 03-Feb-12 03-Feb-12 10-Feb-12 10-Feb-12 24-Feb-12 03-Feb-12 02-Mar-12 27-Jan-12 02-Mar-12 02-Mar-12 09-Mar-12 02-Mar-12 09-Mar-12 -5 14 11 7 20 27 5
11
European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Pavan WadhwaAC (44-20) 7777-3370 Fabio Bassi (44-20) 7325-8615 Khagendra Gupta (44-20) 7777-1980 J.P. Morgan Securities Ltd.
European Derivatives
The EONIA curve is pricing in an unchanged refi rate over the next 12 months Volatility in reds and greens EONIA is close to its lows of the past 5 years, and is expected to stay low leading to increasing demand for carry strategies further out the EONIA curve Slide on the EONIA curve has contributed about 40% to the overall P&L of long green EONIA trades initiated at the beginning of 2012 Longs in greens EONIA are attractive as carry trades; however, we refrain from recommending outright longs, given our short 10Y duration view and, instead, suggest holding weighted greens/10Y steepeners, which are attractive on carry and RV considerations and should perform well in a bear market Receive 5Y in the 1s/5s/12s level-neutral fly Implied directionality is trading cheaper than delivered directionality for curve trades anchored at the very front end and for 2s/5s/10s and 3s/7s/15s butterflies We favour 1s/3s and 1s/5s bull flatteners and recommend 3s/7s/15s OTM bear belly cheapeners We target 2Y German benchmark swap spreads at 75bp, or 15bp narrower than current levels and believe that 10Y swap spreads will trade between 20bp and 40bp Hold June Schatz swap spread narrowers both outright and hedged-with June FRA/OIS basis wideners We are biased towards narrower front-end EUR/USD FX basis and would target the 3M FXOIS basis at -30bp Stay bearish gamma via 3Mx10Y swaption straddles but switch from daily delta hedging to once every two weeks Hold shorts in 109.90/110.50 Jun12 Schatz unhedged strangle
Exhibit 1: The EONIA curve is broadly pricing in an unchanged refi rate over the next 12 months
ECB OIS rate, EONIA/refi bias, imputed refi rate and cumulative ECB refi rate cuts priced in; % (unless stated) Date ECB OIS (%) Bias Imputed refi Cum. cuts priced in (bp)
Apr12 May 12 Jun12 Jul12 Aug12 Sep12 Oct12 Nov 12 Dec12 Jan13 Feb13 Mar13 0.35 0.35 0.33 0.33 0.33 0.33 0.33 0.33 0.35 0.34 0.36 0.36 -0.64 -0.64 -0.64 -0.64 -0.64 -0.64 -0.64 -0.64 -0.64 -0.64 -0.64 -0.64 0.99 0.99 0.97 0.97 0.97 0.97 0.97 0.97 0.99 0.98 1.00 1.00 1 1 3 3 3 3 3 3 1 2 0 0
Exhibit 2: Delivered volatility in reds and greens EONIA has collapsed to its lows of the past 5 years and is expected to stay low
1M delivered volatility on reds and greens EONIA; bp/day
14 12 10 8 6 4 2 0 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11
Reds Greens
Mar 12
Swap Curve
Since our last publication, the EONIA curve has remained broadly unchanged at the front end but has steepened marginally from Dec12. Outright macro flows remain limited, with the curve now broadly pricing the ECB on hold for the remainder of 2012 (Exhibit 1) under the assumption that the EONIA/refi bias remains around 85% of the refi/deposit corridor. The decline in EONIA volatility extended further out the curve, with 1M delivered volatility on reds (1Yx1Y) and greens (2Yx1Y) EONIA declining to the lows of 2007 (Exhibit 2). Recent eye-popping increase in excess liquidity has been a key factor driving volatility lower.
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Exhibit 3: In a low-volatility environment, carry and slide matter, contributing about 40% to total overall performance to longs in greens EONIA initiated at the beginning of 2012
EONIA forward rate 2Y6Mx6M versus 1Jul14x6M; %
Exhibit 5: and, instead, suggest holding weighted greens/10Y steepeners, which are attractive on carry and RV considerations and should perform well in a bear market
Weighted greens/10Y EUR swap curve* regressed against 2s/10s EUR swap curve; past 6M; bp
1.15 1.10 1.05 1.00 0.95 0.90 0.85 0.80 03-Jan 16-Jan 29-Jan 11-Feb 24-Feb 09-Mar 01 Jul 2014x 6M 2Y6Mx 6M
-5
-10 Sep 11 Oct 11 Nov 11 Dec 11 Feb 12 Mar 12
Exhibit 4: leading to increasing demand for carry/slide strategies further out the EONIA curve. Although long green EONIA trades appear attractive, we refrain from recommending them due to our short duration view
6M carry (bp) and annualised risk*-adjusted carry across the EONIA curve (unitless); Lev el 6M Carry Risk* Annualized risk-
* Curve defined as 10Y 0.66*(greens yield).
Exhibit 6: 5Y continues to trade cheap on the curve; receive 5Y in the 1s/5s/12s level-neutral fly
Residual from regressing 1s/5s/12s 50:50 EUR swap butterfly* vs. 5Y EUR swap yields**; past 6M; bp
6 4 2 0 -2 -4 -6 Sep 11 Oct 11 Nov 11 Dec 11 Feb 12 Mar 12
(bp) 6M 6Mx 6M 1Yx 6M 1Y6Mx 6M 2Yx 6M 2Y6Mx 6M 3Yx 6M 3Y6Mx 6M 4Yx 6M 4Y6Mx 6M 5Yx 6M 34 34 41 52 70 93 120 147 173 198 222
(bp) -3 1 7 11 17 23 29 27 25 24 24
(bp) 0.5 1.2 1.8 2.2 2.7 3.2 3.7 4.1 4.3 4.3 4.0
adjusted carry -0.6 0.1 0.5 0.7 0.8 0.9 1.0 0.8 0.7 0.7 0.8
* Risk is defined as 1M standard deviation of daily changes of the underlying EONIA rate.
* Swap butterfly defined as: Yield body 0.5*(Yield Wing1 + Yield Wing2). ** Regression equation: Y = 23.9*(5Y) 64.7; R2=84%.
We believe that high excess liquidity is here to stay and therefore expect low EONIA volatility to persist, driving investor interest in carry trades. In a low-volatility environment, carry and slide tend to contribute more to the overall performance of duration and curve trades. This has been especially true for the EONIA curve over the past few months. Exhibit 3 shows the level of constant maturity 2Y6Mx6M EONIA vs. the level of the same trade using fixed dates, initiated at the beginning of January 2012. The long position has generated P&L of 25bp since its inception in early January, of which 9bp (about 40%) has resulted directly
from the slide in the curve. Longs in greens and blues EONIA offer the highest risk-adjusted carry, with 4-5bp of positive slide per month (Exhibit 4). Although carry remains attractive on greens EONIA, we refrain from recommending outright longs given our bearish duration view (see Euro Cash). Instead, we continue to position for a steeper curve via weighted greens/10Y steepeners, which remain attractive on carry and RV considerations (Exhibit 5), and is expected to perform well in a bear market. Investors looking to express this view and benefit from our 10Y swap spread
13
Exhibit 7: On curve trades, implied directionality is cheaper than delivered directionality at the very front end; we favour 1s/3s and 1s/5s bull flatteners
Current implied* and delivered** directionality for various curve trades; % Trades Implied Deliv ered Implied-Deliv ered
Exhibit 8: On butterfly trades, implied directionality is cheaper than delivered directionality in 2s/5s/10s and 3s/7s/15s; we favour 3s/7s/15s bull belly richeners and bear belly cheapeners
Implied* and delivered**directionality for various butterflies; % Trades Implied Deliv ered Implied-Deliv ered
1s/2s 1s/3s 1s/5s 1s/10s 1s/30s 2s/5s 2s/10s 2s/30s 5s/10s 5s/30s Schatz/Bobl Schatz/Bund Bobl/Bund
0% 15% 42% 77% 90% 42% 76% 90% 24% 34% 86% 119% 18%
40% 58% 76% 86% 88% 49% 65% 71% 20% 32% 59% 67% 15%
-40% -43% -34% -9% 2% -7% 11% 19% 4% 2% 27% 52% 3%
1s/2s/3s 1s/3s/5s 2s/5s/7s 2s/5s/10s 2s/7s/12s 2s/10s/30s 3s/7s/15s
-7% -6% 9% 3% 12% 18% 7%
-10% -14% 9% 17% 18% 33% 22%
3% 8% 0% -14% -6% -15% -16%
* Implied directionality for swap fly is calculated as (3MxLeg2 implied vol average of 3MxLeg1 implied vol and 3MxLeg3 implied vol) divided by 3MxLeg2 implied vol ** Delivered directionality for swap fly is defined as 3M beta of daily changes in the fly vs. daily changes of Leg2 swap yields.
Exhibit 9: as the fly is expected to remain directional
* Implied directionality for swap curve calculated as a ratio of implied volatility of 3MxLong leg/3MxShort leg -1. ** Delivered directionality for swap curve calculated as 1 - 3M beta of daily changes in Short leg regressed against daily changes in Long leg.
3s/7s/15s 50:50 EUR swap butterfly regressed against 7Y EUR swap yields and isopremium* line for conditional trades implemented with 1M swaptions; past 3M; bp
14 12
y = 22.4x - 40.8 R 2 = 85%
narrowing bias (see Swap Spreads) may consider implementing weighted greens/Bund curve steepeners as alternative carry-efficient trades. Over the past week, the swap curve bear steepened with modest outperformance of the 5Y sector, with 2s/10s broadly unchanged and 10s/30s 1bp steeper. Despite this outperformance, we believe the 5Y sector remains cheap on the curve and recommend investors receive 5Y in the 1s/5s/12s level-neutral fly (-50%/75%/-50%). The trade has about 4bp of relative value (Exhibit 6) and carries positively by 6bp over 3M. With the front end likely to remain anchored, we expect the swap curve to remain directional with the level of yield. The decline in volatility across various tails (see Volatility) has increased the implied directionality and reduced the attractiveness of conditional structures. Exhibit 7 shows the implied and delivered directionality across various curve trades. We draw the following conclusions from this table. First, implied directionality is extremely expensive in Bund, Bobl and Schatz, thereby limiting the attractiveness of conditional structures in these instruments. Second, implied directionality is cheaper than delivered directionality only for swap curve trades anchored at the very front end. Thus, we favour 1s/3s and 1s/5s bull flatteners.
10 8 6 4 2 0 1.60 1.80 2.00 7Y sw ap y ield; % 2.20 2.40 Spot Forw ard
* Isopremium indicates the breakeven level for entering conditional curve trades at zero cost.
Implied directionality appears about 15% cheap relative to delivered directionality in 2s/5s/10s and 3s/7s/15s butterflies (Exhibit 8). Our long-standing 2s/5s/10s bull belly richener is up about 2bp since inception, but offers more upside; we hold the trade. Investors wishing to express a bearish view with conditional structures should consider OTM 3s/7s/15s bear belly cheapeners implemented with 1M payers. The combined 1M negative carry from curve and volatility is only 2bp, which is broadly equivalent to the expected move for a 10bp sell-off in 7Y yields if the recent directionality holds (Exhibit 9).
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2Y German b/m swap spreads regressed against 1) 21-day MA of NSA excess liquidity, and 2) 10Y weighted average spread of peripherals (ex-Greece) to Germany; past 3M; bp
Exhibit 10: Front-end swap spreads have narrowed over the past 3 months due to the mitigation of the sovereign debt crisis and the recent eye-popping increase in excess liquidity
Exhibit 11: but continue to trade too wide relative to the FRA/OIS basis; hold 2Y swap spread narrowers both outright and hedged-with FRA/OIS wideners
Residual from regressing rolling-front Schatz swap spread* against back IMM FRA/OIS basis; past 1Y; bp
85 80 75 70 65 60 55 250 300
y = -0.08*(Ex Liq) + 0.06*(Wtd Peri Sprd) + 98.9 R 2 = 94%
20
10
-10
-20 350 400 450 500 1M MA of NSA ex cess liquidity ; bn 550 600 Mar 11 May 11 Aug 11 Oct 11 Dec 11 Mar 12
* 10Y Weighted peripheral spread (ex Greece) computed against Germany for Ireland, Italy, Portugal, and Spain (weighted by the size of their outstanding bond market).
* Futures contract rolled 20 days before expiration. Schatz swap spread = 1.00 * IMM2 FRA/OIS basis + 27.5. R-sq = 87%.
Exhibit 12: Swapped issuance continues to run at high levels

20-day MA of J.P. Morgan estimate of swapped issuance*; past 1Y; bn
Swap Spreads
Swap spreads widened across the curve as market participants focused on risks around the imminent Greek debt restructuring. During the week, 2Y, 10Y and 30Y German b/m spreads widened 5bp, 4bp, and 2bp, respectively. Going forward, we expect swap spreads to narrow due to the twin factors of the mitigation of the sovereign debt crisis and high levels of excess liquidity. As Exhibit 10 shows, front-end swap spreads have been driven narrower over the past 3 months by a combination of these factors. Specifically, each 100bp of narrowing in the weighted average peripheral (ex Greece) spread to Germany has put 6-7bp of narrowing pressure on 2Y swap spreads. Additionally, each 100bn of excess liquidity has put 7-8bp of narrowing pressure. Since the first 3Y LTRO on 21 December 2011, 10Y weighted-peripheral spreads have narrowed more than 100bp, while excess liquidity has increased by an eyepopping 500bn. Moreover, high levels of excess liquidity are expected to stay with us for a very long time since 90% of all open-market operations are now in the 3Y LTRO. Therefore, we expect peripheral spreads to continue to narrow, especially since we expect the riskon sentiment to continue. The addition of 500bn of excess liquidity is itself expected to put about 7.5*5 = 35bp of total narrowing pressure on 2Y swap spreads.
0 Mar 11 May 11 Aug 11 Oct 11 Dec 11 Mar 12
* We use fixed-rate, -denominated issuance by financial institutions (including covered bonds) and supras/agencies, plus onehalf of corporate bond issuance, as an estimate of swapped issuance.
Given that 2Y spreads have narrowed a meagre 20-25bp since the first 3Y LTRO, we believe that front-end spreads can narrow further, and target 2Y German benchmark spreads at 75bp, or about 15bp tighter than current levels. Our target of 15bp tightening in 2Y swap spreads appears reasonable, given that front-end spreads are trading too wide relative to the FRA/OIS basis. Indeed, Exhibit 11 shows that 2Y front Schatz swap spreads are trading about 15bp too wide relative to the 2nd IMM FRA/OIS basis. We therefore recommend that investors hold
15
2Y swap spread narrowers both outright and hedged-with FRA/OIS basis wideners. Swapped issuance continues to run at high levels (Exhibit 12). We estimate that the 20-day MA of swapped issuance is currently at 4.3bn/day, or about 40% higher than the average over the past year (3.1bn/day). Each 1bn/day increase in swapped issuance over a 1-month period puts around 3bp of narrowing pressure on 10Y swap spreads (Exhibit 13). With sentiment in the market improving by the day, swapped issuance is likely to remain high, putting narrowing pressure on intermediate-maturity swap spreads. Continued abatement of the sovereign debt crisis is also expected to put narrowing pressure on the FX basis. The 3M EUR/USD FX-OIS basis has narrowed from its peak level of -100bp to its current level of -43bp. Each 100bp narrowing of weighted peripheral (ex Greece) spread to Germany causes this spread to narrow 18bp (Exhibit 14). We believe that 10Y peripheral spreads can narrow another 75bp (from 375bp to 300bp) and would target the 3M EUR/USD FX-OIS basis around -30bp from its current level of -43bp.
10Y German b/m swap spread regressed against 1) 20-day MA of swapped issuance*, 2) 10Y German b/m yield, and 3) 3Mx10Y swaption implied volatilities; past 1Y; bp
Exhibit 13: putting narrowing pressure on intermediate swap spreads
80 70 60 50 40 30 0
y = -3.1*(Iss) - 12.4*(10Y) + 4.4*(3Mx 10Y) + 59.6 R 2 = 85%
2 4 6 20D MA of sw apped issuance*; bn/day
* See Exhibit 12 for definition of swapped issuance.
Exhibit 14: The FX basis will likely continue to be pressured narrower as the sovereign debt crisis continues to abate
3M EUR/USD FX-OIS basis regressed against 10Y weighted average spread of peripherals (ex Greece) to Germany*; past 1Y; bp
20 0 -20 -40 -60 -80 -100 -120 100 09-Mar-12
y = -0.18x + 33.2 R 2 = 74%
Euro Volatility
Swaption volatility continued its decline over the past week. Specifically, the gamma surface flattened, with volatility on longer tails declining more compared to shorter tails (Exhibit 15). For instance, 3Mx10Y declined 0.2bp/day while 3Mx2Y declined 0.1bp/day. 1M delivered volatility also exhibited similar behaviour; 1M delivered volatility on 10Y swaps declined 0.5bp/day while that on 2Y swaps declined 0.1bp/day. Govie volatility surface, on the other hand, steepened over the past week. Implied volatility on Schatz options declined 0.4bp/day, while that on Bund options remained flat. 1M delivered volatility on govie futures declined between 0.1bp/day and 0.5bp/day. We continue to remain bearish on gamma and hold short gamma positions in 3Mx10Y. Short gamma positions have been profitable since the announcement of the 3Y LTRO in December 2011, with significant contributions from both vega and gamma. Implied volatility has been on a one-way, downward track over the past several weeks. In addition, current 3M delivered volatility on 10Y swaps is well below the implied volatility of 3 months ago (Exhibit 16). This has
200 300 400 500 10Y w td peri spread (ex Greece); bp
600
* See Exhibit 10 for definition of 10Y weighted peripheral spreads (ex Greece).
Exhibit 15: Swaption volatility continued its decline over the past week
Change since 2 March 2012 in implied volatility on EUR swaptions; 3M, 2Y and 5Y expiries; bp/day
0.00 -0.05 -0.10 -0.15 -0.20 -0.25 -0.30 1Y 2Y 5Y Tails 10Y 30Y 3M 2Y 5Y
16
Note: Implieds on 1Y tails are based on the 3s curve
resulted in both vega and gamma contributing towards total PnL over the past 3 months. Going forward, we expect gamma to dominate the total return, as implied volatility is likely to remain sticky at current low levels. Exhibit 17 shows the evolution of rolling 1M gamma and vega PnL.4 As seen, over the past few weeks, gamma has outperformed vega as implied volatility has either remained range-bound or has declined at a slower pace compared to 3 months ago. Going forward, we expect 3Mx10Y implied volatility to flatten out around current levels and therefore do not foresee significant vega contribution. Gamma, on the other hand, is likely to contribute as we target 3M delivered volatility to be at 4bp/day (with risks biased lower) versus a current implied volatility level of 4.6bp/day. This mainly reflects our view that market sentiment remains positive as near term event risks (mainly around Greece) have diminished significantly. Thus, we continue to recommend holding short gamma positions in 3Mx10Y. Going forward, however, we recommend reducing the delta-hedging frequency on short gamma positions. This mainly reflects our view that swap yields are likely to stay range-bound, as has been the case over the past few weeks (Exhibit 18). Indeed, as Exhibit 19 shows, lowfrequency delivered volatility (estimated using, say, 2W changes in swap yields) is lower than high-frequency delivered volatility (estimated using daily changes in swap yields), suggesting that mean reversion in swap yields is large. We analyse the performance of various delta hedging strategies over the past 3 months. Exhibit 20 shows the average 1M return, SD, and annualised return for various short gamma positions with varying delta-hedging frequencies. We draw the following conclusions from this analysis. First, irrespective of the delta hedging strategy, selling 3Mx10Y would have yielded the highest risk-reward. This vindicates our choice of selling 10Y volatility compared to other tails. Second, hedging once every two weeks would have resulted in superior returns compared to hedging daily. We believe that swap yields are likely to stay range-bound and therefore recommend reducing delta-hedging frequency from daily to once every two weeks. Another way to benefit from a range-bound environment is by selling unhedged strangles. Indeed, we have
We analyze 1M returns on short volatility trades. Specifically, we initiate a short volatility trade every day and hold it over the next 1M.
4
Exhibit 16: Short gamma positions have been profitable recently, as implied volatility has declined and delivered volatility has been significantly below implied volatility at inception
8
3Mx10Y implied volatility vs. current 3M delivered volatility of 10Y swaps; bp/day
6 Implied v ol 5 Current 3M deliv ered v ol: 4.3bp/day 4 01-Dec 20-Dec 09-Jan 29-Jan 18-Feb 09-Mar
Exhibit 17: Given the low level of implieds, we expect gamma to become the dominant driver of total return of short volatility positions; stay short gamma 3Mx10Y
Rolling 1M vega and gamma return from selling 3Mx10Y swaption straddles and holding the trade for 1M; bp of notional
80 60 40 20 0 -20 04-Jan 16-Jan Vega 29-Jan 11-Feb Trade end date 24-Feb 08-Mar Gamma
Exhibit 18: Swap yields have moved in a tight range since the first 3Y LTRO
10Y EUR swap yield; %
2.80 2.70 2.60 2.50 2.40 2.30 2.20
3Y LTRO announcement
First 3Y LTRO
01-Dec
20-Dec
09-Jan
29-Jan
18-Feb
09-Mar
17
recommended selling 109.90/110.50 Jun12 Schatz unhedged strangles (see Global Fixed Income Markets Weekly, 24 February 2012). We remain convinced that yields will remain within a tight range at the front end due to extremely high excess liquidity and an on-hold ECB. Thus, we continue to recommend holding this trade at current total premium of 12cents vs. inception level of 17cents.
Exhibit 19: while exhibiting a high degree of mean reversion

3M standard deviation of 1D, 1W, 2W, and 1M changes of 5Y and 10Y swap yields expressed in daily terms*; bp/day
5.0
5Y
10Y
4.0
Trade Recommendations
Curve: Receive 5Y in 1s/5s/12s level-neutral fly. Implement 3s/7s/15s OTM bear belly cheapeners. Hold greens/10s weighted steepeners. Hold 2s/5s/10s bull belly richeners, 1s/3s bull flatteners and Jun12/Jun13 Euribor bear flatteners Receive 75mm 3Mx5Y (start date 13 June 2012) vs. paying 245.0mm 3Mx1Y (start date 13 June 2012) and 22.6mm 3Mx12Y (start date 13 June 2012) to enter into a level neutral fly (defined as 75% * Yield 5Y - 50% * Yield 1Y - 50% * Yield 12Y) at -55.5bp; Buy 100mm 1Mx7Y 2.02% payers (notification date 09 Apr 2012) vs. selling 113.3mm 1Mx3Y 1.26% payers (notification date 09 Apr 2012) and 25.8mm 1Mx15Y 2.68% payers (notification date 09 Apr 2012) to enter into a conditional bear belly cheapeners at 5bp vs. spot level of 2bp and 1M forward level of 3.4bp; Stay short 100% risk (50mn) in 2.345% 3Mx10Y swaps vs. long 66% risk in 27Mx1Y (311mn) 1.495% swaps to remain in a weighted steepener at 134.5bp vs. entry level of 135.8bp (weighted spread defined as 3Mx10Y 0.66*27Mx1Y) as a carryefficient proxy to 2s/10s curve steepener (Global Fixed Income Markets Weekly, 24 February 2012); P/L since inception: -1.3bp of yield; Hold longs in 100mn 1.67% 3Mx5Y receivers (notification date 27 April 2012) vs. shorts in 1.135% 122.6mn 3Mx2Y receivers and 2.39% 3Mx10Y 26.4mn receivers to remain in a conditional bullbelly richener in the 2s/5s/10s 50:50 weighted fly at -9.25bp vs. forward level of -11.6bp and spot level of -14.1bp (Global Fixed Income Markets Weekly, 27 January 2012); P/L since inception: +7.7bp of notional; Hold longs in 100mn 1.33% 3Mx3Y receivers vs. short 297.7mn 1.25% 3Mx1Y receivers to stay in a conditional bull flattener at 8.0bp vs. spot level of 5.8bp and forward level of 10.9bp (Global Fixed Income Markets Weekly, 6 January 2012); P/L since inception: -7.9bp of notional;
3.0
2.0 1 5 10 # business day s change in sw ap rate 21
* For example: 10 is calculated as (3M delivered volatility of 10D changes in 10Y swap yield)/sqrt(10).
Exhibit 20: We recommend delta-hedging short gamma positions less frequently. Our choice is to sell 3Mx10Y gamma and deltahedge once every two weeks
Statistics on 1M return from selling various straddles with varying hedging frequencies; since 15 Dec 2011; bp of notional 1D 2W Unhedged
3Mx2Y Av g SD Inf ratio Av g SD Inf ratio Av g SD Inf ratio 10 12 2.8 3Mx5Y 24 27 3.1 58 64 3.1 3Mx10Y 70 72 3.3 54 60 3.1 29 30 3.3 17 22 2.6 12 14 2.9 10 14 2.5
Continue holding longs in 1000 98.875 Jun12 Euribor puts vs. shorts in 1000 98.75 Jun12 Euribor mid-curve puts to remain into a Jun12/Jun13 Euribor bear flatteners at 12.5bp vs. forward levels of 7bp (Global Fixed Income Markets Weekly, 15 December 2011); P/L since inception: -0.75cents. Swap spreads: Hold Jun12 Schatz ASW narrowers outright and hedged with Jun12 FRA/OIS wideners Continue to receive 100mn Schatz CTD expirymatched swaps and sell 910 110.20 Jun12 Schatz futures to remain in Jun12 Schatz swap-spread
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narrower at 78.6bp vs. an entry level of 76.3bp (Global Fixed Income Markets Weekly, 24 February 2012). P/L since inception: -2.3bp of yield; Continue to receive 100mn Schatz CTD expirymatched swaps, sell 911 Jun12 Schatz futures, sell 704 Jun12 Euribor futures, and receive 698mn Jun12 IMM EONIA swaps to remain in Jun12 Schatz swap spread narrower hedged for FRA/OIS widener at 41.8bp vs. an entry level of 40bp (Global Fixed Income Markets Weekly, 02 March 2012); P/L since inception: -1.8bp of yield. Volatility: Stay short 3Mx10Y EUR swaption straddles but change delta hedging frequency to once every two weeks. Stay short 109.90/110.50 Jun12 Schatz unhedged strangles. Stay long GBP 2Yx1Y vol vs. GBP 1Yx1Y vol Stay short 100mn 2.34% 3Mx10Y EUR swaption straddles (ATMF 2.34%, notification date 24 May 2012, maturity date 28 May 2022) at 4.6bp/day vs. an entry level of 5.1bp/day. This trade requires infrequent delta hedging (once every two weeks) (Global Fixed Income Markets Weekly, 24 February 2012); P/L since inception: +38bp of notional; Continue to sell 1000 109.90/110.50 Jun12 Schatz unhedged strangle for 12cents vs. entry level of 17cents (Global Fixed Income Markets Weekly, 24 February 2012); P/L since inception: +5cents; Stay long 100mn 1.40% GBP 2Yx1Y straddles (notification date 20 January 2014, maturity date 20 January 2015) vs. short 112mn 1.21% GBP 1Yx1Y straddles (notification date 20 January 2013, maturity date 21 January 2014) at an implied spread of 1.4bp/day (defined as 2Yx1Y 0.8*1Yx1Y) vs. an entry level of 1.55bp/day (Global Fixed Income Markets Weekly, 20 January 2012); P/L since inception: -2.7bp of notional. * P/L for open trades calculated using Thursdays closes.
Closed Trades in 2012

Trade Duration Long 6Mx6M EONIA Long 2Y6Mx6M EONIA Long Dec12 EONIA Curve Greens/10s weighted steepeners 03 Feb 12 10 Feb 12 0.0 09 Dec 11 06 Jan 12 03 Feb 12 24 Feb 12 20 Jan 12 02 Mar 12 10.0 5.0 1.0 Entry Exit P&L
Conditional curve and flies 1s/5s bull flatteners Mar12 Schatz/Bund bear steepener Swap Spreads Mar12 Schatz ASW wideners Mar12 Bund bull wideners Options (outright) Short Mar12 Schatz straddles Buy 3Mx5Y EUR gamma Short Mar12 Schatz straddles Options (relative) Sell Mar12 Schatz vs. mat matched swaption 20 Jan 12 Sell 3Mx10Y EUR vs. 3Mx5Y 03 Feb 12 Buy Mar12 Bund vs. mat matched swaption 20 Jan 12 Buy Jun12 Bund vs. mat matched swaption 27 Jan 12 10 Feb 12 10 Feb 12 8.0 -4.0 18.0 8.0 15 Dec 11 06 Jan 12 04 Nov 11 20 Jan 12 20 Jan 12 10 Feb 12 10.0 -58.0 7.0 15 Dec 11 20 Jan 12 20 Feb 12 24 Feb 12 -11.0 0.0 09 Dec 11 06 Jan 12 20 Jan 12 24 Feb 12 8.5 0.0
10 Feb 12 02 Mar 12
Trade P&L is shown in bp for all trades except option trades, which are shown in bp of notional. Conditional trades are normalised by the PVBP of the underlying * Option Expiry; ** Annualised bp
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European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Francis DiamondAC (44-20) 7325-3541 francis.diamond@jpmorgan.com J.P. Morgan Securities Ltd.
United Kingdom
10Y gilt yields ended the week little changed and traded in a very tight 4bp range Momentum and technicals suggest staying neutral 10Y duration Keep reds/greens swap curve steepener and for investors looking to express this view in cash space, we think a 4H13/5s14 gilt steepener is the best proxy Our curve momentum model suggests the 5s/10s gilt curve is too flat keep tactical stepeener as a non-directional view The 10s/20s/30s fly has been cheapening but we think this can continue given reduced market expectations for any additional QE extensions Stay long the belly of the 10s/30s/50s gilt fly 30Y gilts remain cheap on the curve and the belly of the fly should outperform as the reds/greens curve steepens Gilt RV: The belly of the 5s18/4H19/3T20 fly is rich. Take profit on being long the belly of the 5s18/4s22/4Q27 fly. Stay short gilt 4s60 vs. 4Q55 on cash-for-cash basis We preview the FY12/13 gilt financing remit and expect an 11bn reduction in gross gilt sales to 168bn but we see a modest downside risk to this forecast as the treatment of the Royal Mail Pension Fund assets in the national accounts is unclear We expect a small increase in short nominal gilt issuance in FY12/13, with medium and long nominal issuance falling
Exhibit 1: Back white and front red Short Sterling contracts have underperformed over the last week
Change in Short Sterling, FRA/OIS and IMM OIS rates, 2-9 Mar; bp
15
SS
FRA/OIS
OIS
10
0 Dec12 Dec13 Dec14 Sep12 Sep13 Sep14 Mar12 Jun12 Jun13 Mar13 Mar14 Jun14
Exhibit 2: Our momentum model shows a neutral signal for 10Y gilts
Momentum model signal* for 10Y benchmark gilt
0.10 0.05 0.00 -0.05 -0.10 Feb 11
bullish signal at peak
bearish signal at trough Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12
* We first generate a MACD (Moving Average Convergence Divergence) measure. This is calculated as the expected moving average (EMA) of 10Y yields over a 5 day period minus the EMA of 10Y yields over a 25 day period. We then generate a signal measure which is the 10 day EMA of the MACD measure. The rule is defined as the MACD minus the signal
Sterling yields have risen on the week (Exhibit 1), although they remain at very low levels. Further out, intermediate gilt yields are close to their average levels for the last 3M and as we discussed in the previous GFIMs, we think the range-bound environment will continue. We suspect that investors have a bearish bias on duration given the improving economic backdrop and reduced expectations for further QE, but we think risk appetite remains low and that positions dont truly reflect this bias. We continue to focus on technical and momentum indicators and we remain neutral on 10Y
Neutral 10Y duration, stay long the belly of 10s/30s/50s fly

10Y and 30Y gilt yields are essentially unchanged since the last GFIMs, with 5Y yields around 5bp higher, and 10Y gilts trading in a tight 4bp range on the week. Market sentiment appears to be improving, risky assets continue to perform well and yet this dynamic is really only being reflected at the very front end, where Short
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duration, but we remove our bearish bias given our momentum model is showing a neutral signal (Exhibit 2). In the last GFIMs we recommended entering 1Yx1Y/2Yx1Y swap curve steepeners as an attractive way to position for modestly improving sentiment and an increase in term premia in the forward curve. We stick with this medium term reds/greens steepening view. For those investors who are constrained to trading cash gilts, we analyse how to proxy this swap curve steepening view in bond space (Exhibit 3). Overall, the correlation between the gilt curve and reds/greens swap curve has been moderate over the last few months but in general front end cash curve steepeners should provide investors with some broad exposure to a steeper reds/greens swap curve. For choice we prefer a 4H13/5s14 steepener as this has the highest beta and shows the largest dislocation vs. the reds/greens curve. However, we acknowledge that some investors will be unable to take a long position in 4H13 as it has less than one year remaining maturity and may well be excluded from their benchmarks. We keep our 5s/10s gilt curve stepeener. The 5Y sector of the curve has underperformed and our curve momentum model suggests that the 5s/10s gilt curve is too flat (Exhibit 4). The directionality of 5s/10s with the level of yields has been weak recently and we view this more as a tactical trade rather than a directional view on duration. We target the 115bp level in 1T17/3T21 with a tight stop loss of 100bp (currently 105bp). Further out we note that the 20Y sector of the gilt curve remains cheap, with forwards in this sector having underperformed since the February QE announcement. In fact, 15Yx5Y gilt forwards (i.e. 5Y gilt yields 15Y forward) now offer the highest yield on the gilt forward curve at around 4.5%. However, we would not recommend fading this cheapness as we think the 20Y sector can underperform further. Typically, in the absence of QE latent investor demand for 20Y gilts is low compared to 10Y and 30Y gilts. The 10s/20s/30s curve-adjusted fly has generally traded rich during QE periods and cheap during non-QE periods (Exhibit 5). We think QE purchases conducted since October 2011 have led to an artificial richening of the 20Y sector which has now started to correct as the market expects no extension to QE once the current 50bn of purchases have been completed.
Exhibit 3: Front end gilt curve steepeners can be viewed as modest proxies for our reds/greens swap curve steepening view
Statistics from regressing selected cash gilt spreads against GBP 1Yx1Y/2Yx1Y swap curve over the past 6M, 3M carry and slide for gilt curve steepener; bp unless stated Beta R-squ Residual 3M C+S
4H13/2Q14 8s13/2Q14 4H13/5s14 8s13/5s14 2Q14/2T15 5s14/2T15 2T15/2s16
0.4 0.3 0.8 0.7 0.4 0.0 0.2
44% 42% 48% 50% 29% 0% 32%
-3 -1 -9 -7 -7 0 -3
-3 -2 -3 -5 -2 -1 -3
5s/10s gilt par curve momentum signal vs. 5s/10s par curve
Exhibit 4: Our gilt curve momentum model suggests 5s/10s is too flat keep tactical steepener
6 4 2 115 0 -2 -4 Sep 11 Oct 11 Nov 11 Dec 11 Jan 12 Feb 12 105 95 Momentum signal 5s/10s curv e 135 125
10s/20s/30s par gilt fly 50:50 and curve adjusted*; bp
Exhibit 5: We think the 20Y sector can underperform vs.10s/30s if QE finishes in May
50 QE1 40 30 20 10 0 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 lev el adjusted 5 0 -5 -10 -15 50:50 fly QE2 10
* residual from regressing 10s/20s/30s fly vs. 10s/30s curve, r-squ: 58%, std error: 4bp
We keep our recommendation to be long the belly of the 10s/30s/50s gilt fly. The 30Y sector remains cheap on the curve and we expect to see ultra-long gilt issuance
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Exhibit 6: The belly of the 10s/30s/50s gilt fly should outperform as the reds/greens swap curve steepens
10s/30s/50s par gilt fly regressed against GBP 1Yx1Y/2Yx1Y swap curve, last 12M; bp
early in FY12/13 which should cheapen 50Y gilts. In addition, we note that the 10s/30s/50s fly has shown reasonable directionality with the reds/greens swap curve. Being long the belly is a good proxy for a steeper 1Yx1Y/2Yx1Y swap curve (Exhibit 6) and the fly currently looks some 5bp cheap given the slope of the reds/greens curve.
70 y = -0.24x + 58 60 50 40 30 R 2 =65%
4H42 auction, gilt RV

The DMO will tap gilt 4H42 for 2bn on 15 March, taking the total outstanding to 21.5bn (excluding DMO collateral outstanding is 17.5bn). This bond is now trading as the 30Y benchmark and looks close to fair value on our par curve model. At a macro level we think that the cheapness of the 30Y sector vs. 10s/50s could provide reasonable support for the auction. At a micro level, 4H42 looks a touch cheap on a fly basis vs. neighbouring gilts with the belly of the 4Q40/4H42/4Q46 fly at its cheapest level since the end of January. We think this cheapness may attract some auction interest but we think this RV interest will be limited as the fly has traded in a very tight range over the last 3M. On an ASW basis, 30Y gilts in general offer the highest pick-up vs. LIBOR at around 10-11bp, with 4H42 trading close to its average ASW level for the past 6M. In the 10Y sector of the curve we note that the belly of the 5s18/4H19/3T20 fly looks rich (Exhibit 7). The fly is non-directional with the level of yields and directionality with the slope of the 5s18s/3T20 curve has been patchy, except during January. The 5s18/3T20 curve steepened sharply following the QE announcement at the February meeting as the BoE shuffled the purchase buckets and bonds in the 3-7Y sector outperformed (as it became the smallest buyback bucket), which resulted in a cheapening of the fly. Gilt 4H19 falls into the 3-7Y purchase bucket for all operations going forward but we think that the fly is already reflecting this dynamic. The BoE holdings of 5s18 are larger than the other two bonds (52% compared to 40% and 23% respectively) but the BoE needs to buy another 4.4bn of this to reach the 70% threshold something we think is unlikely. We recommend selling the belly of the 5s18/4H19/3T20 fly. Elsewhere, we take profit on our recommendation to be long the belly of the 5s18/4s22/4Q27 fly. We close our recommendation to be long the belly of the 4H19/4T20/3T20 fly. At the ultra-long end, we keep our recommendation to be short 4s60 vs. 4Q55 on a cash-for -cash basis. The implied forward remains close to its highest level and we
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current 20 0 20 40 60 Reds/greens sw aps; bp 80 100
Exhibit 7: The belly of the 5s18/4H19/3T20 fly is rich

50:50 fly and 5s19/3T20 curve; bp
2 0 -2 -4 -6 -8 Mar 11
5s18/4H19/3T20 5s18/3T20
Feb QE
75 70 65 60 55 50
Jun 11
Sep 11
Dec 11
Mar 12
Exhibit 8: We expect a modest decline in gross and net gilt sales for FY12/13
Financing remit breakdown, shaded cells are J.P.Morgan forecasts
bn Fiscal (PSNB) Financial transaction Other Total (CGNCR) Redemptions Reserv e Financing ST Financing adjustment NS&I Roy al Mail PF Adjustment* Net Financing Requirement T-Bills Way s and means DMO net cash Gross gilt Sales Net gilt Sales BoE QE gilt purchases Gilt issuance net of QE + redemptions*
FY 10/11 FY 11/12 FY 12/13 FY 13/14 137 6 -3 140 39 6 -26 0 0 158 -1 0 6 165 126 0 126 127 8 0 135 49 6 -9 3 0 178 0 0 0 179 130 115 15 120 11 -3 128 53 10 -7 2 -13 170 2 0 0 168 115 10 105 100 13 4 117 47 10 0 0 -13 161 2 0 0 159 112 0 112
* we estimate the impact of the absorption of the Royal Mal Pension Fund assets into the National Accounts will be split over two fiscal years. However it is possible that the total 25bn benefit is taken in just one fiscal year
expect issuance of 4s60 in the first quarter of FY 12/13 (see below).
Exhibit 9: We expect a small increase in the proportion of short nominal gilt issuance for FY12/13
March Budget and gilt financing remit

The Chancellor will present the 2012 Budget on 21 March with the DMO releasing the financing remit for FY12/13 after the end of the Budget speech. At the top level we think that the fiscal outlook will be little changed from the Autumn OBR forecasts, with net borrowing expected to fall to 7.7% of GDP in the next fiscal year, equivalent to 120bn. Over the longer run we think net borrowing will fall to around 4.4% of GDP in FY14/15 with debt/GDP creeping up to 76%. Investors are starting to focus on the issuance remit and potential gilt market impact and Exhibit 8 outlines our estimates of the financing requirement and gross gilt issuance for FY12/13. The central government net cash requirement (CGNCR) is expected to fall by around 7bn but with redemptions rising by around 4bn this suggests, at a first glance, a 3bn fall in gross gilt issuance (assuming T-Bill issuance is unchanged). However, we expect a slightly larger reduction in gross gilt issuance of 11bn, with gross gilt sales expected to be 168bn in FY12/13. Sometimes the remit throws up a few surprises in terms of additional or unexpected factors and we highlight three areas of uncertainty in our forecast: 1) Reserve Financing; 2) a short-term financing adjustment, and 3) the inclusion of the Royal Mail Pension Fund assets in the National Accounts. We pencil in a 7bn short-term financing adjustment to take account of an expected overshoot in borrowing in FY11/12 due to better than expected budget outturns, but as the final outcome is not yet known the actual adjustment could be different from our forecast. The third of these factors, namely in the inclusion of the Royal Mail Pension Fund assets, could potentially have the biggest impact on our issuance forecast. We recently discussed this issue in a briefing email (see UK Inflation markets and the Royal Mail Pension Fund, 8 Mar) but as a recap the Government will be taking the assets of the Royal Mail Pension Fund onto its balance sheet from April 2012, with the liabilities being added to the existing off-balance sheet contingent liabilities of existing public sector pensions. Total assets are around 28bn, with around 2bn of this in cash, and the OBR estimates that the inclusion of these assets net of cash could reduce public sector net borrowing (PSNB) by
Gilt issuance by maturity bucket, historic and FY12/13 forecast; bn unless stated Chg. Chg. FY FY FY 12/13 FY FY FY 12/13 10/11 11/12 12/13 vs. 10/11 11/12 12/13 vs. 11/12 11/12
Short nominal Medium nominal Long nominal Linkers Total 53 38 41 34 166 61 40 40 39 179 61 34 35 38 168 1 -6 -4 -1 0 32% 23% 25% 20% 34% 22% 22% 22% 37% 20% 21% 23% 3% -2% -1% 1% 0%
100% 100% 100%
Total gilt redemptions by fiscal year
Exhibit 10: We think that any new gilts will be issued in sectors of the curve where redemptions are low
80 70 60 50 40 30 20 10 0 amount, bn 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%
% of total
11/12
12/13
13/14 14/14
15/16 16/17
17/18
18/19 19/20
20/21 21/22
22/23
23/24 24/25
around 25bn. The timing of this is uncertain and we are unsure exactly when this would be realized, so we have assumed that half of the 25bn is recognized in FY12/13 and the other half in FY 13/14. However, we acknowledge downside risk to our issuance forecast if we are wrong on the timing. Exhibit 9 outlines our forecast by sector of the curve. We think the DMO will be reluctant to change the % of issuance by sector by much but we think that short nominal issuance (<7Y) will increase by around 3% as 1) funding at the front end is cheap given low level of spot and forward yield, and 2) we expect MFI and overseas Central Bank demand for gilts to continue. We also expect a slight increase in linker issuance given the very low level of real yields, with medium and long nominal issuance falling by a total of 7bn (3%). The DMO is likely to focus new bonds in maturities of the curve where the redemption profile is low (Exhibit 10). We would expect any new short maturity bond to be issued with a 2018/19 maturity and any new medium
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25/26
maturity bond to be issued with a 2022-2024 maturity. We expect syndications to continue to be a key method of issuing and think that the DMO could well announce a long nominal syndication to be held in the first quarter of the upcoming fiscal year (i.e. April-Jun). We would favour a reopening 4s60 given the richness of this bond in forward space compared to other ultra-long end gilts.
2012 closed trades P/L

bp unless stated
TRADE DURATION Short 10Yx 5Y forw ard CURVE 5s/30s gilt flattener 10s/30s gilt flattener 5s/12s sw ap curv e steepener RELATIVE VALUE Lev el- and curv e-adj. long 5s18/4s22/5s25 Sell 4s16 v s. 1T17 on ASW Long lv l. And curv e adj 3s/12s/25s sw ap fly Long belly lv l. Adj. 2s/15s/30s sw ap fly 30Y sw ap spread w ideners Long belly 4H19/4T20/3T20 Long belly 5s18/4s22/4Q27 INFLATION Receiv e 2Y RPI Long ILG16 30s/50s RY curv e flattener Short belly ILG16/ILG17/ILG22 RY fly Long 30Y UK BE v s. 30Y France BE Short ILG50 v s. ILG47 cash-for-cash 15-Dec-11 06-Jan-12 10-Feb-12 10-Feb-12 10-Feb-12 10-Feb-12 21-Feb-12 24-Feb-12 24-Feb-12 17.0 2.0 13.0 10.0 110p 24-Feb-12 -105p 15-Dec-11 16-Sep-11 27-Jan-12 20-Jan-12 03-Feb-12 03-Feb-12 03-Feb-12 06-Jan-12 20-Jan-12 10-Feb-12 24-Feb-12 02-Mar-12 09-Mar-12 09-Mar-12 2.0 3.0 4.0 7.0 5.0 -1.0 3.5 15-Dec-11 20-Jan-12 27-Jan-12 06-Jan-12 10-Feb-12 10-Feb-12 16.0 -10.0 7.0 27-Jan-12 10-Feb-12 138c ENTRY EXIT P/L
Sell the belly of the 5s18/4H19/3T20 fly (50:50) Sell 30mn notional of gilt 4.5% Mar19 vs. buying 17mn notional 5s18 and buying 13mn notional of gilt 3.75% Sep20 @ -7.5bp. Target -3.5bp, stop loss @ -9bp. Close long the belly of the 4H19/4T20/3T20 fly (50:50) Buy 50mn notional of gilt 4T20 vs. selling 28mn notional of gilt 4H19 and 25mn of gilt 3T20 @ weighted spread of 7.5bp. Target 3bp, stop loss @ 8bp.P/L since inception is -0.5bp (recommended 3 Feb). Close long the belly of the 5s18s/4s22/4Q27 (50:50 fly) Buy 50mn nominal of gilt 4s22 vs. selling 38mn nominal of gilt 5s18 and 17mn nominal of gilt 4Q27 at a weighted spread of 15bp. P/L since inception is 3.5bp (recommended 3 Feb). Keep reds/greens swap curve steepener Pay 50mn of 2Yx1Y GBP swaps vs. receiving 50.4mn of 1Yx1Y GBP swaps @ 23bp. Target 45bp, stop loss @ 15bp.3M carry and slide is -3bp. P/L since inception is -2bp. Stay long belly of 10s/30s/50s gilt fly cash-andduration neutral fly Buy 40mn of gilt 4Q40 vs. selling 16mn of gilt 3T21 and selling 25mn of gilt 4s60 @ 46bp. Target 30bp, stop loss @ 50bp.P/L since inception is 0bp. Keep 5s/10s gilt curve steepener Buy 50mn of gilt 1T17 vs. selling 29.3mn of gilt 3T21 @ 105bp. Target 115bp, stop loss @ 100bp. 3M carry and slide is 0.5bp. P/L since inception is -6bp (recommended 24 Feb). Sell 4s60 vs. 4Q55 cash-for-cash Sell 20mn of gilt 4s60 vs. buying 20mn of gilt 4Q55 @ a relative price ratio of 0.964. Target 0.959, stop loss @ 0.9655. P/L since inception is 0c (recommended 24 Feb).
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04-Nov -11 24-Feb-12
Sell belly of 3T21/5s25/4T30 fly (50:50) Sell 30mn of gilt 5s25 vs. buying 21mn of gilt 3T21 and 12mn of gilt 4T30 @ -4.0bp. Target -1bp, stop loss @ -7.5bp. P/L since inception is 1bp (recommended 10 Feb). Stay long the belly of the 4Q32/4T38/4H42 fly (50:50) Buy 30mn notional of gilt 4T38 vs. selling 19mn notional of gilt 4Q32 and 14mn notional of gilt 4H42 @ weighted spread of 5.0bp. Target 2bp, stop loss @ 7bp. P/L since inception is 0bp (recommended 3 Feb). Keep paying 12Mx6M GBP swaps Pay 50mn of 12Mx6M swap @ 1.18. Target 1.30%, stop loss @ 1.05%. 3M carry and slide is -2bp. P/L since inception is 1p (recommended 20 Jan). Keep pay belly of 2s/5s/10s GBP swap fly via 3M payers (buy payers on 5Y vs. selling payers on 2Y and 10Y) Pay 100mn of 5Y swap vs. receiving 50mn of 2Y swaps and 50mn of 10Y swaps via 3M payer options. Zero cost entry level -22bp, 3M forward -22bp, spot level -26bp. Stay short belly of the 4s16/1T17/5s18 fly (50:50) Sell 50mn of gilt 1T17 vs. buying 25mn of gilt 4s16s and 19mn of gilt 5s18 @ -5.0p. Target -0bp,
stop loss @ -6bp. 3M carry and slide 0.5bp. P/L since inception is -0.5bp (recommended 20 Jan). Stay short the belly of the 2Q14/2T15/4T15 fly (50:50) Sell 30mn of gilt 2T15 vs. buying 21mn of gilt 2Q14 and 12mn of gilt 4T15 @ weighted spread of 2bp. Target 11bp, stop loss @ -0.5bp. P/L since inception is 0bp (recommended 6 Jan). Stay long ILG16 BE Buy 10mn cash of ILG16 vs. selling 29.5mn cash of gilt 4s16 @ a breakeven spread of 268bp. Target 280bp level, stop loss @ 255bp. P/L since inception is 12bp (recommended on 24 Feb). Stay long belly of the ILG22/32/40 real yield cashand-duration neutral fly Buy 15mn of ILG22 vs. selling6mn of ILG22 and 9mn of ILG40 @ spread of 21bp. Target 12bp, stop loss @ 25bp. P/L since inception is 0bp (recommended on 24 Feb).
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US Fixed Income Strategy Global Fixed Income Markets Weekly March 9, 2012 Srini RamaswamyAC (1-212) 834-4573 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC.
US Cross Sector
The risky asset rally took a bit of a breather this week, likely due in part to robust supply Supply is a headwind in some markets, keeping us bearish on Treasuries and munis but in other markets, such as high grade and high yield, supply has been met with strong demand, and we stay overweight Weak trade numbers, in conjunction with last weeks disappointing consumption and durable goods orders data, lead us to revise our forecast for 1Q12 growth down from 2.0% to 1.5% On the other hand, the February employment report was solid. Given that the Feds dual mandate focuses on employment and inflation, not growth, we do not expect the Fed to embark on QE3 at next weeks meeting, and we think the bar for action is higher for the April meeting as well. That said, if QE3 were to eventually occur, it would be supportive of risky assets even if it is implemented on a sterilized basis We think the generally supportive macro backdrop and declining tail risks in Europe will continue to outweigh headwinds such as the Middle East and stay overweight risky assets
Exhibit 1: The risky asset rally took a bit of a breather this week
Current level,* change since 3/2/12, quarter-to-date change, and change over 4Q11 for various market variables
Current Chg from 3/02 QTD chg 4Q11 chg Global Equities (level) S&P 500 E-STOXX FTSE 100 Nikkei 225 Sovereign par rates (%) 2Y US Treasury 10Y US Treasury 2Y Germany 10Y Germany 2Y JGB 10Y JGB 5Y Sovereign CDS (bp) Spain Portugal Italy Ireland Funding spreads (bp) 2Y EUR par swap - par gov't spd 2Y USD par swap - par gov't spd EUR FRA-OIS spd USD FRA-OIS spd 1Y EUR-USD xccy basis Currencies EUR/USD USD/CHF USD/JPY JPM Trade-weighted USD Spreads (bp) 30Y CC MBS L-OAS 38.9 220.0 196.9 635.0 342.5 163.0 242.2 234.9 98% 104% 1698.70 -2.8 5.0 4.3 12.4 -5.3 -1.5 1.2 -3.7 4.1% -1.1% -23.50 -7.1 -55.0 -39.8 -89.1 -83.9 -64.9 -88.5 -117.3 3.4% -18.0% 157.80 -0.6 -90.0 -17.6 -83.9 -38.6 16.6 -3.4 25.1 -15.6% 1.6% -74.60 10Y AAA CMBS spd to swaps JULI portfolio spd to Tsy JPM US HY index spd to worst EMBIGLOBAL spd to Tsy MAGGIE (Euro HG spd to govies) US Financials spd to Tsy Euro Financials spd to govies 10Y AAA muni/Tsy ratio (level) 30Y AAA muni/Tsy ratio (level) Commodities Gold futures ($/t oz) Oil futures ($/bbl) 107.40 0.70 8.57 19.63 * 3/8/12 level for Europe and US corporate credit spreads, and the J.P. Morgan trade-weighted USD index; 3/9/12 level for all others. 1.312 0.919 81.78 80.83 -0.010 0.006 0.15 -0.01 0.020 -0.024 4.08 -1.41 -0.051 0.037 0.95 0.23 97.3 23.5 38.5 32.8 -54.2 6.2 -0.4 2.9 2.2 4.1 -23.7 -23.1 -32.6 -23.0 45.7 21.8 18.6 7.7 12.3 -27.3 396 1296 369 618 20 57 8 20 14 117 -118 -134 -1 -36 13 12 0.341 2.099 0.093 1.917 0.113 0.989 0.053 0.057 -0.037 0.049 0.011 0.014 0.077 0.157 -0.009 0.024 -0.015 0.083 -0.032 -0.080 -0.406 -0.046 -0.017 -0.089 1370.9 2516.0 5887.5 9929.7 1.2 -30.2 -23.6 152.7 113.3 199.4 315.2 1474.4 126.2 136.9 443.8 -244.9
Market views
The risky asset rally took a bit of a breather this week: European sovereign spreads and funding spreads widened, European stocks fell, and credit spreads were mixed (Exhibit 1). The pause in the rally likely partially reflects the heavy supply environment. As we highlighted last week, supply in high grade and high yield have been running at extremely high levels (see also Exhibit 1 in Interest Rate Derivatives), and it has also picked up in markets like munis and CMBS. As Exhibit 2 shows, we expect over $6bn of CMBS to price this month, which would be the most monthly issuance since the primary market reopened in early 2010. In munis, issuance has been increasing steadily over the past four weeks, with this week seeing over $10bn of new supply, which is double the average weekly pace over the first two months of the year.
Although recent supply is likely opportunistic to some extent (driven by low yields and tight spreads) and reflects the strength of issuance markets, supply technicals could nonetheless dampen the rally in some markets. In munis, for instance, elevated supply and the potential for investors to withdraw funds ahead of the upcoming tax season causes us to take a cautious stance
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(see Municipals). Moreover, with the bulk of supply now coming in longer-term debtsince the ECBs LTRO has significantly lowered short-term funding needs for banks (see Short-Term Fixed Income)duration supply has been substantial. Heavy duration supply keeps us bearish on Treasuries, particularly in light of slowing foreign demand (see Treasuries). In high grade and high yield, however, heavy supply has been met with strong demand. As Exhibit 3 shows, concessions on new issues have fallen to nearly zero due to robust demand. Given this supportive technical backdrop, we stay overweight both high grade and high yield. Beyond elevated supply, the macro backdrop is not without headwinds, but we continue to expect positives to dominate negatives. This weeks data point to both a slowing of growth in the first quarter and continued healing of the labor market. Last week we highlighted the downside risk around our 1Q12 growth forecast due to soft consumption and a weak durable goods report. This weeks trade report showed that the trade deficit widened to $52.6bn in January, worse than expected, so we revise down our forecast for 1Q12 GDP growth from 2.0% to 1.5% (see Economics). In addition, the recent rise in energy prices does increase downside risks to growth. On the other hand, Fridays employment report was solid: total nonfarm payrolls rose 227K in February, with upward revisions to the prior months, and the unemployment rate was unchanged at 8.3%. What does this all mean for the upcoming FOMC meeting? We think the Fed is highly unlikely to announce additional asset purchases at next weeks meeting. Given that the Feds mandate is concerned with inflation and employment, not GDP growth, the slowdown in growth is worrisome, but it is unlikely to cause the Fed to embark on QE3. In addition, we think todays solid jobs report has raised the bar for action at the April meeting as well (see Jobs, growth, and the Fed, Michael Feroli, 3/9/12). However, as we have highlighted in past publications, the potential for an eventual QE3 remains, and if QE3 occurs, we would expect it to be supportive of risky assets. Furthermore, we would expect further asset purchases to be supportive of risky assets even if purchases are sterilized as has been suggested recently. This is because we find that risky assets have been more correlated with the size of the Feds securities holdings rather than the amount of reserves in the banking system.
Exhibit 2: Supply has been very strong in a number of markets recently

Monthly gross issuance of CMBS; $bn
7 6 5 4 3 2 1
Priced
Expected
Nov-10
Nov-11
0
Jan-10 May-10 Mar-10 Jul-10 Sep-10
Jan-11
May-11
Mar-11
Jan-12
Source: Commercial Mortgage Alert
Exhibit 3: but in high grade, it has been met with very strong demand
New issue concessions* (10-day average); bp
120 100 80 60 40 20 0 Oct 07
Feb 09
Jun 10
Sep-11
Nov 11
* Note: Average new issue concession is the running average of the difference between the spread at which a new issue printed and the spread at which corresponding bonds trade in the secondary market. The average is a 10-day running average weighted by the size of the newly issued bond. Source: J.P. Morgan
Under a sterilized asset purchase program, the size of the Feds securities holdings will increase, but the total amount of reserves in the banking system would stay the same. In Exhibit 4, we show the partial betas and T-stats for two versions of our stylized model for spreads. Three of the variables remain the same in both versionsthe 4week average of jobless claims to proxy the economy, an average of French bank CDS to proxy the European crisis, and our Middle East crisis indexand then we use either the Feds securities holdings or total reserves to proxy QE. As the table shows, the magnitude of the partial betas for the Feds securities holdings is larger and statistically significant, while reserves are not generally statistically significant. Thus, if the Fed were to
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Mar-12
Jul-11
eventually embark on an asset purchase program, whether sterilized or not, we would expect spreads to tighten as a result. Another factor that we expect to continue to support risky assets is the decline in tail risks around Europe. Thanks to the Greek PSI and the accompanying EU/IMF aid package, near-term risks around Greece have fallen. First, we estimate that Greeces gross debt burden has fallen by 106bn, with its upcoming interest payments reduced by around 1/3rd and upcoming bond redemptions reduced by around 2/3rds (see Overview, Global Fixed Income Markets Weekly, 3/9/12). Second, the debt restructuring effectively transforms much of Greeces private debt into official-sector debt, which means less chance of a disruptive default in the near term. As we have highlighted in the past, declining tail risk has led to increased risk appetite. Indeed, as Exhibit 5 shows, prime money funds increased their exposure to core European banks again in February. Furthermore, we highlight that unlike in January, when increased Eurozone bank exposures were driven more by investments in secured products like ABCP and repo, Februarys increases were driven primarily by investments in unsecured products, reflecting improving tone (see Short-Term Fixed Income). Thus, with tailwinds likely to outweigh the headwinds, we remain largely overweight risky assets. In corporates, we believe that the developments in Europe and the release of the bank stress test results next week should be positive, though ongoing active supply, weaker 1Q12 earnings and the pending Moodys bank rating actions are offsets. However, we continue to believe that positive technicals will dominate and push spreads tighter over time (see Corporates). In CMBS and ABS as well, increased supply has been easily absorbed by the market. Within CMBS, new issue single-As remain our top pick, while in ABS, we favor non-prime auto ABS, subordinate benchmark ABS, and USD-denominated foreign ABS. In emerging markets, the pace of the rally has slowed, but we think a big correction is unlikely and we look for opportunities to add risk. We stay overweight EM sovereigns and corporates, and we trim our year-end EMBIG spread forecast to 325bp from 350bp, and CEMBI target to 350bp from 400bp (see Emerging Markets).
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Exhibit 4: We find that risky asset spreads have been more correlated to the size of the Feds securities holdings than reserves, suggesting that a sterilized asset purchase program should benefit spreads
Partial beta and T-stat for two versions of our stylized model for spreads*; spreads are in bp unless otherwise indicated
Fed sec holdings Beta T-stat 10Y AAA CMBS spd to swaps JULI portfolio spd to Tsy JPM US HY index spd to worst US Financials spd to Tsy S&P 500 (points) -0.078 -0.020 -0.084 -0.031 0.158 -3.1 -2.3 -3.0 -2.3 5.9
Reserves Beta T-stat -0.025 -0.013 -0.048 -0.017 0.117 -1.1 -1.7 -2.0 -1.4 4.8
* 2-year regression of spreads or levels versus the 4-week average of jobless claims (000s), French bank CDS** (bp), our Middle East crisis index*** and either the size of the Feds securities holdings ($bn) or total reserves in the banking system ($bn); regression uses weekly data. ** Average of 5-year CDS for BNP Paribas, Credit Agricole, and Societe Generale. *** Defined as exp[0.5*(Brent oil prices 0.1075*S&P + 3.6274*JPM Trade-weighted dollar index + 0.0959*EM stocks -348.34)/4.2]. EM stocks are defined as the weighted average of Brazil, Mexico, Russia, India, China, Hong Kong, Taiwan, Korea, Singapore, Malaysia, Thailand and Indonesia benchmark stock indices in USD terms. Weights determined by market values of the indices (in USD terms) as of year-end 2011. Source: Bloomberg, J.P. Morgan
Exhibit 5: Money market funds increased their exposure to Eurozone banks again in February
Monthly change in prime money market fund exposures to Eurozone bank credit; $bn
100
50
-50
-100 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12

Source: J.P. Morgan estimates, fund holdings reports
US Fixed Income Strategy Global Fixed Income Markets Weekly March 9, 2012 Terry BeltonAC (1-212) 834-4650 Meera Chandan (1-212) 834-4924 Kimberly L. Harano (1-212) 834-4956 J.P. Morgan Securities LLC.
US Treasuries
Valuations are still rich and sponsorship from Japan is likely to weaken in the near term we maintain our outlook for Treasury rates to increase gradually, still targeting 10-year yields to reach 2.5% by mid-year We discuss the impact of sterilization of QE; a $50 bn per month increase in term repo should increase 2-year Treasury rates by 5bp and cheapen 2-year Treasuries versus OIS by 2-3bp Increase exposure to well-hedged carry trades; 2s/6s Treasury steepeners hedged with EDM4/EDZ4 Eurodollar flatteners are especially attractive Initiate 5s/10s and 5s/30s weighted flatteners The latest Flow of Funds release shows demand for fixed income securities (Treasuries, GSE securities, and corporate debt) by international investors fell sharply in 4Q11 while FDI and cash holdings increased Tactically position for a steeper 10s/30s TIPS breakeven curve hedged for the nominal curve
Exhibit 1: J.P. Morgan rate forecast

%
Actual 9 Mar 12 Rates Effective funds rate 3-mo LIBOR 3-month T-bill (bey) 2-yr Treasury 5-yr Treasury 10-yr Treasury 30-yr Treasury 0.11 0.47 0.08 0.32 0.90 2.04 3.19 1m ahead 9 Apr 12 0.10 0.40 0.04 0.27 0.95 2.05 3.15 2Q12 3Q12 4Q12 30 Jun 12 30 Sep 12 31 Dec 12 0.10 0.45 0.02 0.30 1.25 2.50 3.60 0.10 0.50 0.02 0.30 1.25 2.50 3.60 0.10 0.50 0.02 0.30 1.25 2.50 3.60
Exhibit 2: Japan has historically been a net seller of Treasuries during the mid-March to mid-April period
1-month rolling sum of Japans net purchases of foreign bonds and notes by residents averaged in the business days around the 1st day in March; $bn
20 15 10 5 0 -5 -10 -50 -40 -30 -20 -10 0 10 20 30 Business days around 1st trading day in March 40 50
Market views
Treasury yields rose this week with 2-year yields increasing 4 bp, 5- and 10-year yields increasing 5 bp, and 30-year yields increasing 7 bp. The sell-off occurred as event risk in Europe fell with the completion of the Greek bond swap, while US economic data remained solid. The sell-off leaves 10-year Treasury notes yielding 2.04%, up 17 bp year-to-date, and 2 bp below the highs of the year. Economic data released this week was solid with nonfarm payrolls increasing 227,000 in February (consensus = 210,000) and upward revisions showing job growth has averaged 245,000 over the past three months. Initial jobless claims data weakened modestly, but still show strength in the labor market with the 4-week average at 355K. The ISM nonmanufacturing survey increased by 0.5pts to 57.3, with the business activity and new orders components reaching their highest levels since February 2011. However, the January trade deficit increased for the third month in a row and came in larger
Source: MoF
than expected at $52.6bn, further reinforcing a softening in growth in Q1. As a result, we have lowered our 1Q12 growth forecast to 1.5% from 2% while noting increased downside risks to our 2Q12 growth forecast of 2.5% (see Economics). Looking ahead, we maintain our outlook for higher Treasury rates, and still target 10-year yields to reach 2.5% by mid-year (Exhibit 1). As discussed in recent weeks, the outlook is driven primarily by 1) rich Treasury valuations, 2) our analysis that suggests the risk premium in forward OIS rates is much too low given the large uncertainty around the Feds unemployment rate forecast, and 3) recent data highlighting a clear weakening in Chinas sponsorship of Treasuries with China selling 9% of its Treasury holdings in 4Q11. More tactically, as we approach Japanese year-end, we expect sponsorship from Japanese investors to weaken; on average over the last 5 years, Japan has been a net seller of Treasuries during the mid-March to mid-April period.
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Exhibit 3: Speculative investors derisked ahead of payrolls, reducing front-end duration longs
Exhibit 4: but these unwinds are likely to be reversed
Rolling 1-month change in net longs held by non-commercial investors in ED, TU and FV contracts; 000s of 10-year contract equivalents
Net longs held by non-commercial investors in ED, TU and FV contracts averaged around periods* in which large de-risking occurred; 000s of 10-year contract equivalents
400 300 200 100 0 -100 -200 -300 -400 -500 2008
Source: CFTC
340 320 300 280 260 240 220 200 180 160 -20 2010 2012 -15 -10 -5 0 5 10 15 Business days around derisking by spec investors* 20
This compares to an average of $15 bn of net buying during February (Exhibit 2). Finally, next week brings heavy duration supply with the Treasury auctioning $66 bn of 3s, 10s, and bonds for a total duration supply of $55 bn in 10-year equivalents. To be sure, there are important offsets that are likely to keep any rise in rates muted. Demand for fixed income assets from US commercial banks remains strong with US banks buying $64 bn of securities during February or 9 times their average pace during 2011. Moreover, with payrolls behind us without incident, we would expect investors to re-enter carry trades, helping keep rates in their recent trading range. De-risking in front of this months payroll release was unusually large, with CFTC data showing speculative investors reduced front-end duration longs by 200,000 10-year futures equivalents in the last few weeks (Exhibit 3). Following the pattern in other periods where de-risking was large, these unwinds are likely to be reversed (Exhibit 4), with investors overweighting the high-carry parts of the yield curve. The sell-off in the front end this week was helped by a report in the Wall Street Journal that the Fed was considering sterilizing any future asset purchases. This can be done either by conducting reverse repo operations or by offering term deposits to banks with the former having the benefit of placing less of a burden on bank balance sheets (see Next moves for the Fed, Michael Feroli, 3/8/12). While the near-term prospects for QE3 appear low, most of the centrist FOMC members have indicated support for further asset purchases if economic
30
* Net longs averaged in the business days around 9/3/10,7/8/11,6/4/10,3/4/11 and 9/2/11. Dates correspond to the 5 largest 1-month declines in net speculative longs (excluding yearend) since 2010.
Exhibit 5: Inflation expectations rose sharply leading into all three QE announcements that involved an increase in excess reserves, but fell leading into Operation Twist
5yx5y inflation swap rates averaged in the business days around QE announcements* and Operation Twist; %
3.4 3.2 3.0 2.8 2.6 2.4 -50 -40 -30 -20 -10 0 10
Operation Twist Pre Operation Twist
20
30
40
50
Business days around Fed announcements

* Dates used are 11/25/08, 3/18/09 and 9/21/10 for pre Operation Twist, and 9/21/11 for Operation Twist.
data were to weaken. If QE3 were to occur, we would still place the odds of the Fed sterilizing its purchases at only around 50%. The main benefit would be to minimize an increase in inflation expectations; these rose sharply leading into all three asset purchase programs announced by the Fed that involved an increase in excess reserves. By contrast, inflation expectations fell leading into the Operation Twist when the Fed bought duration without increasing excess reserves (Exhibit 5).
Exhibit 6: A $50 bn per month increase in term repo should increase 2-year Treasury rates by 5-6 bp
1-month average of the residual* of 2-year yields to fair value (bp) versus the monthly net issuance of T-bills ($bn)
Exhibit 7: Weighted 2s/6s steepeners hedged with 9th/11th ED flatteners are currently at their 1-year lows
0.33 * 6-year yields 2-year yields (0.85 * 11th ED yield 9th ED yield); %
15 10 5 0 -5 -10 -15 -20 -60 -40 -20 Y = 0.1059 X1 - 0.4399 R = 24.62% standard error = 8.1712 period = Mar 09,11 - Mar 09,12 0 20 40 Net issuance of Tbills; $bn 60 80 100
0.10 0.08 0.06 0.04 0.02 -0.00 -0.02 -0.04 -0.06 Jun 11 Sep 11 Dec 11 Mar 12
* Residual is actual minus fair value where fair value of 2-year Treasury yields (%) estimated as 0.0858 + 0.219 * 5yx5y inflation swap rates (%) + 0.94 * 3mx3m OIS rates (%) 0.0017*semi-peripheral Europe CDS (bp) 0.093* J.P. Morgan positions index
Exhibit 8: Look for the long-end of the curve to flatten in coming weeks
0.71 * 30-year yields 5-year yields and 0.63 * 10-year yields minus 5-year yields averaged in the business days around the last six 30-year auctions; %
The impact of sterilization on front-end rates would depend on whether the Fed uses term deposits or term repo. An increase in term deposits would likely have a very small or no impact on yields as banks are simply moving overnight reserves into reserves with a slightly longer term without directly impacting the supply of collateral in the short-term markets. By contrast, term repo done directly with money market funds would more directly increase the supply of short-term assets available to money funds and be akin to an increase in Treasury bill supply. Based on the historical relationship between bill supply and front-end rates, we estimate a $50 bn per month increase in term repo should increase 2-year Treasury rates by 5 bp (Exhibit 6). To be sure, 2-year Treasury rates are already quite elevated largely because of a seasonal increase in bill supply during February and March. This supply could keep front-end rates elevated for a few more weeks but is likely to reverse in April as bill supply turns sharply negative. The impact of sterilization on Treasury/OIS spreads is less clear although on balance, we would expect 2-year Treasury-OIS spreads to widen (i.e., Treasuries to cheapen) by 2-3 bp. Historically, a $50 bn increase in monthly bill supply has caused 2-year Treasury-OIS spreads to widen by 4 bp as the increase in front-end supply increases GC repo rates. However, because the Fed can do term repos directly with the GSEs, sterilization will increase OIS by a larger amount than when bill supply increases, as it causes GSEs to move
1.33 1.32 1.31 1.30 1.29 1.28 1.27 1.26 1.25 1.24 -8 -6 -4 -2 0 2 4 6 Business days around the 30-year auction 8 5s30s 5s10s
0.380 0.375 0.370 0.365 0.360 0.355 0.350 0.345 0.340 0.335 0.330
short-term assets from Fed funds into term repo with the Fed. This switch from Fed funds should be quite attractive to the GSEs as they can increase yield without increasing their credit exposure. On the yield curve, we recommend increasing exposure to carry trades and find Treasury curve steepeners hedged with Eurodollar curve flatteners attractive. In particular, we recommend 2s/6s Treasury steepeners hedged with a EDM4/EDZ4 Eurodollar flattener (see Trade recommendations). This trade has been weighted to be market-neutral and the entry level is attractive with the weighted spread at its 1-year low (Exhibit 7). The 3month weighted carry and roll is 5.1bp, and the riskadjusted carry (i.e. the carry and roll in the trade divided
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Exhibit 9: International investors shed Treasury holdings in 4Q11, preferring FDI and cash instead
Average monthly net buying of various USD financial assets by international investors; $bn 50 Prior 1y avg 40 4Q11
Exhibit 10: The data did not shed much light on which investors ramped up buying in 4Q11 to make up for the lost demand by international investors
30 20 10 0
Corporates
FF/ Repo
-10
Average monthly Treasury net purchases by various investor type; $bn Avg since Description 4Q11 Difference 2010 Households 48 3 45 Broker dealers 21 0 21 International investors 17 42 -25 Money market funds 10 0 10 Private pension funds 8 11 -4 Mutual funds 7 4 3 GSEs 2 2 0 U.S.-chartered commercial banks 1 2 -1 Fed -4 43 -47 SLG ex employee retirement funds -4 -2 -2 Other 4 4 0 Total 110 110 0
Source: Federal Reserve Z.1
Deposits
Tsy
FDI
Other
Equities
CP
Source: Federal Reserve Z.1
GSE
by the 2-year standard deviation of 3-month changes in the weighted trade) is 86%. We also recommend initiating 5s/10s and 5s/30s weighted flatteners as tactical trades to position for cyclical patterns around supply. The 5s/10s and 5s/30s curves have flattened in the week following 10-year and bond supply in 4 of the last 6 auction cycles (Exhibit 8). Given that both curves are near the steep end of their recent trading range, and that forward OIS is rich, we expect the pattern to repeat itself this cycle, and favor intermediate and long-end flatteners (see Trade Recommendations).
Exhibit 11: The 10s/30s breakeven curve is near historically flat levels
1-month forward 10s/30s TIPS breakeven curve*; bp
100 80 60 40 20 0 -20 Mar 02 Jul 03 Dec 04 Apr 06 Sep 07 Jan 09 May 10 Oct 11
Note: We look at the 1-month forward curve to remove the impact of near-term carry.
Flow of Funds data

The Federal Reserve released Flow of Funds data for 4Q11 this week, providing additional information on the composition of investor demand for Treasuries during the quarter. The following observations are noteworthy from the latest release. First, the data is consistent with the TIC holdings released last week and shows that foreign sponsorship declined in 4Q11 after increasing in 3Q11 (US Fixed Income Markets Weekly, 3/2/12). As discussed in our previous publication, lower demand was driven by China, which went from buying $16bn per month on average to selling $26bn in 2Q11. Selling was concentrated primarily in 4Q11. China sold $118bn of Treasuries in 4Q alone, or 9% of their Treasury portfolio.
Second, the data suggest a broader reallocation by international investors out of fixed income securities into cash and direct investments during 4Q11. International investors were net sellers of spread product (GSE securities as well as corporate debt) during the quarter while FDI and cash increased significantly (Exhibit 9). Finally, the data did not shed much light on which investors ramped up buying in 4Q11 to make up for the lost demand by international investors. As shown in Exhibit 10, while average monthly net Treasury purchases by broker dealers and money-market funds were $21bn and $10bn higher relative to their longerterm average in 4Q11, the amount of net buying attributed to households (a residual line item used by the Fed to account for gaps in the data) increased by $45bn.
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Exhibit 12: and looks too flat relative to the nominal curve and oil
Exhibit 13: The 10s/30s breakeven curve has tended to steepen around 30-year nominal auctions
1-month forward 10s/30s TIPS breakeven curve regressed against 10s/30s nominal curve (bp) and rolling front Brent oil futures contract price ($/bbl); past 1 year; bp
Hedged* Jan-21/Feb-41 TIPS breakeven curve averaged around nominal 30year bond auctions; 3/11-2/12; bp
-23.0 -23.5 -24.0 -24.5 -25.0
75 70 65 60 55 50 45 40 90
Y = 0.48(nom 10s/30s curve) - 0.30(oil)-1.86 R-sq = 71%
Current
-25.5 -26.0
100
110
120
130
140
150
-10
-5 0 5 Business days around 30-year nominal auction
10
Nominal 10s/30s curve; bp
This line item often gets revised in subsequent quarters as new data is released, and we will look for more information on this front in the coming months.
* Hedged for the nominal curve using the 1-year beta partial beta of 1-month forward 10s/30s breakeven curve regressed against 10s/30s nominal curve and oil as of the start of cycle (T-10 date).
Exhibit 14: and Fed purchase operations in TIPS
Hedged* Jan-21/Feb-41 TIPS breakeven curve averaged around Fed purchase operations; 10/11-2/12; bp
TIPS
Breakevens widened modestly this week as nominal yields rose and oil prices rallied. Despite the Fed selling $1.33bn front-end TIPS on Monday, the breakeven curve ended the week flatter: 5-, 10-, 20- and 30-year breakevens widened by 8bp, 5bp, 6bp, and 6bp, respectively. We remain bullish on TIPS breakevens given our bearish view on duration and our positive view on risky assets. In addition, carry in long breakeven positions is likely to remain attractive. We expect next weeks CPI report to show a 0.59% increase in headline CPI in February, which implies that 10-year TIPS breakevens will carry positively by 3.3bp in April. On the curve, we recommend positioning for a steeper 10s/30s breakeven curve. As Exhibit 11 shows, the 10s/30s breakeven curve is near historically flat levels (excluding the 2008-09 crisis), and is at its flattest levels since benchmark 30-year TIPS were reintroduced in February 2010. With the curve close to pancake flat, we think further flattening will likely be limited. In addition, the breakeven curve currently looks too flat relative to the nominal 10s/30s curve and oil prices (Exhibit 12). Furthermore, we think there are two factors that could support a steepening of the 10s/30s breakeven curve over
-31 -32 -33 -34 -35 -36 -5 -4 -3 -2 -1 0 1 2 3 4 5 Business days around Fed purchase operation
* Hedged for the nominal curve using the 1-year beta partial beta of 1-month forward 10s/30s breakeven curve regressed against 10s/30s nominal curve and oil as of the start of cycle (T-5 date).
the very near term. Next week Wednesday, we have both a 30-year nominal bond auction and a Fed purchase operation in TIPS. As Exhibits 13 and 14 show, the 10s/30s breakeven curve (hedged for the nominal curve) has tended to steepen around both these events. Over the past year, the breakeven curve has steepened ahead of a nominal bond auction in 8 out of 12 cycles. In addition, the breakeven curve has steepened around four of the five Fed purchase operations under Operation Twist. This steepening likely reflects the Feds strong preference for the long end: under Operation Twist, it has purchased $5.4bn on-the-run and old 30-year TIPS, and none of the
33
on-the-run/old 10-year TIPS. Thus, we recommend tactically positioning for a steepening of the 10s/30s breakeven curve.
Initiate 2s/6s steepeners hedged with 9th/11th Eurodollar flatteners We recommend increasing exposure to carry trades. This weighted trade carries well (3-month weighted carry and roll at 5.1bp; 2-year standard deviation of 3month changes of 5.9; risk adjusted carry of 86%) and is at an attractive entry level, with the weighted spread at its 1-year low. Buy 100% risk, or $475.6mn notional of T 0.25% Feb14s (yield: 0.318%; bpv: $196/mn). Sell 33% risk, or $50mn notional of T 2.875% Mar18s (yield: 1.17%; bpv: $615/mn). Sell 100% risk, or 3,725 EDM4 contracts (price: 99.075). Buy 85% risk, or 3,166 EDZ4 contracts (price: 98.805). Weighted spread is -2.2bp. Three-month weighted carry and roll is 5.1bp. Initiate 5s/10s and 5s/30s flatteners The 5s/10s and 5s/30s curves have flattened in the week following 10-year and bond supply in 4 of the last 6 auction cycles. Given that both curves are near the steep end of their recent trading range, and that forward OIS is rich, we expect the pattern to repeat itself this cycle, and favor intermediate and long end flatteners. Sell 100% risk, or $148.6mn notional of T 0.875% Jan-17s (yield: 0.889%; bpv: $477/mn). Buy 63% risk, or $50mn notional of T 2% Feb-22s (yield: 2.034%; bpv: $893/mn). Weighted spread is 39.2bp. One-month weighted carry is -0.3bp and roll is -1.1bp. Sell 100% risk, or $281.3mn notional of T 0.875% Jan-17s (yield: 0.889%; bpv: $477/mn). Buy 71% risk, or $50mn notional of T 3.125% Feb42s (yield: 3.185%; bpv: $1905/mn) Weighted spread is 137.2bp. One-month weighted carry is -0.5bp and roll is -2.1bp. Tactically position for a steeper 10s/30s breakeven curve The 10s/30s breakeven curve is near historically flat levels and looks too flat relative to the level of the nominal curve and oil. In addition, the curve is likely to tactically steepen around the upcoming 30-year
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nominal bond auction and Fed purchase operation in TIPS. Thus, we recommend positioning for a steepening of the 10s/30s breakeven curve hedged for the level of the nominal curve. Sell 100% risk, or $25mn notional of TII 0.125% Jan22s (yield: -0.250%; bpv: $1016/mn). Buy 100% risk, or $9.7mn notional of TII 0.75% Feb42s (yield: 0.808%; bpv: $2630/mn). Buy 50% risk, or $14.2mn notional of T 2% Feb-22s (yield: 2.034%; bpv: $893/mn) Sell 50% risk, or $6.7mn notional of T 3.125% Feb42s (yield: 3.188%; bpv: $1905/mn) Unweighted breakeven curve spread is 9.6bp. Weighted spread is -48.1bp. Two-week carry is -0.8bp and 2-week roll is -0.4bp. Stay overweight 4s and 8s versus 6s Stay overweight 69% risk, or $151.7mn notional of T 3.25% May-16s (yield: 0.742%). Stay underweight 100% risk, or $168.7mn notional of T 2.25% Nov-17s (yield: 1.093%). Stay overweight 40% risk, or $50mn notional of T 3.375% Nov-19s (yield: 1.565%). (US Fixed Income Markets Weekly, 3/2/12). P/L since inception: -1.0bp of yield. Stay in 2s/7s steepeners hedged with reds/ greens flatteners Stay overweight 100% risk, or $170.1mn notional of T 0.25% Feb-14s (yield: 0.320%). Stay underweight 98% risk, or $50mn notional of T 1.375% Feb-19s (yield: 1.426%). Stay underweight 98% risk, or 1,327 EDM3 contracts (price: 99.375). Stay overweight 100% risk, or 1,354 EDZ4 contracts (price: 98.80). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: -1.4bp of yield. Maintain exposure to belly cheapening trades Stay overweight 94% risk, or $307.1mn notional of T 0.25% Feb-15s (yield: 0.445%). Stay underweight 100% risk, or $157.4mn notional of T 2.75% Feb-18s (yield: 1.147%). Stay overweight 42% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.583%). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: -2.0bp of yield. Stay overweight 75% risk, or $191.7mn notional of T 0.25% Jan-15s (yield: 0.433%). Stay underweight 100% risk, or $112.8mn notional of T 1.25% Jan-19s (yield: 1.409%).
Stay overweight 54% risk, or $25mn notional of T 6.625% Feb-27s (yield: 2.583%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -6.7bp of yield. Stay underweight May-38s versus May-37s Stay overweight 100% risk, or $48.9mn notional of T 5% May-37s (yield: 3.031%). Stay underweight 100% risk, or $50mn notional of T 4.5% May-38s (yield: 3.063%). (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: +0.3bp of yield. Stay underweight on-the-run 10s versus triple olds Stay underweight 100% risk, or $50.6mn notional of 2% Feb-22s (yield: 2.036%). Stay overweight 100% risk, or $50mn notional of T 3.125% May-21s (yield: 1.877%). (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: -0.8bp of yield.
Closed trades in 2012

P/L reported in bp of yield unless otherwise indicated
TRADE Nominal Treasuries 10-year duration shorts Curve Underweight 4s versus 3s and 7s Buy 2.375% Jun-18s versus 1.875% Oct-17s 7s/30s flatteners Buy Nov-21 Cs versus Ps 4s/6s steepeners vs. reds/greens flatteners 7s/30s flatteners 3s/7s flatteners 01/20/12 02/10/12 -11.1 ENTRY EXIT P/L
12/09/11 10/14/11 01/06/12 09/23/11
01/06/12 01/06/12 01/27/12 01/06/12
0.9 -2.8 -14.2 -0.2 3.0 3.5 8.5
01/06/12 01/27/12 02/10/12 02/24/12 02/12/12 02/24/12
Misc. Sell 2s versus OIS 12/09/11 01/06/12 Buy 5s versus OIS 01/06/12 02/04/12 Sell 2-year Treasuries vs. JGBs swapped into USD 08/12/11 02/10/12 Buy the March CTD Bond basis 12/09/11 02/24/12 TIPS Sell 5-year TIPS on a breakeven basis
0.8 5.0 44.0 1/32nds
12/16/11 01/20/12
-12.3
Stay in weighted 2s/3s steepeners Stay overweight 100% risk, or $219.8mn notional of T 0.125% Dec-13s (yield: 0.315%). Stay underweight 70% risk, or $100mn notional of T 0.25% Jan-15s (yield: 0.433%). (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -1.8bp of yield.
Stay in weighted 4s/25s steepeners hedged with reds/10s flatteners Stay overweight 96% risk, or $156.8mn notional of T 2.125% Feb-16s (yield: 0.67%). Stay underweight 78% risk, or $25mn notional of T 4.75% Feb-37s (yield: 3.033%). Stay overweight 100% risk, or $76.4mn notional of T 2% Nov-21s (yield: 1.996%). Stay underweight 100% risk, or 2,732 EDM3 contracts (price: 99.375). (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: -5.0bp of yield. Stay overweight 6.5% Nov-26s versus a weighted barbell of Aug-23s/Feb-31s Stay underweight 62% risk, or $39mn notional of T 6.25% Aug-23s (yield: 2.173%). Stay overweight 100% risk, or $50mn notional of T 6.5% Nov-26s (yield: 2.566%). Stay underweight 38% risk, or $16.5mn notional of T 5.375% Feb-31s (yield: 2.805%). (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: -2.7bp of yield.
Stay underweight Apr-14 TIPS versus Jan-14 TIPS Stay long 100% risk, or $25mn notional of TII 2% Jan-14s (yield: -1.937%); Stay short 100% risk, or $25.4mn notional of TII 1.25% Apr-14s (yield: -2.022%); (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: +3.3bp of yield.
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US Fixed Income Strategy Global Fixed Income Markets Weekly March 9, 2012 Srini RamaswamyAC (1-212) 834-4573 Praveen Korapaty (1-212) 834-3092 Alberto Iglesias (1-212) 834-5116 J.P. Morgan Securities LLC.
US Interest Rate Derivatives

Stay biased towards narrower intermediate maturity swap spreads hedged for FRA-OIS, and maintain outright wideners in the 30-year sector With todays payrolls report validating the recent improving trend in labor markets, the upside risk to the Feds projected path of the funds rate remains in focus. Positioning for an eventual renormalization of the yield curve is thus an attractive theme; however, given the considerable uncertainty around timing, such trades will need to exhibit several important characteristics positive carry, relatively little exposure to outright yield levels locally, attractive entry levels relative to the recent trading range, as well as significant upside in the event of a renormalization. We identify several trades that exhibit these characteristics initiate Reds/10Y swap curve steepeners hedged with weighted 2Y/Blues flatteners We recommend short gamma positions in the 10year sector; returns from even actively deltahedged gamma positions are likely to exhibit directional exposure to yield levels, but hedged for rates, selling 3Mx10Y delta-hedged straddles is likely to prove profitable The opposite is true at the front endbuy 3Mx2Y swaption straddles hedged with a weighted long in 2-year swaps
Exhibit 1: Corporate issuance remains elevated

Monthly total fixed rate long term issuance; $bn
100 80 60 40 20 0
pressuring intermediate spreads narrower in coming months. Beyond issuance-related technicals, the broader macro backdrop continues to point to a stable outlook for swap spreads overall. Funding stresses stemming from the European crisis have now largely moderated, auguring stability in FRA-OIS spreads in the near term; budget deficit expectations remain relatively stable, trending narrower only very slowly and remaining near $1Tn; Treasury coupon issuance sizes have remained unchanged since late 2010; and there is little reason to expect a near-term rise in Fed tightening expectations. Thus, the bigger picture remains one of relatively rangebound spreads. Given such a context, our strategy in swap spreads remains centered around taking advantage of cheap/rich valuations, as well as opportunities that arise due to seasonal trends (while being careful to hedge out other risk factors). In that vein, we remain biased towards wider long-end swap spreads (with 30-year spreads continuing to appear narrow versus fair value), and we recommend staying biased towards narrower 10-year swap spreads (due to our expectations of rising issuance and related swapping activity, as outlined earlier), hedged with FRA-OIS wideners.
Swaps
Swap spreads are largely unchanged over the past week, with front-end spreads modestly wider and back-end spreads slightly narrower. For instance, maturity matched swap spreads are 0.5bp wider in the 2-year sector relative to week-ago levels, but 1-1.5bp narrower in the 10- to 30-year sector. Issuance activity remains strong; month-to-date issuance in March has been near $45bn, in excess of last years run-rate, after an above-average issuance month in February. In all, the pace of overall fixed-rate issuance remains quite strong (Exhibit 1); however, with nonfinancial firms dominating recent issuance (who tend to swap smaller fractions of overall issuance), swapping activity is likely more modest but still an important factor
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Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08 Dec 08 Mar 09 Jun 09 Sep 09 Dec 09 Mar 10 Jun 10 Sep 10 Dec 10 Mar 11 Jun 11 Sep 11 Dec 11
At the front end of the curve, risks to spreads remain balanced and we stay neutral. On the one hand, the threat of bank downgrades remains a potential source of upside pressure. This, however, is balanced by the fact that central banks (and the ECB in particular) stand ready to provide liquidity to the banking system. Also, on the margin, this weeks indications that the Fed could possibly sterilize its reserve creation in any future asset purchase programs (likely via reverse repos) are also supportive of narrower swap spreads. Should such sterilization occur (and in the form of reverse repos), this would essentially have the effect of a large (albeit temporary) increase in T-bill supply, at the expense of reduced issuance in longer tenors. Our Treasury strategists estimate that 2-year Treasury-OIS spreads could cheapen by 2-3bp, suggesting that front-end swap spreads could be biased narrower by a similar amount. To be sure, we do not see this as imminent going into next weeks FOMC meeting; it is however, a new possibility that has come into focus this week, with (on the margin) a narrowing influence on front-end spreads. Given offsetting influences in this sector, we therefore remain neutral on front-end swap spreads.
Exhibit 2: Even though forward OIS rates have rebounded from recent lows, they remain well below pre-August levels
1-month OIS rate at a 12/31/2014 forward horizon; %
1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 Nov 11 Jan 12
Forward OIS rate; %
Mar 12
Exhibit 3: Several trades offer attractive ways to position for a renormalization of the yield curve to pre-August levels
Weighted spreads with no current exposure* to 3Mx2Y swap rates, current carry and entry level**, average in the past 6 months and in the 6 months prior to 7/29/2011 and prior exposure to 3Mx2Y rates
Trade -3Mx10Y/+REDS/+BLUES/-3Mx2Y -3Mx5Y/+BLUES/-2Yx5Y/-3Mx2Y +BLUES/-1Yx5Y/-2Yx5Y/-3Mx2Y -3Mx5Y/+BLUES/-1Yx5Y/+3Mx2Y +BLUES/-2Yx5Y/-3Mx2Y +BLUES/-1Yx5Y/+3Mx2Y -3Mx7Y/+BLUES/-2Yx5Y/-3Mx2Y +GREENS/+BLUES/-2Yx10Y/-3Mx2Y -3Mx7Y/+BLUES/-1Yx5Y/-3Mx2Y -3Mx7Y/+BLUES/-3Mx2Y -3Mx10Y/+2Yx2Y/-3Mx2Y Carry Weighted spread avg (%) Prior exposure Entry level (bp) Recent Prior Difference to 2Y rates z-score Weights -1/1/0.485/-1.113 0.6 1.49 1.88 0.40 0.06 -0.44 -0.105/1/-1/-0.275 1.0 0.81 1.01 0.20 0.16 -0.33 1/-0.09/-1/-0.299 1.0 0.84 1.05 0.21 0.18 -0.33 -0.309/1/-1/0.115 1.2 0.34 0.39 0.04 0.07 -0.32 0.929/-1/-0.302 0.8 0.81 1.01 0.21 0.17 -0.32 0.791/-1/0.036 0.7 0.33 0.40 0.07 0.10 -0.32 -0.096/1/-1/-0.306 1.0 0.86 1.08 0.21 0.17 -0.31 1/0.178/-1/-1.083 1.0 2.15 2.56 0.40 0.02 -0.24 -1/1/-0.33/-0.03 1.7 0.70 0.78 0.08 0.05 -0.16 -1/0.739/-0.042 1.4 0.59 0.65 0.06 0.02 -0.12 -1/0.897/-0.514 1.6 1.37 1.58 0.21 0.00 -0.11
Swap yield curve renormalization

In the past few months, since the Fed began publishing its forecast for the funds rate (specifically suggesting a stable funds rate well into late 2014), swap yield levels and the curve have settled into a new regime, with yield levels lower, the curve flatter, and relative volatilities between different sectors shifting as rates have fallen closer to the zero barrier. More recently, risks have emerged to the Feds projections of a stable funds rate, at least for forward horizons such as late 2014. The sharp decline in the unemployment rate (which has fallen 0.7%-age points in the last nine months or so) highlights this risk. As our Treasury strategists have pointed out, even assuming a stable participation rate going forward, there is still material risk of a lower unemployment rate (relative to the Feds baseline forecast) at a 2-year forward horizon, implying upside risk to the Feds own projections of the appropriate funds rate at such a horizon. To be clear, we are not forecasting a material decline in the unemployment rate or any Fed tightening in the near term. However, as we have noted often in recent weeks, risks of such an outcome remain underpriced into forwards. Even though Dec-2014 forward OIS rates have risen off their recent lows, they remain well below their 6-month-ago levels (Exhibit 2), despite the significant decline in labor market slack since then.
* Exposure is defined as the 6-month beta of weekly changes between weighted spread and 3Mx2Y swap yield. ** 6-month z-score of weighted spread.
Exhibit 4: such as Reds/10Y steepeners, hedged with weighted 2Y/Blues flatteners
3Mx10Y minus 1Yx1Y + 1.11*3Mx2Y minus 0.485*3Yx1Y swap yields, average in the past 6 months and in the 6 months prior to 7/29/2011; %
2.0 1.9 1.8 1.7 1.6 1.5 1.4 1.3 Jun 11 Sep 11 Dec 11 Mar 12 Recent average Prior average
Looking ahead in the medium term, a renormalization of the yield curve is likely if future employment reports
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validate the recent trend, and/or if the Fed modifies its language to refer to downside risks to the unemployment rate or the data-dependent nature of its funds rate projections. Given todays strong employment report and the upcoming FOMC meeting, a focus on such a renormalization in the yield curve is likely the right theme at the present time. Positioning for such a renormalization can however be tricky. Outright shorts at the front end are not particularly attractive, given that the Feds near-term policy is likely to be very stable, and the timing of any Fed action/communication change is very uncertain. Thus, any trade designed to position for a yield curve renormalization should ideally possess the following characteristics. First, it should exhibit relative little directional exposure to front-end yield levels in the current rangebound yield environment, in light of the above discussion. Second, the trade should have close to zero, or even positive carry; this is essential to being able to hold the trade for a prolonged period of time until eventual renormalization. Third, the weighted yield spread corresponding to the trade should have exhibited little directional exposure to front-end yields in the months prior to August 2011this would indicate stability of the risk weightings used in the trade. Fourth, the entry level on the trade should be favorable, in normalized terms relative to the average levels in recent months. Last but not least, the weighted yield spread corresponding to the tradewhich would have been roughly mean-reverting prior to August 2011 as well as in the months sinceshould have experienced a discrete shift of significant magnitude in its average, a consequence of the regime shift triggered by the Feds communications policy since August 2011. In the event of yield curve renormalization, we may reasonably assume that the mean would shift back to its pre-August levels, thereby providing the rationale for trade. Exhibit 3 provides a list of several trades that meet the above mentioned criteria, and Exhibit 4 illustrates the characteristics of one of the those trades. As can be seen, in the case of a Reds/10Y steepener hedged with a weighted 2Y/Blues flattener, the weighted yield spread has been relatively mean-reverting both prior to August 2011 as well as recently, albeit around different means in the two regimes. In addition to its flat-to-modestlypositive carry, a yield curve renormalization would likely cause the mean to shift back up by about 40bp, making this trade an attractive way to position for a potential change in yield curve regime. Therefore, we now recommend initiating Reds/10s steepeners, hedged with a
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Exhibit 5: Short volatility positions were profitable this past week
P/L* from short straddles in various options instruments since 3/2/12 and current levels of volatility; bp of notional**
Return Return Theta Adj** Gamma PL Vega PL Current Implied Vol Current Realized Vol
6M2Y 1 6 0.2 0.3 2.4 2.2 6M5Y 3 7 1.3 1.4 4.3 4.0 6M10Y 7 7 4.0 2.7 5.8 4.4 6M30Y 22 9 3.3 18.4 6.0 4.8 Front FV 2 7 -9.9 12.3 3.9 3.7 Front TY 14 16 18.7 -4.9 5.6 4.5 Front US 40 21 18.4 22.0 6.3 4.8 * Returns calculated using the J.P. Morgan Volatility Index, which assumes daily delta rebalancing and zero transaction costs. Options are re-struck at the start of each month. ** Adjusted to a theta-neutral amount of 6Mx10Y swaptions.
Exhibit 6: Normal volatilities have become highly directional with rates

3Mx10Y implied volatility (bp/day) versus level of 3Mx10Y rate (%)
6.2 6.1 6.0 5.9 5.8 5.7 5.6 5.5 5.4 5.3 5.2 12 Jan 26 Jan
3Mx10Y implied volatility 3Mx10Y rate
2.30 2.25 2.20 2.15 2.10 2.05 2.00 1.95
09 Feb
23 Feb
08 Mar
1.11:0.48 weighted 3Mx2Y/Blues flattener (see Trade recommendations).
Options
Implied volatilities were generally unchanged for the week, rising before the payrolls report on Friday, and falling in the aftermath. For instance, 3Mx10Y implied volatility ended the week lower by 0.1bp/day over the prior week, having been up before payrolls, and then dropping 0.2bp/day on Friday. Implied volatilities on longer expiries, as well as shorter tails, were relatively more stable over the week. Realized volatility fell across the volatility grid, causing short volatility positions to outperform (Exhibit 5). Looking ahead, with the payrolls report now behind us, we now turn bearish on short expiry volatility in the 10year sector, but recommend adding a pay-fixed swap to hedge the directional nature of short gamma positions.
Our model for look-ahead delta-hedged returns from short 3Mx10Y straddle positions is currently projecting attractive returns from selling gamma in this sector (around 40bp of notional, which is nearly twice the standard error of the model); however, the model also uses contemporaneous yield levels as a factor, meaning that if yields were to rise over the next month, short gamma positions could suffer a loss as a result. Why do daily-delta-hedged returns from short gamma positions still exhibit directional exposure? In part this is because the compressive effect of the zero boundary causes yields to become more lognormal at low yield levels, which is evidenced by the directional nature of ATMF 3Mx10Y implied volatility (Exhibit 6). Using lognormal deltas for delta-hedging (rather than normal deltas, which we use for analysis) could mitigate this effect, but not fully. Even fixed-strike implied volatilities show directional exposure, which is partly a reflection of the fact that the markets option coverage needs are themselves asymmetric, with greater option demand at higher yield levels. In sum, in the current regime, returns from short-expiry positions are likely to remain highly directional, which poses a risk to short gamma positions; such positions, however, are likely to be profitable if rates remain rangebound, which remains highly likely in the near term. Therefore, to take advantage of the likely attractiveness of selling gamma, while also guarding against the prospect of higher yields, we recommend selling 3Mx10Y swaption straddles, hedged with a payfixed swap (see Trade recommendations). In the 2-year and 5-year sector as well, the directional exposure of delta-hedged volatility positions to yields is similarly high. This is seen, for instance, in the high (and statistically very significant) coefficients on the yield factor that we estimate in our model for look-ahead deltahedged returns from short gamma positions in these sectors (Exhibit 7). Indeed, because of the lower level of front-end yields, volatility returns on these tails tend to have a stronger and more statistically significant dependence on rates. Interestingly, assuming relatively rangebound yields, our model suggests that long positions in 3Mx2Y volatility are now likely to be profitable. While the magnitude of the projected return on long gamma positions in the 3Mx2Y sector is relatively modest (slightly less than the standard error of the model), such long gamma positions at the front end are
Exhibit 7: Returns on long gamma positions on shorter tails show greater sensitivity to level of rates, as well as economic surprises
1-month return forecast for delta-hedged long-straddles*; bp of notional 3Mx5Y Model 18-month model Current Coefficient T-statistic value 3Mx5Y implied vol (bp/day) -26.7 -13.5 4.02 EASI index 0.54 5.7 -16.7 JP Morgan postions index 71.46 12.1 0.14 3mx5y rate level (%) 50.20 11.9 1.26 Intercept 41 5.7 Long straddle returns (bp of notional) -3
R2 Std Error 3Mx2Y Model 3Mx2Y implied vol (bp/day) EASI index 3mx2y rate level (%) Intercept Long straddle returns (bp of notional) R2 Std Error
62% 22.5 18-month model Current Coefficient T-statistic value -13.3 -21.3 2.22 0.11 4.1 -16.7 56.9 20.3 0.62 1.15 0.7 5 61% 7.0
* Returns calculated using the J.P. Morgan Volatility Index, which assumes daily delta rebalancing and zero transaction costs. Options are re-struck at the start of each month.
nonetheless attractive for the following reasons. First, if our model forecast is correct, long delta-hedged straddles at the front end would result in a positive carry position net of estimated delta hedging costs and the carry on the swap hedge, which is attractive given the backdrop of rangebound front-end yields. Second, as also seen in Exhibit 7, these positions are likely to offer exposure to positive economic surprises. Third, as we discuss in earlier sections, an eventual renormalization in the yield curve would likely cause front-end implied volatility to shift upwards as well. Therefore, at the front end of the curve, we now recommend buying 3Mx2Y swaption straddles on a delta-hedged basis, with a receive-fixed swap against it to hedge the likely directional exposure of returns from this trade (see Trade recommendations).
Initiate Reds / 10Y steepeners hedged with weighted 2Y / Blues flatteners This trade provides an attractive way to position for a possible renormalization of the yield curve to a preAugust 2011 regimea likely outcome if future employment reports continue the strong trend. It exhibits little directionality currently and carries modestly positive, and the weighted spread corresponding to this trade is likely to revert sharply higher if and when the yield curve eventually normalizes.
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Initiate a 1Yx1Y/3Mx10Y swap curve steepener hedged with a weighted 3Mx2Y/3Yx1Y curve flattener (1.11/0.485 weights) at a weighted yield spread (defined as 3Mx10Y minus 1Yx1Y + 1.11*3Mx2Y minus 0.485*3Yx1Y) of -145.5bp. 3M carry and slide on this trade is approximately 0.4bp. Sell delta-hedged 3Mx10Y swaption straddles layered with a duration short Ten-year tails have been relatively sticky over the past few months, and given levels of drivers of realized vol in this sector, selling gamma is likely to result in positive returns. However, given the directionality of vol returns with rates, we recommend overlaying a short duration position to offset the risk of a move higher in rates. Sell $100mn notional of 3Mx10Y swaption straddles (notification date 6/11/2012, maturity date 6/13/2022, ATMF and strike 2.189%, premium 329bp) versus paying fixed in $10.7mn notional of a 3Mx10Y forward starting swap (swap start date 6/13/2012, swap end date 6/13/2022). This trade requires frequent delta rebalancing. Buy delta-hedged 3Mx2Y swaption straddles layered with a duration long Long gamma positions in the 2-year sector offer a relatively inexpensive asymmetric way to position for positive economic surprises. The directionality of this position with rates requires a long duration overlay, which generates positive carry. Buy $100mn notional of 3Mx2Y swaption straddles (notification date 6/11/2012, maturity date 6/13/2014, ATMF and strike 0.620%, premium 29.3bp) versus receiving fixed in $28.6mn notional of a 3Mx2Y forward starting swap (swap start date 6/13/2012, swap end date 6/13/2014). This trade requires frequent delta rebalancing. Continue to pay in 3.25% June 16 spreads versus receiving in 3.25% July 16 maturity matched swap spreads Stay long $100mn notional of 3-1/4% June 16 and continue to pay fixed in $105.3 notional of a 06/30/2016 swap; stay short $98mn notional of 31/4% of July 16 and continue to receive fixed in $103.5mn notional of a 7/31/2016 swap (US Fixed Income Markets Weekly, 03/02/12). P/L since inception: profit of 0.7bp of yield.
Maintain belly cheapening position in a sell-off on the EDU3/7Y/25Y butterfly using ED midcurve puts and payer swaptions Stay long $100mn notional of 6Mx7Y payer swaptions (notification 09/14/12, maturity 09/18/19, strike 1.797%), stay short 1598 0EU2 99.375 puts (midcurve option expiry 09/14/12, EDU3 strike 99.375), and stay short $22.3mn notional of 6Mx25Y receiver swaptions (notification 09/14/12, maturity 09/18/37, strike 2.845%). (US Fixed Income Markets Weekly, 03/02/12). P/L since inception: loss of 1.4bp of yield. Continue to receive in 10-year swap spreads hedged with 20% risk in September FRA-OIS wideners Continue to receive in $100mn notional of 2% Feb 22 maturity matched swap spreads (stay short $100mn notional of 2% Feb 22s, and continue to receive fixed in $96.2mn notional of a 2/15/2022 swap), and continue paying 20% of the risk (or $18035/bp) in September 2012 3M FRA-OIS spreads (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 0.1bp of yield. Maintain 30-year swap spreads wideners Continue to pay in 4.75% of Feb 2041 spreads (stay long $100mn notional of the 4.75% of Feb 2041, and continue to pay fixed in $110.3mn notional of a 02/15/2041 swap). (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 1.3bp of yield. Maintain 5-year swap spread wideners in a rally Stay long 1,000 FVM2 123.25 calls (FVM2 @ 12304, strike 123.25, expiry 5/25/2012) and stay short $129mn notional of a 05/25/12x8/31/16 receiver swaption (notification 05/25/12, swap start date 07/05/12, maturity 8/31/16, strike 1.073%, ATMF 1.098%) (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 2bp of yield. Stay long 3Mx1Y payer spreads Stay long $100mn notional of a 0.506%/0.756% 3Mx1Y payer swaption spread (1:1 weighted, notification 5/10/2012, maturity 5/14/2013, ATMF 0.506%; buy the ATMF strike and sell the A+.25 strike) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 1.4bp of yield. Maintain belly cheapening position on the 1-year forward 2s/5s/10s swap butterfly Continue to pay fixed in $100mn notional of a 1Yx5Y forward starting swap (swap start date 02/14/2013,
40
swap end date 02/14/2018, yield 1.513%), continue to receive fixed in $138.3mn notional of a 1Yx2Y forward starting swap (swap start date 02/14/2013, swap end date 02/17/2015, yield 0.734%) and continue to receive fixed in $29.6mn notional of a 1Yx10Y forward starting swap (swap start date 02/14/2013, swap end date 02/14/2023, yield 2.354%) (US Fixed Income Markets Weekly, 2/10/12). P/L since inception: loss of 2.9bp of yield. Maintain conditional 2s/30s steepeners via 3-month expiry options, versus selling 3-month expiry caps on the 2s/30s CMS curve Stay long $50mn notional 3Mx30Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2042, ATMF and strike 2.883%) versus staying short $500mn notional 3Mx2Y payer swaptions (notification 5/3/2012, swap start date 5/8/2012, swap maturity date 5/8/2014, ATMF and strike 0.5275%); also stay short $998.5mn notional of 3-month expiry 1-look caps on the 2s/30s CMS curve (end date 5/8/2012, ATMF CMS 10s/30s yield spread and strike at 239.7bp) (US Fixed Income Markets Weekly, 2/3/12). P/L since inception: profit of 0.8bp of yield. Maintain 30-year matched maturity swap spread wideners, hedged with 5-year swap spread wideners and the 5s/30s Treasury yield curve Stay long $50mn notional of 3.125% of Nov 2041s and pay fixed in $51.6mn notional of a 11/15/2041 swap; also, stay long $95mn notional of 0.875% of Jan 2017s and continue to pay fixed in $67.4mn notional of a 01/31/2017 swap (US Fixed Income Markets Weekly, 1/27/12). P/L since inception: loss of 2.9bp of yield. Continue to receive fixed in the belly of a 3-month forward weighted 5s/10s/30s swap butterfly Continue to receive fixed in $100mn notional of a 3Mx10Y forward starting swap (swap start date 04/24/2012, swap end date 04/25/2022) and continue paying fixed in $133mn notional of a 3Mx5Y forward starting swap (swap start date 04/24/2012, swap end date 04/24/2017) and paying fixed in $21.9mn notional of a 3Mx30Y forward starting swap (swap start date 04/24/2012, swap end date 04/24/2042) (US Fixed Income Markets Weekly, 1/20/12). P/L since inception: profit of 1.6bp of yield.
Closed trades in 2012
P/L reported in bp of yield for swap spread, yield curve and miscellaneous trades, and in annualized bp of volatility for option trades, unless otherwise specified
Trade Swap spreads 10-year swp sprd widener Front end swap spread wideners via options Pay Aug 20 vs Feb 20 sprds (hedged) Yield curve 5s/10s swp sprd crv steepeners 3m fwd 1s/15s crv flatteners via rec swptns Buy belly of EDZ2/EDZ3/EDZ4 bfly Buy wtd WN calendar sprd PL in 32nds Options relative value Sell 10s/30s YCSO vs 6Mx2Y swptn strddls Buy 6Mx5Y vs 9Mx5Y swptn strddls Entry 01/06/12 01/06/12 01/20/12 Entry 11/04/11 01/06/12 01/20/12 02/10/12 Entry 10/28/11 01/20/12 Exit 1/20 2/3 2/3 Exit 2/3 2/3 3/2 3/2 Exit 1/27 2/10 P/L (1.8) (4.4) 1.7 P/L (3.5) (16.1) (9.9) 1.9 P/L 18.2 (0.6)
Maintain synthetic conditional trade by selling 10s/30s YCSO caps versus 10Y receiver swaptions Sell $500mn notional (i.e., $50K/bp forward DV01) of single-look 6-month caps on the 10s/30s swap curve (end date 6/11/12, strike and ATMF 10s/30s CMS yield spread at 60.1bp) versus buying $21.3mn notional of 6Mx10Y receiver swaptions (notification date 06/11/12, maturity date 06/13/22, ATMF and strike 2.335) (US Fixed Income Markets Weekly, 12/09/11). P/L since inception: loss of 0.5bp of yield. Stay long 6Mx30Y versus 6Mx10Y swaption straddles Stay long $43.7mn notional of 6Mx30Y swaption straddles (notification date 8/24/2012, maturity date 08/29/2042, ATMF and strike 2.849%) and stay short $100mn notional of 6Mx10Y swaption straddles (notification date 8/24/2012, maturity date 8/30/2022, ATMF and strike 2.220%) (US Fixed Income Markets Weekly, 2/24/12). P/L since inception: loss of 3.7abp. Stay short 6M single-look CMS curve straddles on the 2s/10s swap curve Stay short $250mn notional of 6-month curve straddles on the 2s/10s CMS curve (end date 09/06/2012, ATMF CMS 2s/10s yield spread and strike at 1.64%) (US Fixed Income Markets Weekly, 03/02/12). P/L since inception: profit of 0.8abp.
41
Japan Rates Research Global Fixed Income Markets Weekly March 9, 2012 Takafumi Yamawaki (81-3) 6736-1748 Yuya Yamashita, CFA (81-3) 6736-1493 JPMorgan Securities Japan Co., Ltd.
Japan
The benchmark 10Y JGB yields remained almost unchanged this week. The curve continued to steepen The low and stable JGB yields appear at odds with the rally in equities since the beginning of this year, but such divergence is also seen in the US and European markets. One explanation for this is the monetary easing worldwide Support from the BoJs monetary easing helped the 5Y sector remain rich on the curve despite supply pressure from this weeks auctions The super-long sectors were heavy, and the JGB curve continued to steepen, partly backed by the steepening of the swap curve We maintain our neutral view on JGBs. The BoJs purchase is expected to support JGBs, while any downside in yields should be limited unless the BoJ introduces more easing measures The BoJ will hold the Monetary Policy Meeting (MPM) on 12 and 13 March. Our economic research team expects no change in policy at this meeting Potential downside in 5Y yields may be 5bps or so even if additional monetary easing measures are introduced
Exhibit 1: The futures sector led the rally in up-to-10Y JGBs while the super-long sectors were modestly sold off. The 10Y sector in the middle of the curve was almost unchanged this week.
JGB yield change over this week; bp
2 1 0 -1 -2 1 2 3 4 5 6 7 8 910 12
Source: Bloomberg, J.P. Morgan
15
20 Maturity
25
30
40
Exhibit 2: The low and stable JGB yields appear at odds with the rally in equities since the beginning of this year, but such divergence is also seen in the US and European markets. One explanation is monetary easing implemented globally
10Y JGB yield and Nikkei 225 Index since 2011; %
1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 1.00 0.95 0.90 Jan '11 Apr '11 Jul '11 Oct '11 Jan '12 9500 9000 8500 8000 10Y JGB Yield (LHS) Nikkei (RHS)
Yen
11500 11000 10500 10000
Overview
The benchmark 10Y JGB yields remained almost unchanged this week, but the curve continued to steepen. Early in the week, German Bunds and US Treasury yields declined on uncertainty around the Greek PSI, but rebounded later as the media reported high participation in the Greek debt exchange. The heightened expectations of strong US payroll numbers may have been responsible for the mid-week rebound in US Treasury yields. The range of the yields, however, was relatively tight in a wait-and-see mode ahead of the Greek debt exchange participation deadline and outcome, and US non-farm payroll numbers. Lacking external drivers, the JGB market was range-bound. The results of the two auctions in the 30Y and 5Y JGBs were firm, but these auctions too followed the recent pattern of heavy upside after strong auction results. The futures sector led the rally in up-to-10Y JGBs, while the super-long sectors were
42
modestly sold off, resulting in a twist-steepening of the curve (Exhibit 1). The 10Y sector in the middle of the curve remained almost unchanged. The low and stable JGB yields appear at odds with the rally in equities since the beginning of this year (Exhibit 2), but such divergence is also seen in the US and European markets. One explanation is the global monetary easing, i.e., the abundant liquidity supporting both debt and equity markets. The BoJs monetary easing continued to support the intermediate sectors. The 5s/10s curve is steep relative the yield level, indicating that the 5Y sector remained rich (Exhibit 3). The richness could be explained by the following reasons. First, the supply and demand balance
in short-term sectors is tight on the back of the BoJs expanded JGB purchase. The low and stable short-term yields stabilise the intermediate sectors. Second, the intermediate sectors appear to be pricing in additional easing measures such as a further upsizing of the BoJs JGB purchase under the Asset Purchase Program (APP) or extension of the maturity of JGBs eligible under the programme. Third, investors may be switching positions out of longer sectors into shorter ones, given the bearish factors that have recently emerged. The issuance amount of 10Y and 20Y sectors will be increased by JPY100bn each on a monthly basis, starting April. Some market participants think the BoJs current and potential future monetary easing may heighten inflation expectations. A reversal of the risk-off mode may continue after the Greek debt exchange sees sufficiently high participation. The super-long sectors were heavy, and the JGB curve continued to steepen, partly backed by the steepening of the swap curve. The pace of the steepening in the swap curve looks too quick, but it has been largely in line with the rise in the AUD/JPY FX rate (Exhibit 4). The recent rally in the Nikkei and the depreciation of the JPY could have driven dealers exotic/hybrid risk-hedging. Another factor for the steepening in the JGB curve may be concerns about the increase in issuance in the 10Y and 20Y sectors from April 2011. However, it may not be valid as an explanation for the steepening in the JGB 10s/20s curve as the two sectors have the same amount of issuance increase (JPY 100bln per month). Exhibit 5 shows the JGB 10s/20s curve vs. 10Y JGB yields since 2011. There was a shift in the yield directionality of the JGB 10s/20s curve around September 2011, and the 20Y has remained rich since then. The steepening of the curve may partly be a reversal of this richness. We maintain our neutral view on JGBs. The yields will likely remain range-bound in the near term. The BoJs purchase is expected to support the short-to-intermediate sectors, and the stability of the shorter sectors could spill over to longer sectors. Meanwhile, any further downside in intermediate yields should be limited unless the BoJ introduces more easing measures. Our economic research team expects additional easing measures to be introduced, but not until April 2012 (see below). The 10Y sector appears to have more room for upside from a relative value and carry perspective. Nevertheless, the steepening bias of the curve, if it continues, could limit the downshift in 10Y yields.
Exhibit 3: The 5s/10s curve is steep relative to the yield level, indicating that the 5Y sector remained rich
JGB 5s/10s curve since April 2011; bp
80 78 76 74 72 70 68 66 64 62 60 0.90 1.00 1.10 1.20 10Y JGB Yield (%) 1.30 1.40
Exhibit 4: The steepening of the swap curve has been largely in line with the rise in the AUD/JPY FX rate
Swap 10s/30s spreads and AUD/JPY FX since 2011; bp Yen
95 90 85 80 75 70 Jan '11
Swap 10-30 (LHS) AUDJPY (RHS)
95 90 85 80 75 70
Apr '11
Jul '11
Oct '11
Jan '12
Exhibit 5: There was a shift in the yield directionality of the JGB 10s/20s curve around September 2011 and the 20Y remained rich since then. The steepening of the curve may be partly a reversal of this richness.
JGB 10s/20s curve vs. 10Y JGB yields; bp
90 85
January 2011 - August 2011 Current
80 75 70
Since September 2011

65 0.90 1.00 1.10 1.20 10Y JGB Yield (%) 1.30 1.40
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The MoFs Balance of Payment data shows that the nonseasonal adjusted current account balance for January 2012 marked JPY -437bn, the largest deficit since 1985. The weakness in the trade balance, which was the major reason for the current account deficit, may be exaggerated by such factors as seasonality, the floods in Thailand and the Chinese New Year. After a seasonal adjustment, the January current account balance showed a surplus of JPY115.6bn. The current account balance also turned into a deficit in January 2009 after the Lehman shock, but soon recovered and continued to show a surplus over 2009 and 2010. Therefore, the impact on the market should not be large until it is confirmed that the current account balance constantly runs a deficit. There has been no notable progress on the discussion on the consumption tax rate hike. Our main scenario is that the consumption tax rate will be hiked sooner or later. It is widely thought that both the ruling party (the Democratic Party of Japan, DPJ) and the biggest opposition party (the Liberal Democratic Party, LDP) basically agree on the consumption tax rate hike. The focus now appears to be on the conflicts within the DPJ. Ex-DPJ leader Ichiro Ozawa opposes the tax hike. Some views that the conflict between Prime Minister Yoshihiko Noda and Ozawa will delay the submission of the bill or, in a worst-case scenario, may lead to the disintegration of the party, evoking the possibility of another Ozawa Shock. However, we think another Ozawa-shock scenario is unlikely because factions and members opposing the tax hike are a minority within the DPJ.
Exhibit 6: The MoFs Balance of Payment data shows that the nonseasonally-adjusted current account balance for January 2012 marked a deficit of JPY 437 billion.
Non-seasonally-adjusted current account balance since 2006; JPY bln
3500 3000 2500 2000 1500 1000 500 0 -500 -1000 Jan '06 Jan '07 Jan '08 Jan '09 Jan '10 Jan '11 Jan '12
Source: MoF, J.P.Morgan
Exhibit 7: The flattening in the 2s/5s curve since the previous MTM was largely in line with the yield directionality realized since 2011
JGB 2s/5s curve vs. 2Y yields since 2011; bp
40 35
2s/5s curve
y = 116.02x + 5.2151 R = 0.7986
30 25 20 15 0.10 0.15 2Y JGB yield (%) 0.20 0.25
Source: Bloomberg, J.P.Morgan
BoJ Monetary Policy Meeting

The BoJ will hold the Monetary Policy Meeting on 12 and 13 March. Our economic research team envisages the following steps as a main scenario (see BoJ preview: BoJ to hint further easing, 8 March 2012): 13 March: BoJ Governor Masaaki Shirakawa changes the wording at the press conference to indicate the BoJs commitment towards further monetary easing 27 April: The Bank extends the maturity of JGBs eligible for the BoJs APP to 5 years from 2 years, and, possibly, increases the JGB purchase to JPY29tn in the APP by extending the deadline for achieving the target amount to June 2013 from the current December 2012 (this may be postponed to May or June 2012).
Exhibit 8: The 2s/5s curve flattened by more than implied by the directionality last summer, probably pricing in a possibility of a cut in the IOER
JGB 2s/5s curve since 2011; bp
40 2s/5s spread current
35
30
25
20
15 Jan '11
Apr '11
Jul '11
Oct '11
Jan '12
Source: Bloomberg, J.P.Morgan
44
2H 2012: The Bank increases the JGB purchase to JPY39tn in APP.
Recommended trades
Maintain neutral stance on duration Maintain JGB steepeners (such as 8s/30s) Maintain paying 10Y swap via 5s/10s/20s butterfly Maintain JGB 5s/8s flattener Maintain FX LIBOR basis 1s/5s steepener Maintain weighted 20s/30s swap spread curve flattener Maintain paying 3x2 forward swap with long JGB futures Maintain long 7Y JGB via weighted 5s/7s/10s butterfly
2Y and 5Y yields have declined 1.4bp and 3.8bp, respectively, since the last MPM held in February 2012. The flattening in the 2s/5s curve was largely in line with the yield directionality realised since 2011 (Exhibit 7). This fact indicates that further downside in 5Y yields, and accordingly in longer yields, would be limited as long as the APP buys up-to-2Y JGBs without introducing more drastic easing measures. Last summer, there was a period when the curve flattened more than what was implied by the directionality, probably because the market priced in the possibility of a cut in the IOER (Exhibit 8). A cut in the IOER, however, is very unlikely, considering the fact that banks currently must pay annual deposit insurance fee of 8.4bp, which is only 1.6bp lower than the level of the IOER. The Fed also discussed the option but has not introduced it, given the uncertainty about its potential impact on the economy. It would be no surprise if the BoJ has similar concerns. In addition, given that a cut in the IOER is seen as one of the most drastic measures the Bank can take, last summers flattening may indicate a potential downside in 5Y yields. Looking at the moves last summer, potential downside in 5Y yields may be 5bp or so, even if additional measures are introduced
45
European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Aditya ChordiaAC (44-20) 7777-9841 aditya.x.chordia@jpmorgan.com J.P. Morgan Securities Ltd.
Interest rate forecasts

Euro area Refi rate Euribor 09-Mar-12 Jun-12 1.00 0.75 3M 0.89 0.65 2Y 0.15 0.20 5Y 0.77 1.00 10Y 1.79 2.15 30Y 2.44 2.85 2s/10s 164 195 10s/30s 65 70 2s/30s 229 265 2Y 91 70 5Y 74 50 10Y 44 30 30Y 8 5 Sep-12 0.75 0.65 0.20 0.90 2.00 2.70 180 70 250 75 55 35 5 Sep-12 0.50 1.00 0.50 1.10 2.10 3.15 160 105 265 80 60 20 -15 Dec-12 0.75 0.70 0.20 0.90 1.95 2.65 175 70 245 80 60 40 10 Dec-12 0.50 1.00 0.50 1.10 2.10 3.15 160 105 265 80 60 20 -15 Mar-13 0.75 0.75 0.20 0.85 1.90 2.60 170 70 240 85 65 45 10 Mar-13 0.50 1.00 0.50 1.10 2.10 3.15 160 105 265 80 60 20 -15 United States 09-Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Fed funds 0 - 0.25 0 - 0.25 0 - 0.25 0 - 0.25 0 - 0.25 Libor 3M 0.48 0.45 0.50 0.50 0.50 2Y 0.31 0.30 0.30 0.30 0.30 5Y 0.90 1.25 1.25 1.25 1.25 10Y 2.04 2.50 2.50 2.50 2.50 Govt curve 30Y 3.21 3.60 3.60 3.60 3.60 2s/10s 173 220 220 220 220 10s/30s 116 110 110 110 110 2s/30s 289 330 330 330 330 2Y 25 31 32 24 24 5Y 24 31 33 28 28 Swap spreads 10Y 7 11 12 7 7 30Y -30 -25 -22 -22 -22 Australia Cash rate Govt curve
Govt curve
Swap spreads
United Kingdom 09-Mar-12 Jun-12 Base rate 0.50 0.50 Libor 3M 1.04 1.05 2Y 0.43 0.50 5Y 1.02 1.10 10Y 2.07 2.20 30Y 3.22 3.15 Govt curve 2s/10s 164 170 10s/30s 114 95 2s/30s 279 265 2Y 80 80 5Y 52 60 Swap spreads 10Y 25 25 30Y -11 -10 Japan O/N call rate 2Y 5Y 10Y 20Y 30Y 2s/10s 10s/30s 2s/30s
10Y
4.25 4.10
4.25 4.30
4.00 4.25
4.00 4.20
4.00 4.30
New Zealand Cash rate Govt curve 10Y
2.50 4.10
2.50 4.40
2.75 4.30
3.00 4.20
3.25 4.40
Govt curve
0.05 0.11 0.30 0.99 1.77 1.96 88 97 185
0.05 0.12 0.40 1.15 1.80 2.00 103 85 188
0.05 0.13 0.35 1.05 1.80 2.00 92 95 187
0.05 0.13 0.35 1.05 1.85 2.05 92 100 192
0.05 0.13 0.40 1.15 1.95 2.15 102 100 202
46
Recent curve movements

EUR Govt. curve 2Y 5Y 10Y 30Y 2s/5s 2s/10s 10s/30s Swap curve 2Y 5Y 10Y 30Y 2s/5s 2s/10s 10s/30s GBP
09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago 0.15 0.16 0.24 0.27 0.32 0.43 0.39 0.38 0.42 0.38 0.77 0.78 0.84 0.96 1.04 1.02 0.96 0.96 1.10 0.91 1.79 1.80 1.88 2.03 2.15 2.07 2.06 2.07 2.24 2.16 2.44 2.42 2.47 2.67 2.66 3.22 3.22 3.24 3.38 3.24 61 62 60 70 72 59 57 58 69 53 164 164 164 177 182 164 167 169 183 178 65 62 59 64 52 114 116 118 114 107 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago 1.07 1.04 1.15 1.18 1.40 1.24 1.17 1.26 1.24 1.31 1.52 1.50 1.58 1.66 1.95 1.58 1.52 1.57 1.64 1.61 2.25 2.22 2.30 2.43 2.66 2.39 2.37 2.39 2.52 2.45 2.53 2.49 2.56 2.68 2.73 3.12 3.12 3.13 3.24 3.16 45 46 42 49 55 34 35 31 40 31 118 118 115 125 125 115 120 113 128 115 28 27 26 25 7 73 75 74 72 70
Swap spreads 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago 2Y 91 86 88 85 108 80 77 86 79 88 5Y 74 71 73 70 86 52 53 58 52 64 10Y 44 40 40 37 51 25 24 26 21 25 30Y 8 6 8 0 6 -11 -11 -12 -15 -9 2s/5s -18 -15 -15 -15 -22 -28 -24 -28 -27 -24 2s/10s -48 -46 -49 -47 -57 -55 -53 -60 -58 -63 10s/30s -35 -33 -32 -37 -45 -36 -35 -38 -37 -34
USD Govt. curve 2Y 5Y 10Y 30Y 2s/5s 2s/10s 10s/30s Swap curve 2Y 5Y 10Y 30Y 2s/5s 2s/10s 10s/30s JPY
09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago 0.31 0.28 0.31 0.27 0.22 0.11 0.11 0.11 0.12 0.13 0.90 0.85 0.89 0.86 0.88 0.30 0.30 0.31 0.35 0.35 2.04 1.98 1.97 2.05 2.05 0.99 0.99 0.97 0.99 1.01 3.21 3.11 3.10 3.20 3.10 1.96 1.94 1.94 1.93 1.92 58 57 58 59 66 19 19 20 23 22 173 171 166 178 183 88 88 87 87 88 116 113 112 115 105 97 95 97 94 91 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago 0.57 0.53 0.62 0.54 0.64 0.34 0.34 0.34 0.36 0.38 1.15 1.11 1.17 1.13 1.25 0.46 0.47 0.46 0.48 0.48 2.13 2.07 2.08 2.13 2.18 1.02 1.01 1.00 1.00 1.00 2.90 2.82 2.80 2.88 2.78 1.90 1.89 1.87 1.84 1.78 58 58 55 59 61 12 12 12 12 11 155 154 146 159 154 67 67 66 65 62 77 74 72 76 60 89 88 87 83 78
Swap spreads 09-Mar-12 1W ago 2W ago 1M ago 3M ago 09-Mar-12 1W ago 2W ago 1M ago 3M ago 2Y 25 25 30 27 41 23 23 24 24 25 5Y 24 25 28 26 35 16 15 15 13 12 10Y 7 8 10 8 12 3 3 1 0 -1 30Y -30 -29 -30 -31 -31 -6 -6 -8 -11 -16 2s/5s -1 0 -3 -1 -6 -7 -8 -9 -11 -12 2s/10s -18 -17 -20 -18 -30 -20 -20 -23 -24 -26 10s/30s -37 -37 -39 -39 -43 -9 -9 -9 -11 -15
47
Recent sovereign cash spread movements

Spread to Germany; bp
09-Mar-12 1W ago 2W ago 1M ago 3M ago Austria 58 54 55 52 85 Belgium 110 106 132 126 292 Finland 19 20 22 21 18 France 46 40 47 34 88 Netherlands 22 17 17 12 37 Ireland 434 424 382 392 836 Italy 200 198 290 275 558 Portugal 1486 1476 1414 1569 1529 Spain 197 186 218 216 415 Wtd. peri. spread* 289 281 342 345 590
2Y 1Y min 9 32 4 4 3 380 83 493 102 153 5Y 1Y min 30 84 6 21 6 416 102 572 155 181 10Y 1Y min 31 72 24 30 22 494 125 458 170 188 30Y 1Y min 28 75 32 6 153 295 185 173
1Y max 139 469 51 150 70 2164 713 2216 548 737
1Y avg 47 147 17 47 17 831 313 1335 264 387
1Y SD 1Y z-score 31 0.4 89 -0.5 10 0.2 33 -0.1 13 0.2 305 -1.3 158 -0.7 345 0.4 95 -0.7 137 -0.7
1Y max 219 433 93 187 83 1509 675 2079 495 670
1Y avg 87 198 43 75 38 756 347 1193 305 410
1Y SD 1Y z-score 48 0.3 74 -0.5 22 0.2 40 0.4 18 0.4 223 -1.4 151 -0.3 290 1.2 76 -0.3 123 -0.2
1Y max 189 357 80 188 65 1142 575 1406 500 566
1Y avg 84 179 45 84 38 681 331 943 310 387
1Y SD 1Y z-score 39 0.4 62 -0.2 12 0.3 38 0.6 9 0.4 130 -1.3 126 -0.1 190 1.3 71 0.2 104 0.0
09-Mar-12 1W ago 2W ago 1M ago 3M ago Austria 87 86 87 71 96 Belgium 153 160 168 143 197 Finland France 115 116 116 96 109 Netherlands 15 12 14 10 8 Ireland Italy 314 316 345 333 412 Portugal 816 798 757 765 661 Spain 329 318 326 318 368 Wtd. peri. spread* 502 353 372 362 418
1Y max 158 297 199 15 515 919 448 500
1Y avg 65 157 83 10 320 583 303 336
1Y SD 1Y z-score 30 0.7 48 -0.1 39 0.9 2 1.5 100 0.0 143 1.6 62 0.5 91 0.2
*Weighted peripheral spread computed against Germany for Ireland, Portugal, Italy and Spain (weighted by the size of their outstanding bond market). 30Y does not 48 contain Ireland and Finland.
Recent sovereign CDS spread movements

CDS spread*; bp
08-Mar-12 1W ago 2W ago 1M ago 3M ago US 29 29 29 29 29 UK 23 24 28 30 52 Germany 28 27 33 34 50 Austria 109 102 112 110 134 Belgium 181 175 210 189 294 Finland 32 33 33 33 32 France 119 111 130 122 155 Netherlands 51 47 52 51 61 Ireland 633 597 656 662 892 Italy 324 329 384 365 575 Portugal 1756 1683 1580 1712 1579 Spain 350 318 357 344 419 Wtd. peri. spread** 433 422 463 457 612
2Y 1Y min 21 21 10 20 62 12 29 10 597 71 530 142 148 5Y 1Y min 40 47 36 50 115 24 63 28 510 125 525 197 189
1Y max 50 58 62 174 382 45 180 75 1606 627 2306 473 657
1Y avg 36 37 31 81 192 28 97 36 917 333 1315 315 418
1Y SD 1Y z-score 11 -0.7 12 -1.2 16 -0.2 49 0.6 84 -0.1 10 0.4 49 0.5 20 0.7 183 -1.5 173 -0.1 403 1.1 87 0.4 154 0.1
08-Mar-12 1W ago 2W ago 1M ago 3M ago US 40 40 40 40 40 UK 63 66 72 76 92 Germany 77 75 81 85 102 Austria 165 155 170 168 183 Belgium 232 222 244 223 320 Finland 64 65 66 66 64 France 179 166 190 178 211 Netherlands 99 92 102 100 109 Ireland 615 580 580 566 701 Italy 372 355 400 394 535 Portugal 1200 1151 1080 1170 1111 Spain 400 355 376 365 435 Wtd. peri. spread** 442 415 445 443 553
1Y max 65 104 120 243 408 90 252 146 1199 583 1522 488 595
1Y avg 51 76 74 130 232 56 149 78 716 353 965 345 407
1Y SD 1Y z-score 10 -1.1 15 -0.9 25 0.1 56 0.6 71 0.0 19 0.4 56 0.5 34 0.6 110 -0.9 144 0.1 223 1.1 71 0.8 121 0.3
* 25bp running coupon used for Finland, France, Germany, Netherlands and US. 100bp running coupon used for UK, Austria, Belgium, Greece, Ireland, Italy, Portugal and Spain. Spreads for all the countries except US are in $ CDS and for US it is in CDS. **Weighted peripheral spread computed as CDS spread of Ireland, Portugal, Italy and Spain, weighted by the size of their outstanding bond market.
49
Euro area conventional bond* and bank debt** redemptions

bn
Austria Mar-12***** Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Total Sov. Banks 1 2 0 2 0 2 0 10 0 0 0 1 0 0 0 0 13 1 1 0 2 1 1 2 0 1 2 15
Belgium Sov. Banks 4 0 0 0 0 2 0 0 1 11 0 0 7 0 0 13 37 1 0 1 0 3 1 0 2 7 6 24
Finland Sov. Banks 0 0 0 1 0 0 0 0 1 6 0 0 0 0 0 0 7 Italy Sov. Banks 0 5 27 2 1 6 2 17 12 11 20 13 30 0 21 0 154 3 2 2 4 6 4 10 3 10 6 63 1 0 1 0 0 0 0 0 1 0 4
France Sov. Banks 0 4 18 6 0 2 0 28 0 12 19 0 5 22 0 0 105 5 13 0 5 9 1 3 14 3 11 77
Germany Sov. Banks 19 12 16 3 0 2 19 27 0 21 16 0 17 24 0 18 177 9 10 5 11 9 5 3 18 12 11 110
Netherlands Sov. Banks 0 3 0 10 0 4 0 15 0 0 0 0 0 16 0 0 31 2 2 3 2 1 1 1 9 3 5 47
Core Euro-area*** Sov. 24 34 0 19 81 2 50 35 1 29 61 0 31 368 Banks 21 22 12 20 25 10 21 23 9 9 42 26 36 276
Greece Mar-12***** Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Total Sov. Banks 2 0 0 1 1 1 2 1 1 0 1 1 0 10
Ireland Sov. Banks 0 2 0 3 0 0 0 0 0 0 0 0 0 0 0 0 0 2 0 0 0 1 3 0 1 2 1 15
Portugal Sov. Banks 0 1 0 0 0 1 10 1 0 0 0 0 1 0 0 0 13 2 2 0 0 0 0 0 0 2 0 9
Spain Sov. Banks 0 9 12 15 0 10 0 13 0 2 20 0 0 14 0 0 62 25 8 3 7 5 10 5 11 7 9 122
Peri. Euro-area**** Sov. 0 39 1 12 31 12 13 40 13 32 14 21 0 229 Banks 18 21 17 33 12 5 12 12 18 15 16 22 16 219
* Marketable bonds include: conventionals, linkers, floaters zero coupons and international bonds. ** Maturities in all currencies and jurisdictions and include secured, unsecured and securitised issuance, including MTNs but excluding short-term (maturity of less than one year) and self-funded deals (deals where there is only one bookrunner and it is also the issuer). The data also include any government guaranteed issuance by the banks but no direct issuance by government or government sponsored institutions. *** Austria, Belgium, Finland, France, Germany and Netherlands. **** Greece, Ireland, Italy, Portugal, Spain. ***** For the remaining part of the month. Source: J. P. Morgan, Dealogic
50
Event risk/election calendar

Event risk
Month March 2012 Day Mon Mon Tue Sun Tue-Thu April 2012 ?? Wed Thu Wed Fri-Sun Sun May 2012 Thu Sun Sun Thu Mon Tue-Tue Wed Fri June 2012 Wed Thu Sun Sun Mon Tue Thu-Fri 4 5 11 20-22 22 3 6 6 10 14 15-22 16 25 6 7 10 17 18 19 28-29 Date 12 12 13 18 27-29 Country/Region Event Euro area Greece Euro area Greece Greece Greece Euro area UK Greece IMF/World Bank France Euro area France Germany UK Euro area G8 UK Euro area Euro area UK France Euro area Euro area Euro area Euro area Eurogroup meeting (17 finance ministers) Ex pected settlement of Greek PSI for domestic law bonds Ecofin meeting (27 finance ministers) PASOK v otes on a new leader to replace Papandreou Bond holder meeting dates for foreign law bonds in the Greek PSI Greece parliamentary elections ECB rate announcement BoE rate announcement Ex pected settlement of Greek PSI for foreign law bonds IMF/World Bank spring meeting in Washington French Presidential election (round 1) ECB rate announcement French Presidential election (round 2) State elections, Schlesw ig-Holstein BoE rate announcement Eurogroup meeting (17 finance ministers) G8 summit in Chicago BoE Quarterly Inflation Report EU Council Meeting (EU heads of state) ECB rate announcement BoE rate announcement French legislativ e election (round 1) French legislativ e election (round 2) Eurogroup meeting (17 finance ministers) Ecofin meeting (27 finance ministers) EU Council Meeting (EU heads of state)
Election calendar
Period 2012 22 2013 2014 2015 2016 Date Month ?? April Election in Greece France Austria Germany Italy Belgium Netherlands Finland Portugal Spain Ireland
51
European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Aditya ChordiaAC (44-20) 7777-9841 Aditya.x.chordia@jpmorgan.com J.P. Morgan Securities Ltd.
Euro area fact sheet / SMP purchases

Euro-area fact sheet
GDP (bn) 2012 Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain GDP-weighted avg US UK 310 382 198 2,028 2,623 212 159 1,617 623 169 1,094 9,415 15,495** 1,566** GDP growth Inflation* Budget balance^ Prim. Balance Gross debt Curr. acc. bal. (oya, %) 2012 0.7 -0.1 0.8 0.4 0.6 -4.4 0.5 -1.3 -0.9 -3.3 -1.0 -0.3 1.5 0.6 (oya, %) 2012 2.4 2.7 3.0 2.2 1.9 -0.5 1.6 2.9 2.0 3.3 1.3 2.1 1.9 2.9 (% of GDP) 2012 -3.1 -4.6 -0.7 -5.3 -1.0 -7.0 -8.6 -2.3 -3.1 -4.5 -5.9 -3.4 -8.5 -7.8 (% of GDP) 2012 -0.3 -1.3 0.5 -2.5 1.3 1.0 -4.3 3.1 -1.2 0.8 -3.5 -0.2 -5.4 -4.6 (% of GDP) 2012 73 99 52 89 81 198 118 121 65 111 74 91 105*** 89 (% of GDP) 2012 2.8 2.1 0.0 -3.3 4.4 -7.9 1.5 -3.0 7.0 -5.0 -3.0 0.0 -3.1 -0.9 GDPpc (EU=100) 2012 124 116 123 104 108 63 119 90 126 54 80 101 Unempl. rate (%) Latest 4.0 7.4 7.5 10.0 5.8 19.9 14.8 9.2 5.0 14.8 23.3 8.0 8.3 8.4
* HICP; National index if not available **Local currency *** IMF Estimate ^ Net lending (+) or net borrowing (-) Source: EC European Economic Interim Forecast Feb-12, EC European Economic Forecast, Autumn 2011, IMF, Eurostat and ILO
Sovereign ratings
S&P Austria Belgium Cy prus Finland France Germany Greece Ireland Italy Netherlands Portugal Slov akia Slov enia Spain AA+ AA BB+ AAA AA+ AAA SD BBB+ BBB+ AAA BB A A+ A NEG NEG NEG NEG NEG NEG NEG NEG NEG NEG NEG Moody's Aaa Aa3 Baa3 Aaa Aaa Aaa Ca Ba1 A3 Aaa Ba3 A2 A2 A3 NEG NEG NEG NEG DEV NEG NEG NEG NEG NEG NEG* AAA AA BBBAAA AAA AAA RD BBB+ AAAA BB+ A+ A A NEG NEG NEG NEG NEG NEG NEG NEG Fitch
SMP purchases
Trade date Settlement date Weekly (bn) 0.0 0.0 0.0 0.1 0.1 224.9 Amount matured (bn) 0.0 0.0 0.0 0.0 0.0 6.8 Amount offered for sterilization (bn) 219.5 219.5 219.5 219.5 219.0 219.0 First Last First Last
22-Feb 15-Feb 08-Feb 01-Feb 25-Jan
02-Mar 24-Feb 17-Feb 10-Feb 03-Feb
Cumulativ e amount till 24 Jan 2012
* represents under watch; grey highlight: below IG; Outlook:NEG - negative outlook, POS positive outlook, DEV - developing outlook and blank represents stable outlook Notes: 1 Rules for a country to be excluded from its index: 1) J.P. Morgan's EMU IG index requires any 1 of 3 credit ratings (S&P's, Moodys, Fitch) to be below IG. 2) Barclays Capital requires 2 of the above 3 credit ratings to be below IG. 3) Citigroup requires both S&P and Moodys rating to be below IG. 2 Markit iBoxx uses an average rating methodology (S&P, Moodys and Fitch) for 52 a country's exclusion. Source: Bloomberg
Note: Every Tuesday ECB sterilizes SMP purchases during the period between the Wednesday two weeks back (first trade date) and the Tuesday of the previous week (last trade date). This is equivalent to SMP purchases which settle on Monday (first settlement date) to Friday of the previous week (last settlement date). The ECB started buying Italian and Spanish bonds on Monday, 8 August 2011. Source: ECB
European Rates Strategy Global Fixed Income Markets Weekly March 9, 2012 Pavan WadhwaAC (44-20) 7777-3370 pavan.wadhwa@jpmorgan.com J.P. Morgan Securities Ltd.
53
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Unless otherwise expressly noted, all data and information for charts, tables and exhibits contained in this publication have been sourced via J.P. Morgan information sources.
55
Global Market Movers

12 March Germany 0900 CPI final Feb Italy 1000 GDP final 4Q Japan 0850 Private machinery orders Jan 1.0%m/m, sa 0850 Corporate goods prices Feb 0.5%oya 1400 Consumer sentiment Feb 40.5, DI BoJ Monetary Policy Meeting United States 1400 Federal budget Feb Auction 3-year note $32 bn 13 March Germany 1100 ZEW bus. survey Mar France 0730 CPI Feb 2.3 %oya, nsa Italy 1000 CPI final Feb 3.3 %oya, nsa Spain 0900 CPI final Feb 2.0 %oya, nsa Netherlands Auction DSL Apr15 Japan 0850 Tertiary sector activity index -0.5%m/m, sa BoJ Monetary Policy Meeting and statement 1530 BoJ governor Shirakawas press conference United Kingdom 0001 RICS HPI Feb 0930 Trade balance Jan 0930 DCLG HPI Jan United States 0730 NFIB survey Feb 0830 Retail sales Feb 1.1% Ex auto 0.7% 1000 Business inventories Jan 0.6% 1000 JOLTS Jan FOMC meeting Auction 10-year note (r) $21 bn 20 March Germany 0800 PPI Feb Netherlands 0930 CBS cons. conf. Mar Spain Trade balance Jan United Kingdom 0930 CPI Feb 1100 CBI industrial trends Mar United States 0830 Housing starts Feb 1245 Chairman Bernanke speaks in Washington, D.C. 1730 Minneapolis Fed President Kocherlakota speaks in St. Louis 14 March Euro area 1100 HICP final Feb 2.7 %oya, nsa 1100 Industrial production Jan 0.1%m/m, sa Italy Auction BTP Mar15 and Sep19 Japan 0850 Business outlook survey1Q 1330 IP final Jan 1400 BoJ monthly economic report Auction 3-month bill United Kingdom 0930 Labor market statistics Feb Claimant count 5 k,ch,m/m,sa Average Earnings Jan ILO Unemployment Rate Jan 8.4 % sa United States 0830 Import prices Feb 0.5% 0830 Current account 4Q Auction 30-year bond (r) $13 bn 0900 Chairman Bernanke speaks in Nashville, TN 15 March Euro area 1000 ECB monthly bulletin 1100 Employment 4Q Netherlands 0930 Industrial production Jan France Auction OAT Apr14 & Oct14 and BTAN Feb16 & Feb17 Spain Auction Bono Jan15, Apr16 & Jul18 Japan Auction 1-year note Auction 20-year bond United Kingdom Auction 2042 United States 0830 Initial claims w/e prior Sat 355,000 0830 PPI Feb 0.6% Core 0.2% 0830 Empire State survey Mar 17.5 0900 TIC data Jan 1000 Philadelphia Fed survey Mar 11.0 Announce 10-year TIPS (r) $13 bn 16 March Euro area 1100 Foreign trade Jan Italy 1000 Foreign trade Jan Japan 0850 Construction spending Jan 0850 Minutes of Feb 13-14 BoJ Monetary Policy Meeting United States 0830 CPI Feb 0.5% Core 0.18% 0915 Industrial production Feb 0.6% Manufacturing 0.4% Capacity utilization 78.9% 0955 Consumer sentiment Mar preliminary 76.0 1500 Chicago Fed President Evans speaks on monetary policy in Frankfurt
19 March Euro area 1000 BoP Jan Italy 1100 Industrial new orders Jan Japan Auction 2-month bill United States 1000 NAHB survey Mar
21 March Germany Auction Schatz Mar14 Japan 1330 All sector activity index Jan United Kingdom 0930 UK Spring Budget MPC minutes Mar 0930 Public sector finances Feb United States 1000 Existing home sales Feb
22 March Euro area 1000 PMI flash Mar Mfg, services, composite 1100 Industrial new orders Jan 1600 EC cons. conf. prelim Mar France 0900 PMI flash Mar Mfg, services, composite Germany 0930 PMI flash Mar Mfg, services, composite Japan 0830 Reuters Tankan Mar 0850 Trade balance Feb 1110 BoJ board member Morimotos address in Hyogo prefecture Netherlands 0930 GDP final 4Q United Kingdom 0930 Retail sales Feb Auction IL 2042 United States 0830 Initial claims w/e prior Sat 1000 FHFA HPI Jan 1000 Leading indicators Feb Auction 10-year TIPS (r) $13 bn Announce 2-year note $35 bn Announce 5-year note $35 bn Announce 7-year note $29 bn 1245 Chairman Bernanke speaks in Washington, D.C. 2000 St. Louis Fed President Bullard speaks in Hong Kong
23 March France 0845 INSEE bus. conf. Mar Spain 0900 PPI Feb Japan 0850 Flow of funds 4Q Auction 3-month bill United Kingdom 0930 BBA mortgage lending Feb United States 1000 New home sales Feb 1430 Atlanta Fed President Lockhart speaks in Washington, D.C.
Selective list as of 09 March. Forecasts are m/m, nsa, unless stated & times are local. Telephone your J.P. Morgan representative for an update/more details. Highlighted data are scheduled for release on or after the date shown. Times shown are local. . 56

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European Rates Strategy

J.P. Morgan Securities Ltd. March 9, 2012

Global Fixed Income Markets Weekly

J.P. Morgan Securities Ltd.

See page 54 for analyst certification and important disclosures.

Mission PSI: (almost) accomplished

Wed 7 Mar*** Wed 11 Apr*** Wed 11 Apr Wed 11 Apr

Chg -32% -36% -41% -43% -20 -25 -64 -56

131% 157% 154% 124% 48 72 38 21

163% 193% 195% 167% 68 98 102 77

ECB/NCB % of priv ate debt maturities (ex c bills)**

Official % of total debt stock

Official/ Total 77% 76% 72% 69% 48 72 73 79

Period 2012 - 2015 2016 - 2020 2021 - 2025 2026 - 2030

Asset German 10Y US 10Y

b/m yields (%)

2Y 3s/6s 2Y FX basis Itraxx EUR HY CDS S&P500 EUR Stoxx 50 FTSE100

Equity Indices (pts)

Exhibit 7: Birds eye view of our major trade recommendations by currency

Realised - 2Y back fcst

Realised - 1Y back fcst

Source: Consensus Economics

Exhibit 2: and still experience higher-than-expected inflation

Source: Consensus Economics

Same story but less conviction

Exhibit 4: Portugals private sector debt is an additional problem compared to Greece

350 300 250 200 150 100 50 0

General gov ernment

20 15 10 5 0 -5 -10 -15 -20 2013

Spain rich 2014 2015 2016

Exhibit 6: The BTP 4% Feb37 is trading expensive vs. BTP 5% Aug34

20 15 10 5 0 -5 -10 -15 -20 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12

0 2012 2017 2022 2027 2032 2037

Total for March

*Marketable bonds include conventionals, linkers, floaters and zero coupons.

Exhibit 9: The BTP Mar19/Sep19/Mar20 fly is directional to the level of rates

6.00 BTP Sep19; %

-4 Mar-10 Aug-10 Dec-10 May -11 Oct-11 Mar-12

Trades closed in 2012

14 12 10 8 6 4 2 0 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11

-10 Sep 11 Oct 11 Nov 11 Dec 11 Feb 12 Mar 12

* Curve defined as 10Y 0.66*(greens yield).

6 4 2 0 -2 -4 -6 Sep 11 Oct 11 Nov 11 Dec 11 Feb 12 Mar 12

-40% -43% -34% -9% 2% -7% 11% 19% 4% 2% 27% 52% 3%

1s/2s/3s 1s/3s/5s 2s/5s/7s 2s/5s/10s 2s/7s/12s 2s/10s/30s 3s/7s/15s

-7% -6% 9% 3% 12% 18% 7%

-10% -14% 9% 17% 18% 33% 22%

3% 8% 0% -14% -6% -15% -16%

Exhibit 9: as the fly is expected to remain directional

y = 22.4x - 40.8 R 2 = 85%

10 8 6 4 2 0 1.60 1.80 2.00 7Y sw ap y ield; % 2.20 2.40 Spot Forw ard

y = -0.08*(Ex Liq) + 0.06*(Wtd Peri Sprd) + 98.9 R 2 = 94%

Exhibit 12: Swapped issuance continues to run at high levels

0 Mar 11 May 11 Aug 11 Oct 11 Dec 11 Mar 12

Exhibit 13: putting narrowing pressure on intermediate swap spreads

y = -3.1*(Iss) - 12.4*(10Y) + 4.4*(3Mx 10Y) + 59.6 R 2 = 85%

2 4 6 20D MA of sw apped issuance*; bn/day

* See Exhibit 12 for definition of swapped issuance.

20 0 -20 -40 -60 -80 -100 -120 100 09-Mar-12

y = -0.18x + 33.2 R 2 = 74%

200 300 400 500 10Y w td peri spread (ex Greece); bp

Note: Implieds on 1Y tails are based on the 3s curve

2.80 2.70 2.60 2.50 2.40 2.30 2.20

Exhibit 19: while exhibiting a high degree of mean reversion

Wed 7 Mar* Wed 11 Apr* Wed 11 Apr Wed 11 Apr

y = -0.08(Ex Liq) + 0.06(Wtd Peri Sprd) + 98.9 R 2 = 94%

y = -3.1(Iss) - 12.4(10Y) + 4.4*(3Mx 10Y) + 59.6 R 2 = 85%