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US Fixed Income Strategy
26 September 2011
AC
Indicates certifying analyst. See last page for analyst certification and important disclosures.
US Fixed Income Weekly
Cross Sector
 
Srini Ramaswamy, Kimberly Harano
 
We are cautious on risky assets and we prefer to overweight sectors with lowerexposure to Europe and those that offer attractive carry-to-risk after adjusting forEuropean risk. Spread risk is more attractive than duration risk. Stay cautious oncredit.
Governments
Terry Belton, Meera Chandan, Kim Harano, Renee Park 
Treasury valuations are extremely rich, but near-term factors suggest the rally haslegs. Increased Fed buying in the long end will increase STRIPS reconstitutions.Stay neutral on Agencies.
Investment-Grade Corporates
 
 Eric Beinstein
 
We stay underweight as spreads are not wide enough to properly reflect the dualrisks of a recession and significant event risk in Europe.
Municipals
Peter DeGroot, Josh Rudolph
Investors who hold longer-dated BABs and pay above a 14% marginal effectivetax rate should consider selling BABs and purchasing similarly rated tax-exemptbonds for sizable gains in taxable equivalent yield.
Special Topic: A Euro recession and spillover risks
 David Mackie
A second harder debt restructuring in Greece now seems inevitable and a mildrecession in the Euro area is likely to start in 4Q. A deep recession will only beavoided if the mechanisms to limit contagion are dramatically upsized andactively used.
Contents
Cross Sector Overview 2Economics 5Treasuries 10Agencies 17Corporates 19Municipals 23Special Topic 30Forecasts & Analytics 43Market Movers 47
 
Terry BeltonSrini RamaswamyAlex Roever
AC
 
 
US Fixed Income StrategyUS Fixed Income Weekly
September 26, 2011Srini Ramaswamy
AC
 Kimberly L. HaranoJ.P. Morgan Securities LLC
2
Cross Sector Overview
 
The FOMC surprised markets with an aggressiveOperation Twist, announcing its intentions to buya substantial fraction of long-end Treasury debtand reinvest maturing Agencies/MBS into MBS
 
The European crisis is likely to intensify; we nowthink a harsher Greek debt restructuring isinevitable, implying worse macroeconomicoutcomes for Greece and the Euro area. Weexpect the Euro area to fall into recession nextquarter, adding downside risk to our US growthforecast
 
In this environment, we are cautious on riskyassets and we overweight sectors with lowerexposure to Europe and those that offer attractivecarry-to-risk after adjusting for European risk…
 
…On this basis, we find that spread risk is moreattractive than adding duration risk; stay neutralon duration and overweight MBS
 
However, a broader deleveraging event remains apossibility, which could affect any and allmarkets. The sharp sell-off in commodities andEM currencies this week is an ominous sign, andsuggests some deleveraging may already beunderway
Market views
Markets treaded water early in the week, only to collapseon Wednesday and Thursday before stabilizingsomewhat on Friday. European sovereign CDS continuedtheir relentless widening, equities plummeted, creditspreads widened, and 10-year Treasury yields reachednew all-time lows (
Exhibit 1
). The beneficiaries of therisk-off trade were the dollar and the yen, with even goldappearing to take a breather. After this week’s moves,our revamped “crisis meter,” which compares thecheapening in the current cycle to the averagecheapening over late 2008 and last summer, showssignificant stress across many markets (
Exhibit 2
).The tone of news and data were mixed to negative thisweek, though it is difficult to pinpoint a singular triggerfor the risk-off trade. On Tuesday, S&P downgradedItaly from A+ to A with outlook negative, and onWednesday, Moody’s downgraded the long-term ratingsof Bank of America and Wells Fargo and downgraded
Exhibit 1: Risky assets plummeted this week as amassive risk-off trade took hold
Current level,* change since 9/16/11, quarter-to-date change, and change over 2Q11 for various market variables
CurrentChg from 9/16QTD chg2Q11 chg
Global Equities (level)
S&P 5001136.4-79.6-184.2-5.2E-STOXX2026.0-133.3-822.5-62.4FTSE 1005066.8-301.6-878.936.9Nikkei 2258560.3-303.9-1255.861.0
Sovereign par rates (%)
2Y US Treasury0.2590.064-0.212-0.30110Y US Treasury1.886-0.265-1.374-0.2772Y Germany0.348-0.127-1.218-0.16210Y Germany1.778-0.128-1.272-0.3462Y JGB0.133-0.006-0.038-0.02310Y JGB0.931-0.030-0.231-0.143
5Y Sovereign CDS (bp)
Greece510975829981019Spain4184815629Portugal1340202543206Italy4995032824Ireland8843093128
Funding spreads (bp)
2Y EUR par swap - par gov't spd105.35.044.1-0.72Y USD par swap - par gov't spd25.9-4.63.53.8EUR FRA-OIS spd61.7-2.832.33.1USD FRA-OIS spd41.6-1.220.7-0.21Y EUR-USD xccy basis-77.4-12.9-51.30.1
Currencies
EUR/USD1.353-0.026-0.0970.031USD/CHF0.9030.0270.061-0.073USD/JPY76.28-0.44-4.77-1.73JPM Trade-weighted USD81.982.494.38-1.46
Spreads (bp)
30Y CC MBS L-OAS64.9-4.727.29.610Y AAA CMBS spd to swaps355.035.0135.030.0JULI (ex-EM) Z-spd to Tsy239.518.187.014.9JPM US HY index spd to worst775.135.7208.150.1EMBIGLOBAL spd to Tsy461.975.0173.4-10.4MAGGIE (Euro HG spd to govies)68.02.819.66.3US Financials spd to Tsy318.331.3137.221.1Euro Financials spd to govies300.120.8130.320.110Y AAA muni/Tsy ratio (level)104%5.4%20.1%-5.8%30Y AAA muni/Tsy ratio (level)118%8.7%19.1%-7.4%
Commodities
Gold futures ($/t oz)1739.40-39.80229.0086.60Oil futures ($/bbl)79.85-8.33-15.57-11.30
 * 9/22/11 level for Europe and US corporate credit spreads, JGB yields, and the J.P. Morgantrade-weighted USD index; 9/23/11 level for all others.
 
US Fixed Income StrategyUS Fixed Income Weekly
September 26, 2011Srini Ramaswamy
AC
 Kimberly L. HaranoJ.P. Morgan Securities LLC
3
the short-term ratings of Bank of America and Citigroup,but these ratings actions have long been anticipated. InEurope, there was little progress on the policy front thisweek, and the news flow was largely negative, withheadlines around potential delays in parliamentaryapproval of EFSF changes.In the US, economic data were mixed. In the housingsector, the NAHB housing market index fell 1 point to14, and housing starts fell 5% in August, but on the otherhand, existing home sales rose 7.7% in August, and theFHFA house price index showed a 0.8% gain in July.Labor market data were slightly more positive, withinitial jobless claims falling to 423K from an upwardlyrevised 432K.Of course, the big event for the week was the FOMCstatement on Wednesday, and on the margin, the Fedover-delivered: it announced it would sell $400bn front-end securities and buy an equivalent amount of longer-dated securities by June 2012, with 29% of the purchasescoming in the 20-30 year bucket, a much higher fractionthan expected. The Fed did not lower interest on excessreserves, but it also surprised investors by announcingthat it would reinvest maturing Agency debt and MBSback into MBS. Long-end Treasuries and MBS ralliedsharply on the news. Despite the stronger-than-expectedstimulus, however, risky assets sold off, perhaps drivenby the bleak characterization of growth: the Fed wrotethat “there are significant downside risks to the economicoutlook, including strains in global financial markets”and maintained an easing bias.Looking ahead, we expect the environment for riskyassets to remain challenging given global growthheadwinds and the intensifying European crisis. Giventhe lack of meaningful positive developments, we remainbearish on Europe. In the near term, the possibility thatsmall countries such as Slovenia, Slovakia, and Estoniavote against EFSF ratification and implementation risk around Greece’s reform programs are risks. Over themedium term, however, we now think that a much harderdebt restructuring seems inevitable, which will likelyproduce worse macroeconomic outcomes for both Greeceand the entire Euro area (see Special Topic).We now expect the Euro area to fall into recession nextquarter, with the contraction lasting until the middle of next year (
Exhibit 3
). As a result, we also expect theECB to cut its policy rate by 50bp to 1.0% at the nextmeeting, and look for more QE from the BoE in October.If policymakers act very aggressively, by supplyingliquidity to banks and sovereigns and recapitalizingbanks, we expect a mild recession, but the globalrepercussions will be significant. At this point, we are notrevising our US GDP forecast, but we note that downsiderisk to our growth forecast has increased.In this environment, we favor sectors with lowerexposure to Europe and/or higher carry-to-risk ratios
Exhibit 3: We now look for the Euro area to fall intorecession next quarter
J.P. Morgan forecast for real GDP, %q/q, saar 
3Q114Q111Q122Q123Q124Q12Euro area0.5-0.5-1.0-1.50.01.0Germany1.5-0.50.0-0.50.51.0France1.00.0-0.5-1.00.51.0Italy-1.0-1.5-1.5-2.5-0.50.5Spain0.0-1.0-1.0-1.50.01.0Greece5.0-3.0-6.0-10.0-8.0-3.0Ireland1.00.0-0.5-1.00.51.0Portugal-5.0-3.0-3.0-3.5-1.50.0
 Source: “Directing the Greek tragedy: default, a regional recession and spillover risks,”David Mackie et al, 9/23/11.
Exhibit 2: Our revamped crisis meter showssignificant stress this week
Ratio of current cheapening to 2008 and 2010 cheapening* for select variables; asof 9/23/11; %
050100150200250
EM currencyavg
050100150200250
1Y EUR/USD x-ccy basis swap
050100150200250
French bankCDS avg
050100150200250
Euro sovereignCDS avg
050100150200250
EUR/USD
 * Current cheapening is the worst level minus the best level in the month before 6/30/11.The 2008 cheapening is the difference between the worst level over 9/1/08-12/31/08 andthe best level in the prior 1-month period. The 2010 cheapening is the difference betweenthe worst level over 4/15/10-7/15/10 and the best level in the prior 1-month period.Note: EM currency average is the average of BRL, INR and MXN. French bank CDSaverage is the average 5-year CDS spread for Societe Generale, Credit Agricole and BNPParibas. Euro sovereign CDS average is the average 5-year CDS spread for France, Italyand Spain.
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