cross sector investment-grade corporates samplelook for the fed to resume balance sheet expansion,...

US Fixed Income Strategy 27 September 2010

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US Fixed Income Weekly

Cross Sector Srini Ramaswamy, Kimberly Harano Look for the Fed to resume balance sheet expansion, which is a positive for all financial assets. We stay positive on spread product given a dearth of supply, a strong search for carry by investors, QE expansion prospects, and the macro backdrop of positive GDP growth and very tame inflation.

Governments Srini Ramaswamy, Meera Chandan, Kim Harano, Renee Park Turn bullish on duration on the back of increased odds of an eventual QE expansion. Expect curve flattening. We prefer 7s and 10s rather than 2s and 15s. We also like cheap, low SOMA issues in the 2- to 3-day period before purchase operations. Remain bearish on TIPS breakevens. Stay underweight 2-year Agencies vs. Treasuries.

Investment-Grade Corporates Eric Beinstein, Andrew Scott HG spreads are cheap vs. historical default trends. Share buybacks have increased. However, most companies announcing buybacks can return more cash to shareholders without meaningfully impairing their credit metrics.

Municipals Alex Roever, Chris Holmes, Josh Rudolph Supply technicals are supportive of tighter BAB spreads in the near term. Risks to this view are lower Treasury yields and heavy 4Q supply.

Special Topic: Stand and delever: the ongoing contraction in US private credit Michael Feroli, Robert Mellman

Household debt, mortgages in particular, appears set for further declines. The need for businesses to tap external finance is limited. We look for a 28%-pt decline in the ratio of private nonfinancial credit to GDP by end-2012.

Contents

Cross Sector Overview 2

Economics 5

Treasuries 10

Agencies 14

Corporates 17

Municipals 22

Special Topic 25

Forecasts & Analytics 38

Market Movers 42

Terry Belton Srini Ramaswamy Alex RoeverAC

Sample

US Fixed Income Strategy US Fixed Income Weekly September 27, 2010

Srini RamaswamyAC Kimberly L. Harano J.P. Morgan Futures Inc., J.P. Morgan Securities LLC

2

Cross Sector Overview

The FOMC’s recognition of lower-than-mandate inflation increases the odds of an eventual expansion of QE. We expect the Fed to resume balance sheet expansion sometime this year, possibly as soon as the November meeting—turn bullish on duration

Although QE expansion is still likely to come in the form of additional Treasury purchases, the expansion of the Fed’s balance sheet is a positive for all financial assets. We quantify the potential impact of the Fed’s balance sheet expansion on fixed income spreads

Private sector credit continues to contract, promising to aggravate the supply/demand imbalance in spread product. We remain positive on spread product given this dearth of supply amidst the strong search for carry, QE expansion prospects, and the macro backdrop of positive GDP growth and very tame inflation

Stay overweight high grade, subordinate and/or non-benchmark ABS, CMBS, and MBS

Market views

It was all about the Fed and QE expansion prospects this week, with the highlight being Tuesday’s FOMC meeting. Although the Fed did not announce any new measures, the committee signaled heightened readiness to provide further monetary stimulus, and—notably—acknowledged that inflation was running below levels consistent with its mandate. This FOMC-wide recognition of lower-than-mandate inflation likely increases the odds of an eventual expansion of QE, leaving us more comfortable with our view that the Fed will resume expanding its balance sheet at some point, possibly as soon as the November meeting (see Economics.)

Although QE expansion is still likely to come in the form of additional Treasury purchases, the expansion of the Fed’s balance sheet is a positive for all financial assets, and markets traded in that manner. US stocks rallied, and Treasury yields declined over the week (Exhibit 1).

Credit spreads did widen modestly, but mainly due to declines in Treasury yields: as Exhibit 2 shows, after adjusting for directionality with 10-year Treasury yields, spreads are actually flat to modestly narrower.

Exhibit 1: Both equities and bonds rallied againthis week Current level,* change since 9/17/10, quarter-to-date change, and change over 2Q10 for various market variables

Current Chg from 9/17 QTD chg 2Q10 chg

Global Equities (level)S&P 500 1148.67 23.08 117.96 -138.72

E-STOXX 2792.75 35.38 219.43 -357.85

FTSE 100 5598.48 90.03 681.61 -762.77

Nikkei 225 9471.67 -154.42 89.03 -1707.30

Sovereign bond yields (%)2Y US Treasury 0.442 -0.028 -0.177 -0.403

10Y US Treasury 2.611 -0.134 -0.340 -0.881

2Y German Schatz 0.725 -0.054 0.130 -0.367

10Y German Bund 2.338 -0.100 -0.237 -0.520

2Y JGB 0.130 0.005 -0.015 -0.025

10Y JGB 0.995 -0.075 -0.085 -0.310

10Y spd to Germany (bp)Greece 877.7 -34.6 93.8 440.2

Spain 181.4 5.7 -16.7 126.8

Portugal 400.7 35.5 93.5 197.1

Italy 157.8 8.8 6.6 73.8

Ireland 430.9 34.9 120.5 160.5

Funding spreads (bp)2Y EUR swap spd 65.3 1.6 -9.3 28.2

2Y USD swap spd 16.5 -3.1 -19.1 19.6

EUR FRA-OIS spd 34.3 -1.1 -1.7 17.6

USD FRA-OIS spd 19.7 -2.7 -29.8 37.0

5Y EUR-USD xccy basis -42.2 -0.8 4.4 -15.4

CurrenciesEUR/USD 1.348 0.043 0.123 -0.128

USD/CHF 0.983 -0.027 -0.095 0.025

USD/JPY 84.590 -1.265 -4.100 -3.830

JPM Trade-weighted USD 82.85 -0.93 -3.74 2.61

Credit spreads (bp)JULI spd to Tsy 165.2 -0.1 -16.1 42.0

JPM US HY index spd to worst 676.3 11.5 -54.6 120.3

EMBIGLOBAL spd to Tsy 308.1 3.2 -50.2 96.9

MAGGIE (Euro HG spd to gov ies) 42.8 1.2 -5.9 18.6

US Financials spd to Tsy 197.1 1.9 -28.6 63.3

Euro Financials spd to gov ies 160.2 5.4 -29.4 69.0

CommoditiesGold futures ($/t oz) 1294.60 22.40 48.70 141.40

Oil futures ($/bbl) 76.49 2.83 0.86 -8.13

* 9/23/10 level for Europe and US credit spreads, and the J.P. Morgan trade-weighted USD index; 9/24/10 level for all others.

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This week’s outperformance of risky assets as well as Treasuries may have represented an initial reaction to the dovish statement and increasing odds of QE expansion. However, should it occur, we estimate that spreads could narrow considerably further. To see this, we return to the stylized model for spreads presented last month (see Cross Sector Overview, US Fixed Income Weekly, 8/27/10). In the original model, we regressed spreads versus US financial conditions, risky asset supply as a percentage of total fixed income gross supply, the level of jobless claims (a high frequency proxy for economic weakness), and a measure of contagion from the European crisis. To this model, we add an additional factor—the size of the Fed’s securities holdings—to estimate the partial sensitivity of spreads to QE. Using the partial beta for this factor, we then estimate the impact of a $1tn increase in the Fed’s securities holdings on spreads. The projections are shown in Exhibit 3, which shows considerable further narrowing in spreads is possible if the Fed expands its balance sheet, especially in the riskiest sectors.

Beyond QE expansion prospects, the underpinning of a low-growth, tame-inflation macroeconomic backdrop remains firmly in place. In this week’s data, initial jobless claims rose from 453K to 465K, and the failure of claims to decline meaningfully suggests that labor market slack persists. Thus, the inflation outlook clearly remains depressed, as was notably acknowledged by the FOMC committee. In addition, the NAHB housing market index and new home sales were unchanged at depressed levels, while the FHFA House Price Index disappointed with a 0.5% decline in July, following a 0.3% decline in June. Data wasn’t all weak, however; existing home sales rose 7.6% in August, while housing starts rose 10.5%, both better than expected. Also, the one strong release this week was the durables report. Headline new orders fell 1.3% in August, as the rise in aircraft and motor vehicle orders in July reversed itself, but excluding transportation, orders rose a solid 2.0%, and the core capital goods category rose 4.1% (see Economics).

Weak growth and deflation risks imply a low-for-long Fed stance, with growing risks of QE expansion, which is a positive for Treasuries. Treasuries are also supported by the now-higher risk of another round of FX intervention by the Japanese MoF/BoJ given that JPY has already retraced half of its cheapening versus USD. Thus, we turn bullish on duration (see Treasuries).

For risky assets too, positive GDP growth (even if sub-par) and a very tame inflation environment are a supportive combination. This positive backdrop is further supported by supply/demand technicals, given that the supply outlook remains structurally poor. As our economists write in this week’s Special Topic, US

Exhibit 2: After adjusting for the directionality with yields, credit spreads generally narrowed this week Change over 9/17-current* versus beta-adjusted change**; bp

-15

-10

-5

0

5

10

15

CMBS ABS HG HY EMBI

Actual chg

Beta-adj chg

* 9/23/10 for high grade and high yield; 9/24/10 for all others. ** Calculated as actual change minus beta*(change in 10-year Treasury yield), where the beta is the 3-month beta between the spread and 10-year yields.

Exhibit 3: Projected impact of QE expansion on risky assets Projected change* in spreads due to a $1tn increase in the Fed’s securities holdings; bp

-160

-140

-120

-100

-80

-60

-40

-20

0

MBS CMBS ABS JULI HY EMBIG

* Projected using our stylized model, which is a 3-year regression of spreads and prices versus KBW bank stock index, risky asset supply as a percentage of total supply**, jobless claims, overall contagion index***, and the size of the Fed’s securities holdings. ** ABS, CMBS, and corporate fixed-rate supply as a percentage of total supply including those three asset classes and MBS, Agency debt, and Treasuries. *** Overall contagion index is calculated as an average of z-score of EUR 3m spot FRA/OIS, USD 3m spot FRA/OIS, 2Y EUR/USD FX basis, EUR/USD spot FX, 5Y CDX, 5Y Itraxx main, S&P500, DJ Stoxx50, 20 day delivered on S&P500 and DJ Stoxx50.

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private sector credit continues to contract, as was the case in Japan. Business and household borrowing have contracted for 7 straight quarters, and we expect household debt, especially mortgages, to see further declines. In addition, with the need for businesses to tap external finance remaining very limited, we think private nonfinancial credit will likely continue to decline through the end of 2012 (see Exhibit 4 and Special Topic).

As we mentioned last week, the effect of this supply/demand imbalance can be seen in new-issue concessions, which have trended down towards zero in the high grade market. A similar phenomenon can be seen in the Agency debt market (Exhibit 5). Moreover, the new record low coupon for corporate debt set this week offers further evidence of strong demand. Thus, we continue to expect the supply/demand imbalance to remain a structural support for risky assets over the medium term.

Positive supply/demand technicals continue to support high grade, and this week, high grade bond spreads were mostly unchanged despite $25bn of new issuance. We continue to look for spreads to tighten over the medium term.

Supply has also been strong in mortgages, but despite increased supply and heightened call risk, we think mortgage valuations are fundamentally attractive versus competing assets, and we stay overweight.

In CMBS, super-senior A4 cash bond spreads widened this week, but we expect cash bonds to continue to benefit from the combined support of the reach for yield, strong supply/demand technicals, and more reasonable loss expectations. Specifically, we expect 2007-vintage bonds to tighten to inside S+250 by year end. We now also expect CMBX to outperform cash bonds by the end of 2010, particularly in high credit-convexity tranches.

In ABS, we continue to overweight subordinate and/or non-benchmark names, given that we expect technicals and fundamentals to remain supportive. On AAA plain vanilla, benchmark ABS we remain neutral: on one hand, high quality and liquid ABS offer attractive relative value versus Corporates and Agency debt, but on the other hand, incremental tightening on AAA ABS will likely be limited by the low absolute yields.

Finally, Agency debt represents the one exception to our positive view on credit spreads: we remain underweight 2-year Agencies versus Treasuries given rich valuations.

Exhibit 5: New-issue concessions have trended down in the Corporate and Agency debt markets, reflecting supportive technicals Average high-grade new issue concessions (principal weighted) versus 3-issue moving average of new-issue FNMA and FHLMC deal concessions* to similar-maturity secondary market paper on the day of pricing (bp) (bp)

0

20

40

60

80

100

Jan 09 May 09 Aug 09 Dec 09 Apr 10 Aug 10

-4

0

4

8

12

16

20High-grade new issue concessions

Agency new issue concessions

* Concession is calculated as the spread between the new-issue yield and matched-maturity Agency par yield.

Exhibit 4: We expect private sector nonfinancial credit to continue declining through 2012 %ch saar, except as noted

2Q10 level 3Q98- 3Q08- 3Q10-($ bn) 3Q08 2Q10 4Q12 f

Total 24,278 8.6 -1.7 -0.6

Household 13,418 9.0 -2.0 -1.3

Mortgage 10,150 10.0 -2.3 -1.4

All other 3,268 6.4 -1.2 -1.1

Business 10,860 8.1 -1.4 0.2

Memo: Federal debt 8,628 4.0 25.5 10.7 Source: “Stand and delever: the ongoing contraction in US private credit,” Michael Feroli and Robert Mellman, 9/22/10. See also Special Topic.

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Economics Research US Fixed Income Weekly September 27, 2010

Robert MellmanAC Michael Feroli J.P. Morgan Chase Bank

5

Economics

August durables report points to continued solid growth in capital goods spending this quarter

Home sales remain severely depressed in August; homebuilders see more of the same this month

FOMC emphasizes that inflation is undesirably low and hints that LSAP is increasingly likely, reinforcing messages of the Bernanke Jackson Hole speech

Markets have responded: inflation expectations are up, the dollar is down, and risk assets have rallied

Recent reports on durable goods orders and on home sales and housing starts helped to fill in the picture of economic performance in August. The details of the durables report were stronger than expected and provide some assurance that capital spending is continuing to expand at a solid clip this quarter. But the news on housing remains gloomy. New and existing home sales remained severely depressed in August, and respondents to the September homebuilders survey report unchanged sales in September. Housing starts did bounce 10.5% samr from extremely low levels in August, but with most of the improvement coming from multifamily activity. Industry sources indicate that the decline in homeownership is starting to lift rental occupancy rates, and developers are beginning to increase supply.

The statement following the FOMC meeting reiterated two themes from Chairman Bernanke’s Jackson Hole address: that inflation is undesirably low and that the Fed is prepared to embark on another program of large-scale asset purchases. Fed communication in advance of action has been influencing financial markets in a substantial way, helping to raise market-based inflation expectations, drive down the value of the dollar, and support risk markets including equities even in advance of Fed action.

The upcoming calendar includes August reports on income and consumption and on construction (both Friday). Early reports on September activity (also on Friday) are expected to be mixed. Based partly on regional manufacturing surveys in hand, the ISM

Exhibit 1: Core capital goods shipments and new orders%ch saar over 3 months

-60

-45

-30

-15

0

15

30

45

2009 2010

New orders

Shipments

Exhibit 2: New home sales and existing home salesMn units, saar, both scales

0.2

0.4

0.6

0.8

1.0

1.2

2006 2007 2008 2009 2010 2011

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0New homes Ex isting homes

Exhibit 3: Housing startsMn units, saar, both scales

0.30

0.35

0.40

0.45

0.50

0.55

0.60

2009 2010

0.05

0.10

0.15

0.20

0.25

Multifamily

Single family

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manufacturing survey (Friday) is expected to decline 2.3 points to 54.0. Early industry guidance points to an increase in new car and light truck sales to 11.9mn saar this month from 11.4mn in August.

Durable growth for capital goods

Incoming durable goods orders declined 1.3%, but only because of a 40.2% decline in orders for civilian aircraft and a 4.4% decline in orders for motor vehicles and parts that reversed large increases in July. New orders excluding transportation rebounded 2.0% in August and reinforced other upbeat manufacturing indicators for August including the 56.3 reading for the ISM manufacturing survey and the 0.5% increase in nonauto manufacturing production.

The most encouraging part of the durables report for growth prospects is the 1.6% increase in core capital goods shipments, accompanied by an upward revision to the July figure (to 0.1% from -1.0%). More timely data still show that the trend in core capital goods shipments is slowing, from 17.4% saar in 2Q10 to about 10% in the current quarter. But these shipments, key source data for the estimate of spending on equipment and software in the GDP accounts, are tracking considerably stronger than seemed likely before this report was released. The much more volatile series on core capital orders rebounded 4.1% in August, but this followed an even larger decline in July. Core capital goods shipments have slowed to only about 2% saar growth so far in the quarter, hinting at a further moderation in growth of shipments and equipment spending next quarter.

Housing slump drags on and on and on

A good part of this past week’s economic calendar was devoted to updates on housing including home sales and housing starts.

Home sales still severely depressed: Declining mortgage rates have not done much to revive home sales, and both new and existing home sales for August were at severely depressed levels.

Existing home sales did manage to rebound 7.6% in August, but this seemingly encouraging report followed a 27.0% decline the month before. The August level of existing home sales, 4.13mn at an annual rate, was 17.8%

Exhibit 6: Value of dollar, real broad effective exchange rate Index, 2000=100

82

83

84

85

86

87

88

Jan Mar May Jul Sep

Jackson Hole

speech

Exhibit 4: Key US financial market variables %, except as noted

May 3 August 9 Aug 26 LatestEuro fiscal Pre-FOMC Pre-Jackson Hole

10-year Treasury 3.72 2.86 2.50 2.60

S&P 500 index 1202 1128 1047 1145

Dollar, real broad 83.9 83.8 85.1 83.1

Corp. credit spreads (bp):

High grade 114 136 143 140

High yield 587 673 709 672

5yr-5yr breakeven, Fed 3.13 2.49 2.22 2.70

Real 10-year yield 1.30 1.01 0.93 0.74

Exhibit 5: US interest rates %, Fed measure

2.2

2.5

2.8

3.1

3.4

Jan Mar May Jul Sep

0.7

0.9

1.1

1.3

1.5

1.7 5-y ear - 5-y ear

forw ard breakev en

10-y ear TIPs y ield (real)

Jackson Hole

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below the depressed average pace in 2008-2009 and was 22.9% below the average pace in the first half of this year that had reflected some benefit from the homebuyer tax credit. Indeed, August home sales were the second lowest (next to July) of any month in the history of this series dating back to 1999. And single-family existing home sales were the second lowest (next to July) for any month since 1995.

New home sales, which are based on contracts signed rather than closings, provide more timely information. And new home sales for August were also severely depressed. Sales of 288,000 at an annual rate were unchanged from July and not much above May’s 282,000 reading that had been the lowest in a series dating back to 1963.

More timely readings on housing demand were also downbeat. The September homebuilders survey was unchanged at 13, the lowest reading since March 2009. And mortgage purchase applications fell for the second consecutive week. The average level of purchase applications so far this month is up from the low June-July levels, but not by much.

Mixed news on starts: August housing starts surprised by rebounding 10.5% in August, with details of the report showing very different recent trends in the single-family and the multifamily segments of the markets. Single-family starts, accounting for almost 80% of the total, increased 4.3% in August, but this gain recaptures only a small part of the cumulative 25.4% decline between April and July. The August gain looks like an outlier in a still-weakening trend. Single-family permits fell 1.2%, the fifth consecutive monthly decline, and are at a level below starts. And, as noted, the homebuilders survey indicates that industry participants remain exceedingly gloomy about sales prospects.

Multifamily starts, in contrast, are on an improving trend from an extremely low level at the beginning of the year. Multifamily starts increased 36.0% in July and another 32.2% in August to a level nearly double the average pace in 4Q09-1Q10. Moreover, industry analysts look for further gains ahead from levels that are still considered to be extremely low. The REIS survey shows modest declines in apartment vacancy rates and modest increases in rents through the first half of the year, and industry sources indicate that these trends are continuing this

quarter. (Results are different from readings on rents and vacancy rates in official data in part because the REIS sample tends, on average, to be at the higher end.) To be sure, gains in multifamily housing from these levels will not do much to boost GDP since new multifamily construction comprises a minuscule share, less than 0.2%, of the overall economy.

The Fed talks and financial markets listen

Tuesday’s FOMC meeting reinforced the message that the Fed is moving toward additional large-scale asset purchases (LSAP). The first hint of a shift in policy came from the decision to reinvest the paydown of MBS into Treasuries announced at the August 10 meeting. This

Exhibit 7: Core PCE price index, with forecast for August %ch saar

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2008 2009 2010 2011

Ov er y ear ago

Ov er 3 months

Exhibit 8: Unemployment rate and core inflation rate %-pt dev from avg %-pt, 8qtr ch in oya

-2

0

2

4

6

85 90 95 00 05 10

-4

-3

-2

-1

0

1

Core

inflation, chgUnemploy ment rateSample



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was followed by Chairman Bernanke’s discussion of the efficacy of alternative policies to support growth, focusing on asset purchases, in his August 27 Jackson Hole speech. This week’s downbeat growth assessment and statement that the committee is “prepared to provide additional accommodation if needed” signals that the Fed is now likely to embark on Treasury purchases before year-end.

The goal of Fed balance sheet policy since the financial crisis began has been to influence the prices of the assets it purchases. To this end, a decision to purchase longer-term Treasury securities would be geared toward portfolio balance effects that lower longer-term interest rates. However, the Fed also operates through words and actions that communicate its broader policy objectives and path of future actions. In this regard, it has sent an important complementary signal about its objectives in recent weeks. The Committee has publicly stated for the first time that inflation has fallen to unacceptably low levels.

This message was first relayed in the Jackson Hole speech, in which the Chairman said “inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run.” It was reiterated in this week’s statement with a commitment by the FOMC “to return inflation, over time, to levels consistent with its mandate.” A stated goal of raising the level of US inflation implies that the Fed is moving much more aggressively than just acting against downside risks to growth. Although FOMC members employ different frameworks in forecasting inflation, the likely Committee consensus would see sustained above-trend growth and a significant fall in the unemployment rate as necessary to achieve this goal.

More bang for buck after Jackson Hole

There has been considerable skepticism about the effectiveness of monetary policy tools as the Fed reached the lower bound on policy rates. Despite this skepticism, it is impressive to see the size and breadth of the Fed’s impact on financial markets as it has talked about LSAP and its inflation objectives in recent weeks. To be sure, Fed policy is not the only influence, and these market shifts have also reflected incoming economic data that, while generally lackluster, have reduced the risks of a

double-dip back into recession. However, market movements appear to be directly responding to the signal from the Fed.

For purposes of tracking financial markets, it is useful to distinguish between three separate periods.

Stage One: Increasing prospects of weaker growth and lower inflation. The weeks and months after May 3 were followed by a period of troubling news out of Europe, a coincident marked downshift in many US economic indicators including employment, and increased concerns about the economy possibly slipping back into recession. From May until the August 10 FOMC meeting, the financial markets priced in increasing prospects of economic weakness and reduced inflation. Treasury yields declined, equity prices declined, credit spreads widened, and inflation expectations as measured by TIPS spreads moved significantly lower (see table on previous page).

Stage Two: Trends continue past August 10 FOMC meeting. Although the August 10 Fed decision to reinvest MBS prepayments was a surprise, the Fed’s commentary about this move suggested that it should not necessarily be viewed as a shift toward an easing bias. Several Fed official including the Chairman have explained that the decision was necessary just to keep the Fed on hold, as allowing prepayments to reduce the size of the Fed’s balance sheet would be a passive policy tightening. In addition, there was no change in the description of the inflation outlook in the statement. As a result, the August 10 FOMC meeting did not have any discernible influence on financial market performance. Through most of August, Treasury yields declined further, equity prices dropped, credit spreads widened, and market-measured inflation expectations continued to trend lower.

Stage Three: Jackson Hole is a turning point. Nearly half of Chairman Bernanke’s August 27 speech at the Jackson Hole conference was devoted to “Policy options for further easing.” While the Chairman did not provide much specificity about the path of policy, he explicitly expressed the Committee’s concern about inflation and recommended LSAP as the preferred policy tool. Financial markets reversed course immediately following this speech. Between August 26 and the September 21 FOMC meeting, Treasury yields rose, equity prices rose,

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the dollar declined in value, credit spreads narrowed, and inflation expectations increased significantly. These changes are broadly consistent with the view that the market was now expecting LSAP from the Fed that would, at a minimum, cushion downside risks to growth.

To be sure, other influences have contributed to swings in financial market variables since late August. The tone of the incoming economic data has been somewhat better. And some investors may be looking for the early November election to result in a Congress that is friendlier to business and to the financial markets. But the economic data have not been strong, and inflation news has been subdued. It does seem that the Fed’s commitment to reflation and its willingness to embark on another round of LSAP has been an important influence on financial markets since late August.

Against this backdrop, the statement following the Tuesday FOMC meeting largely reinforced the shift made at Jackson Hole with details adding support for those who think that the Fed will start to buy Treasuries in size later this year. The immediate financial market response to the FOMC statement was not dramatic. But by the end of the week the latest readings on market-based inflation expectations, the dollar, and equity prices were continuing to respond to a Fed that views inflation as undesirably low and is increasingly likely to resort to another LSAP program. Sample


Srini RamaswamyAC Meera Chandan Kimberly L. Harano J.P. Morgan Futures Inc., J.P. Morgan Securities LLC

10

Treasuries

The FOMC statement this week included an explicit recognition of below-mandate inflation, raising the odds of eventual QE expansion. Given this as well as growing risk of another round of FX intervention, we turn bullish on duration

We continue to expect curve flattening; QTD strength in equity markets as well as the likelihood of lower intermediate yields are supportive

Buy 7s and 10s rather than 2s and 15s

Security-specific dispersion in valuations is once again on the decline as Fed buying has resumed. Look for valuation differentials to converge as Fed buying results in a more homogenous Treasury market; buy cheap, low SOMA issues in the 2- to 3-day period before purchase operations

Remain bearish on TIPS breakevens

Market views

The highlight of the past week was clearly the FOMC meeting on Tuesday. Although the FOMC did not initiate any new policy measures at this week’s meeting, it indicated a heightened readiness to respond with further monetary stimulus. Most notably, the committee noted that inflation was now below levels consistent with its mandate. We believe this recognition by the committee increases the odds of further balance sheet expansion by the Fed, perhaps as early as at the next meeting in November. Unsurprisingly, given increased risks of QE expansion, yields declined and the curve fattened. All in all, 2-, 5-, 10-, and 30-year yields were 3bp, 9bp, 13.5bp, and 12bp lower on the week, respectively.

In recent weeks, we have highlighted the considerably positive backdrop for Treasuries, but maintained a tactically neutral posture in part due to near-term supply risks and technical positions. Looking ahead, we now return to our call for lower yields, given the prospects for QE expansion as well as rising risk of another round of FX intervention. Our model for 10-year Treasury yields (which includes the funds rate, Fed funds expectations, the structural deficit, trade surplus, and an

index of economic slack; see Exhibit 1) estimates a fair value for yields very close to current levels, before adjusting for any QE expansion. The implication is that virtually no chance of QE expansion is priced into markets currently; as we have estimated in the past, each $10bn 10-year equivalents of Fed buying per month will likely bias fair values lower by about 10bp. Thus, even a 50% chance of a $500bn expansion of QE (assuming a purchase horizon of 6 months and an average maturity of about 7 years) would bias fair values lower by almost 30bp, or closer to 2.25%. As we head toward the November meeting, we would expect markets to price in higher odds of QE expansion, which is likely to bias 10-year yields lower and closer to 2.25% (see revised Interest rate forecast under Forecasts & Analytics).

On top of QE prospects, the risk of another round of FX intervention appears to be growing as well. As our currency strategists had expected, USD/JPY has now retraced about 50% of the richening it experienced initially on the back of the Japanese FX intervention (Exhibit 2). On the margin, any actions undertaken by the MoF/BoJ to defend against dollar weakness would likely be supportive for the Treasury market. In sum, given that yields are not priced to the growing risk of QE expansion, and given some near-term risk of FX intervention, we now like long duration exposure.

Exhibit 1: Our model for 10-year Treasury yields shows a fair value close to current levels, indicating that rising odds of QE expansion are not priced in Fair value model for 10-year Treasury yields using regression between 1995 and 2010 (quarterly data) Variable Coefficient Current LevelFwd funds rate* 0.59 0.189

OIS curve** 1.10 0.376

Structural deficit*** 0.14 2.999

Trade surplus 0.10 -3.537

Slack**** -0.15 0.837

Intercept 2.10

Fair value 2.57

Actual 2.60 * Funds rate is measured as the 6-month forward Fed funds expectation ** Fed expectations is the 18Mx3m minus 6Mx3M OIS rate after 6/1/06 and the 2nd/6th constant maturity Eurodollar curve in the prior period *** Structural deficit calculated as the rolling 10-year regression intercept from regressing the 1-year forward-looking Federal budget deficit as a percentage of nominal GDP against the ex-ante nominal GDP growth and the ex-ante 1-year Federal budget deficit as a percentage of nominal GDP **** Economic slack index is average of 5-year Z-scores of the unemployment rate, capacity utilization and jobless claims

Sample



11

We also continue to expect yield curve flattening. As we noted last week, the quarter-to-date outperformance of equities is tactically supportive of yield curve flattening, as asset allocators rebalance portfolios to maintain their target allocations. This effect has historically been most pronounced in the last week of each quarter, and should bias the curve tactically flatter going into the middle of next week. Even beyond that, our medium-term bullish view on Treasuries is also supportive of a flatter 2s/10s curve, given that front-end yields are effectively anchored now that they are priced to no tightening whatsoever net of term premium.

Continued curve flattening is also likely to alter the carry profile across the curve, with its own implications. As seen in Exhibit 3, as the 2s/10s curve has steadily flattened since the start of the year, carry in longer tenors has improved relative to shorter tenors; specifically, carry and roll in the 7-year sector is now almost equal to that in the 5-year sector, and 10s are only slightly behind. Given the search for carry will likely persist in the current Fed-on-hold environment, this suggests that the 7- to 10-year sector should outperform the wings on the curve. Indeed, carry remains a key driver of the shape of the yield curve. we note that the composition of the Fed purchase program is also supportive of valuations in this sector: thus far in 2010, around 40% of the Fed purchases are occurring in the 6- to 10-year sector, more than that in any other part of the curve.

Fed purchase program and impact on Treasuries

When the Fed first started buying Treasuries as part of its large scale asset purchase program in 2009, there were significant dislocations in the Treasury market. For example, off-the-run/less liquid bonds were trading significantly cheap relative to on-the-run bonds, and given the lack of risk appetite and balance sheet among private investors, such cheapness persisted. However, as Fed purchases of Treasuries in 2009 increased, the overall level of mispricings/dislocations in the Treasury market (as measured by the root mean square error of the fitted Treasury curve) declined, as shown in Exhibit 4. With the resumption of Treasury purchases by the Fed now underway for over a month, the Fed’s purchase of Treasury securities is having a similar impact on Treasuries currently. Exhibit 6 also shows that as the Fed resumed its Treasury purchases in 2010, the RMS error of the J.P.Morgan Treasury par curve has begun to decline once again, and is now close to its 3-year lows.

Thus, risks of even further QE expansion would point to much greater homogeneity in valuations across the curve, and argue for initiating convergence trades between, say, similar duration issues with sufficiently different yields. However, while such convergence is likely to take place progressively, it is interesting to consider if issue

Exhibit 2: USD/JPY has now retraced about 50% of the richening it experienced initially on the back of the Japanese FX intervention USD/JPY

83.0

83.5

84.0

84.5

85.0

85.5

86.0

24-Aug 30-Aug 05-Sep 11-Sep 17-Sep 24-Sep

Before

interv ention

After interv ention

Exhibit 3: As the 2s/10s curve has steadily flattened since the start of the year, carry in longer tenors has improved relative to shorter tenors 3-month carry and roll in long positions in 10-year Treasuries minus that in 7-year Treasuries (bp) versus the 2s/10s Treasury yield curve (%) bp % (inverted)

2.22.32.42.52.62.72.82.93.0

Mar 10 Jun 10

-5.5

-5.0

-4.5

-4.0

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0 1.92.02.1

Sep 10

10-yr minus 7-yr carry and roll2s/10s Tsy yield curve (inverted)

Sample



12

selection and timing can lead to better tactical performance.

Indeed, buying cheap issues with low SOMA holdings close to (and ahead of) a purchase operation appears to produce such tactical outperformance. Specifically, we find that in the 2-3 day period before a purchase operation, securities in that maturity bucket with large positive yield errors that the Fed holds little of tend to richen the most. As shown in Exhibit 5, on average, issues that have yield errors relative to the fitted curve of greater than 4bp and are less than 10% owned by the Fed three days prior to the operation date tend to richen by an average of 2.5bp (i.e., their yield error declines by 2.5bp on average). This suggests that the decline in dispersion of valuations is being primarily driven by the richening of cheap, low-SOMA issues in the 2-3 day period going into a purchase operation, making such issues attractive longs.

The Fed is scheduled to conduct its next purchase operation on September 30 in the very long end of the curve. Exhibit 6 includes a list of issues that we believe will be eligible, have significantly positive yield errors to the fitted curve, and are not already near the Fed’s 35% SOMA portfolio limit.

TIPS

Over the past week, TIPS breakevens widened despite declines in nominal yields. All in all, 5-, 10-, 20-, and 30-year breakevens widened 8bp, 6bp, 5bp, and 3bp, respectively. Breakevens have now retraced the sharp narrowing over the second half of August, but they remain well below the average levels over the past year (Exhibit 7).

The outperformance of TIPS this week, despite the rally in nominal Treasuries, leaves breakevens looking very wide relative to the level of nominal yields (Exhibit 8). We think this outperformance was driven by speculation

Exhibit 4: As the Fed has resumed purchases of Treasuries, dislocations in the Treasury market as measured by the RMS error of the fitted curve have declined to close to 3-year lows Cumulative Fed purchases of Treasuries ($bn) versus the root mean square error of the J.P. Morgan fitted curve (bp); Grey box represents the most recent period in which purchase operations have been conducted $bn bp (inverted)

0

50

100

150

200

250

300

350

Mar 09 Jul 09 Nov 09 Mar 10 Jul 10

0

1

2

3

4

5

6

7

8

9

10

Cumulativ e Fed purchases of Treasuries

RMS error (inv erted)

Exhibit 5: Thus far this year, eligible issues with low-SOMA holdings and high yield errors have richened relative to the curve in the two-day period before the purchase operation Average change in yield errors of issues eligible for Fed purchase 2 days ahead of the Fed operation in that maturity bucket (bp) bucketed by the ex-ante percentage held in the Fed’s SOMA account (%) and the ex-ante yield error of the issue 3 days before the purchase operation (bp)

%ge held in SOMA (%)

<-4 -4--2 -2-0 0-2 2-4 >4 Total

0-10 1.0 0.0 -0.2 -0.1 -0.4 -2.5 -0.210-20 1.0 0.0 0.1 -0.3 -0.6 -1.4 0.020-30 0.3 0.2 0.1 -0.2 -1.3 -0.1 -0.1>30 0.1 0.1 -0.2 0.1Total 0.8 0.1 0.0 -0.2 -0.5 -2.1 -0.1

Ex-ante yield error (bp)

Exhibit 6: Issues with positive yield errors that are likely eligible for the upcoming Fed purchase operation As of 9/24/10

Cpn MatSize ($bn)

%ge held by Fed

Yld Err (bp)

DurationAge (yrs)

Special (%)

Remaining capacity ($mn)

8.000 11/15/21 31 30.7% 2.2 8.0 18.9 0.00 1,3158.125 8/15/21 10 31.0% 1.8 8.0 19.1 0.00 3765.375 2/15/31 16 14.6% 1.4 13.3 9.6 0.00 3,3546.250 5/15/30 17 16.6% 1.2 12.5 10.6 0.00 3,1326.125 8/15/29 11 26.0% 1.0 12.4 11.1 0.00 1,0067.625 2/15/25 10 21.6% 0.9 9.9 15.6 0.00 1,2764.500 8/15/39 41 8.7% 0.9 16.9 1.1 0.00 10,9084.250 5/15/39 39 13.9% 0.8 16.8 1.4 0.00 8,1967.500 11/15/24 10 20.9% 0.7 9.7 16.1 0.00 1,3566.250 8/15/23 23 21.2% 0.6 9.4 17.1 0.00 3,1266.875 8/15/25 11 17.6% 0.5 10.3 15.1 0.00 1,9444.375 11/15/39 45 5.8% 0.4 16.9 0.9 0.00 13,0087.875 2/15/21 10 19.2% 0.4 7.7 19.6 0.00 1,5954.625 2/15/40 45 6.5% 0.2 16.9 0.6 0.03 12,8145.500 8/15/28 12 21.9% 0.2 12.2 12.1 0.00 1,5385.250 2/15/29 11 19.0% 0.1 12.5 11.6 0.00 1,8134.750 2/15/37 17 17.6% 0.0 15.9 3.6 0.00 2,891

Sample



13

that the product would be included in a major global aggregate index. With index inclusion ruled out as a possibility for now (as of late Friday), we would expect breakevens to narrow as this inclusion-driven richening is reversed.

In addition to this near-term effect, fundamentals and technicals keep us bearish on breakevens. As the Fed noted in Tuesday’s statement, the outlook for inflation remains poor. The FOMC notably downgraded its assessment of inflation, writing that “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”

Technicals remain unsupportive for breakevens as well. Although dealer holdings of TIPS declined in the latest reading, they remain near their highest level since April 2009 and could remain a source of narrowing pressure on breakevens. In addition, inflation-protected mutual funds saw outflows for the seventh consecutive week, demonstrating the lack of demand for TIPS.

Next week Tuesday, the Fed will conduct its second TIPS purchase operation. In the previous operation, the Fed purchased $360mn TIPS, but given the Fed’s higher purchase target for the month, we expect purchases of about $550mn this time.

Exhibit 7: TIPS breakevens have retraced their narrowing in August, but remain at below-average levels 10-year TIPS breakevens; bp

140

160

180

200

220

240

260

Sep 09 Dec 09 Feb 10 May 10 Jul 10 Sep 10

Av erage

Exhibit 8: TIPS breakevens look very wide relative to the level of nominal yields Residual of 10-year TIPS breakevens regressed against 10-year nominal yields over the past 5 months; bp

-20

-10

0

10

20

30

23 Apr 23 May 23 Jun 24 Jul 24 Aug 24 Sep

Y=61.35(10Y y ield) + 3.63

R-sq = 89%

Sample


Meera ChandanAC Renee Park J.P. Morgan Securities LLC

14

Agencies

Two-year Agency spreads versus Treasuries remain at the narrow end of their recent range; stay underweight

The 5-year sector continues to appear cheap relative to 2s and 10s on a spread-to-Treasury basis

We discuss the recent sharp decline in custody holdings and attribute it partially to seasonality

New-issue concessions in Agencies have compressed similar to the trend observed in broader credit markets, likely on the back of better risk appetite by investors

Market views

Agency spreads versus Treasuries changed modestly over the past week: 2-year spreads were flat over the week while 5- and 10-year Agencies cheapened by 0.5bp and 2bp, respectively, versus Treasuries. Against swaps, the Agency spread curve flattened with the front end cheapening and the back end richening: 2- and 5-year Agencies cheapened by 3bp and 2bp, respectively, while 10-year Agencies richened by 1bp versus swaps. This week’s performance came amidst another round of new bellwether supply in the 5-year sector: FNMA issued $5.5bn of a new 5-year benchmark note. US investor participation in the issue was at the highest level historically (over the past decade) at 83.6%; on the other hand, central bank participation fell another 1.5% from the prior 5-year issue to 13.4%, the lowest level since August 2009. Given the modest move in Agency spreads versus Treasuries this week, our view on Agencies versus Treasuries is unchanged: we stay underweight 2-year Agencies versus Treasuries given that at a spread of 12bp versus maturity-matched Treasuries, spreads remain at the narrower end of their range and are more likely to widen rather than narrow. Instead, we continue to find value in the 5-year point versus Treasuries. As shown in Exhibit 1, extending maturities out from the 2-year part of the curve to the 5-year sector results in a spread pickup of around 19bp versus maturity-matched

Treasuries. On the other hand, extension from the 5-year sector to the 10-year sector (i.e., FHLMC 3.75% Mar-19s) results in a spread pickup of just 4bp. Given the shape of this spread curve, we remain overweight 5-year Agencies on the Treasury spread curve versus both the 2- and 10-year sectors. Finally, we note that we expect investor demand for the belly of the curve (i.e., the 5- to 10-year sector) to be quite high (see Treasuries), given that outright long positions in this part of the curve have the highest carry and roll on the entire curve, as shown in Exhibit 2. Given that Agencies are

Exhibit 1: Extending from the 2- to the 5-year sector offers a higher spread pickup than extending from the 5- to the 10-year part of the Agency curve versus Treasuries Slope of the Agency spread curve versus Treasuries between maturities (bp); as of 9/24/10

0

5

10

15

20

2s5s 5s10s 10s30s

Exhibit 2: Five-year Agencies offer relatively highercarry and roll relative to Treasuries 3-month carry and roll for outright long positions in Agency (FNMA and FHLMC) debt versus that in Treasuries (bp); as of 9/23/10

0

5

10

15

20

Apr 11 Jul 15 Oct 19 Jan 24 Apr 28 Jul 32

Treasury

Agency

Maturity dates

Sample



15

often used as a substitute asset for Treasuries, we expect that investors in the Agency market will also exhibit a preference for Agency debt in this part of the curve as well: because of the shape of the spread curve, 5-year Agencies offer 4-5bp of additional carry and roll over 3-month horizons versus Treasuries. Thus, given that we expect investor demand to be high for this part of the curve, we stay overweight the sector versus wings (i.e., the 2- and 10-year sectors) on a spread-to-Treasury basis. Supply-side technicals have remained supportive of range-bound Agency valuations as net MTD issuance for FNMA and FHLB has been at close-to-flat levels and has been negative for FHLMC at -$14bn (see Exhibit 3). Notably FNMA’s net issuance has continued to outpace that of FHLMC, a continuation of a trend we discussed a few weeks ago (the difference appears to be stemming from the way the two GSEs are treating delinquent loan buyouts; while FHLMC is selling securities to create room for loans and keeping the overall portfolio size unchanged, FNMA’s portfolio appears to be increasing in size; see US Fixed Income Weekly, 9/10/10). Looking ahead, we expect issuance from FHLB to stay flat-to-negative given that banks remain flush with cash as current deposit growth is high and loan growth is negative. FNMA’s net issuance will likely remain flat as well, given that its portfolio is currently modestly higher than its year-end limit of $810bn. While it can grow up to $900bn intra-year, we expect further growth, if any, to be very modest. The only significant source of supply could be FHLMC, since as of the end of August, its portfolio size was $94bn below its year-end portfolio limit. However, even despite the recent cheapening in mortgages, any such growth has not materialized thus far as indicated by the MTD net issuance of -$14bn. In the event this supply does materialize, we expect that FHLMC will first issue discos and subsequently gradually term out the issuance. Given the high level of investor demand, we do not believe this will likely impact valuations significantly. In our view, demand-side technicals remain generally supportive of range-bound valuations as well, even despite the recent dramatic decline of $81bn over the past 7 weeks from peak-to-trough and $46bn over the past week alone in custody holdings in Agencies (debt and MBS; see Exhibit 4). While at least part of this decline is attributable to summer seasonals, the decline thus far this year is far in excess of history: the peak-to-trough decline

year-to-date has been $81bn, compared to the peak-to-trough of around $40bn in the summer period last year. While it is currently unknown whether this selling came via MBS or debt, spread movements in the Agency debt market suggests that the demand technicals in the sector still appear strong. For instance, new-issue concessions have narrowed to close-to-flat levels, and have remained relatively narrow, mirroring other asset classes (Exhibit 5). Moreover, the Agency market has absorbed huge amounts of supply in recent weeks without any significant impact on spreads. This month, the Agency debt market has had two rounds of new 5-year bellwether issuance totaling $10.5bn, the largest amount of FNMA and FHLMC bellwether supply in the 5-year sector since early’09. In combination with the 50-year TVA issue from last week, this month’s 5-year bellwether issues

Exhibit 3: FNMA month-to-date net issuance has been at close-to-flat levels while FHLMC net issuance has been negative YTD net debt issuance by issuer and debt type ($bn)

Discos Long-term Total Discos Long-term Total1Q'10 0 2 2 11 26 372Q'10 50 13 63 -22 -6 -29

Jul 1 - Jul 29 5 -4 1 -13 -28 -41Jul 29 - Sep 2 -27 5 -23 2 -17 -14

Sep 2 - Sep 23 -9 9 0 7 -20 -14Total YTD 18 25 44 -16 -45 -60

FNMA FHLMC

Exhibit 4: Central bank custody holdings of MBS and Agency debt has fallen dramatically by $81bn from the peak over the past 7 weeks Agency Securities held in Custody for Foreign Official & International Accounts ($bn)

700

750

650

800

850

900

950

1000

2008 2009 2010

Source: Federal Reserve

Sample



16

bring September’s month-to-date duration supply in the Agency market to $8.3bn of 10-year equivalents, significantly higher than the YTD average monthly duration supply of FNMA and FHLMC bellwether issues of $2.7bn. Finally, we note that the custody holdings series tends to overstate the net decline in Agency holdings, especially if the declines are coming via MBS, since these holdings are reported at original face and not current face. Thus, given this discussion, we do not view the recent decline in custody holdings as a huge negative for the Agency debt market. Callable redemptions and gross issuance of callables for FNMA, FHLMC, and FHLB have continued to be elevated with $55bn in redemptions month-to-date in September, which is tracking to reach $72bn for the month if they continue at their current pace. Furthermore, with the Fed on perma-hold, at the current level of interest rates, we expect that 90% of European callables with call dates over the next 3 months are in-the-money to be called, or 70% over the next year (Exhibit 6), and we thus expect callable redemptions to continue to maintain their high pace in the coming months.

Exhibit 5: Agency debt market new issue concessions have compressed in recent months, likely reflecting a stronger risk appetite Average high-grade new issue concessions (principal weighted) versus 3-issue moving average of new-issue FNMA and FHLMC deal concessions* to similar-maturity secondary market paper on the day of pricing (bp) (bp)

0

20

40

60

80

100

Jan 09 May 09 Aug 09 Dec 09 Apr 10 Aug 10

-4

0

4

8

12

16

20High-grade new issue concessions

Agency new issue concessions

* Concession is calculated as the spread between the new-issue yield and matched-maturity Agency par yield.

Exhibit 6: 70 percent of European callables with call dates in the next year are currently in-the-money to be called FNMA, FHLMC, and FHLB European callables grouped by call date and moneyness ($bn; as of 9/20/2010)

0

5

10

15

20

Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep

Out-of-the-money

In-the-moneySample

High Grade Strategy and Credit Derivatives Research US Fixed Income Weekly September 27, 2010

Eric BeinsteinAC Andrew Scott, CFA Dominique D. Toublan Miroslav Skovajsa Anna Cherepanova J.P. Morgan Securities LLC

17

Corporates

HG bond spreads were little changed on the week despite significant new supply, weaker economic data, and lower Treasuries yields

Inflows into HG bond funds were strong once again. Issuance from non-US borrowers continues to increase; we discuss the qualitative considerations and the math of issuing in one currency and swapping into another

YTD there have been $227bn of share buybacks versus $87bn in the first three quarters of 2009

Most companies announcing buybacks have significant cash and/or strong FCF generation such that they can return more cash to shareholders without meaningfully impairing their credit metrics, however

We analyze buyback trends by rating, sector, leverage, and cash on the balance sheet

Our updated cohort analysis comparing default history to ratings highlights how cheap HG spreads are versus historical default trends

It suggests BBB bond spreads are tight compared to A rated bonds

High Grade bond spreads were mostly unchanged this week, though strong demand was evident in the successful placement of $25bn in new issue. Bond spread volatility has been muted recently despite the Fed announcement about potentially purchasing more Treasuries, weaker data on employment, significant supply, and weakening of sovereign credit markets in Europe.

This week we focus on four topics1

Share buybacks. Buybacks are increasing, and this trend is likely to continue. We analyze the sectors, ratings, cash positions, and leverage of the companies doing the buybacks, which are concentrated in companies with either significant cash balances or strong free cash flow

1 We discuss two of the four topics (Share buybacks and European issuance and relatively pricing) at length in this report.

(FCF) generation. Buybacks are, therefore, unlikely to impact the trend of improving credit metrics.

European issuance and relative pricing. Yankee bond issuance is 45% of new supply this year, a record percentage. This is driven by European banks’ significant refunding needs and their desire to broaden their investor base. It is not driven by currency swap rates, as the cost of issuing in dollars or euros is the same; currency swap rates that are favorable for Europeans to issue in dollars are almost exactly offset by the higher spreads that dollar investors demand compared to European investors. This offset has generally taken place historically as well, implying an absence of arbitrage. We explain the mechanics of this in the following pages. Also, half of the companies in our HG bond index have euro-denominated debt as well as US dollar-denominated debt, leading to significant correlation between the two markets.

Cohort analysis. HG bonds are very cheap based on a historical default analysis, even accounting for the downward ratings drift of the HG universe over the years. This has always been the case and remains so. AA rated bonds and A rated bonds appear too cheap to BBB rated bonds using this analysis, but BB rated bonds appear in line with BBB rated bonds. This complements our analysis from last week of relative pricing across ratings, which was based on carry and MTM volatility. In that analysis we found that A rated bonds and BBB rated bonds were too tight, and BB rated bonds too wide.

Private sector credit to shrink through 2012. This is the conclusion of an analysis from our economists, who looked at the drivers of household credit (mortgages, credit cards, auto loans, etc.) and business credit (corporate debt, commercial mortgages, etc.). They conclude that credit is likely to continue declining, as it has for seven quarters, as maturities and defaults will remain larger than new credit extension, in aggregate. This is consistent with our broader theme that the lack of supply of credit products will contribute to tighter HG bond spreads. We update our supply forecasts across products and summarize their conclusions as well.

Sample



18

Share buybacks

Share buyback announcements have surged in 2010 compared to the previous year, but credit metrics continue to improve as companies have significant cash positions and strong free cash flow generation.

US companies have announced $242bn in buybacks so far this year, compared with $49bn in the first three quarters of 2009. A similar story can be seen among companies that are in our JULI Index. JULI companies have announced $159bn of buybacks year to date, compared with $36bn in the first three quarters of 2009. Exhibit 1 shows that actual shares repurchased have been steadily increasing from 3Q09 to 2Q10. The four consecutive quarters of increase is mirrored by the companies in our JULI Index.

Looking at the JULI set of companies that have announced the larger buybacks we see that the largest buybacks were announced by the higher-rated companies. Also, the amount of the buyback is either well below the cash on hand, or the LTM free cash flow generation is larger than the buyback size. Buybacks are usually implemented over a period of up to two years, so the high free cash flow generation means these companies will not necessarily have lower cash balances at the end of the buyback programs.

Credit metrics are improving despite higher share repurchases

These share buybacks are a threat to high grade credit spreads only if they lead to lower cash balances, higher leverage, or a sharp increase in debt issuance, none of which is evident. Non-financial companies in our index generated record free cash flow in 2Q, and they have maintained cash balances approximately steady at a high level for the past year. This was true even in 2Q data, as capex increased. The data suggests that companies, in aggregate, need to pay out more to shareholders to keep cash constant, given the growing FCF. It is logical for companies to be returning greater amounts of cash to shareholders in this environment.

Across domestic issuers in the HG market so far this year, net debt issuance is very modest and EBITDA has

Exhibit 1: While buyback announcements have recently declined, actual share buybacks have been increasing since 3Q09

0

20

40

60

80

100

120

140

160

180

1Q04 4Q04 3Q05 2Q06 1Q07 4Q07 3Q08 2Q09 1Q10

Share buy backs by non-JULI companiesShare buy backs by JULI companies

$ bn

Source: Bloomberg, J.P. Morgan

Exhibit 2: Technology buybacks have been more visible lately,but the sector with the largest share buyback announcements this year has been Food and Beverage thanks to Pepsi’s and Philip Morris’s announcements in 1Q

Amount ann ($mn) 2Q10 Cash 2Q10

Leverage 2Q10 LTM FCF ($mn)

Cash/buybacks announced

Food/Beverages 39,490 21,754 1.74x 27,082 0.55

Technology 22,450 33,549 1.12x 29,659 1.49

Non-Food Retail 21,244 13,448 1.45x 16,221 0.63

Energy 12,000 9,260 1.53x 8,522 0.77

Capital Goods 11,831 15,412 1.36x 15,427 1.30

Healthcare/HMOs 10,900 38,283 1.43x 12,831 3.51 Pharmas/Medical Products

8,550 13,197 1.29x 8,863 1.54

Diversified Media 8,000 5,628 2.32x 4,977 0.70

Cable/TV 5,500 2,000 1.33x 2,767 0.36

Consumer Products 4,312 1,708 1.33x 3,765 0.40

Finance Companies 3,718 8,043 2.11x 1,955 2.16

Chemicals 3,350 1,930 1.25x 2,283 0.58

Transportation 2,925 1,168 1.83x 1,484 0.40

Food/Drug Retail 2,612 2,258 1.59x 4,044 0.86

Utilities 490 1,311 4.38x -51 2.68 Business/Consumer Services

280 604 1.08x 565 2.16

Average 9,853 10,597 1.70x 8,775 1.26 JULI average 1.99x


Sample



19

been growing so leverage has been falling as well. This has been the case as actual share buybacks have grown over the past four quarters. While there are some examples of companies stating that they were issuing debt specifically to fund share repurchases, Exhibits 1 and 2 show that most have either significant cash on the balance sheet or enough FCF to avoid this, and the issuance data suggests the same, in aggregate.

A closer look at Yankee issuance

Non-US companies issuing in the dollar market represent 45% of issuance this year, a record percentage.

The cost for a European company to issue in dollars and swap back to euros compared to issuing directly in euros varies significantly across companies. However, on average, issuers should be indifferent because dollar investors require a higher spread than euro investors, but the currency swap market offsets this difference almost perfectly, in aggregate. This is the case now and has been historically as well.

Therefore, there is no overall swap market driver for the heavy amount of European issuance, even though this matters issue by issue. Instead, it is driven by the significant funding needs of European issuers, particularly banks.

Overall, the US dollar- and euro-denominated markets are highly correlated, and the spread difference between them is mostly explained by the swap market. Again, this is true in aggregate, and correlation might be lower at the single-issuer level.

About 50% of outstanding bonds in each market is comprised of the same companies that have dollar and euro debt outstanding. This contributes to the high correlation between markets.

This year, Yankee issuance has been the largest of the last 10 years, both in relative and absolute terms. Yankee issuance is about 45% of total High Grade issuance so far this year, compared to an overall market weight of about 25% in the JULI. The total Yankee issuance in 2010 is likely to reach about $250bn, slightly more than last year.

Strategic reasons seem to be driving this large issuance. First, overseas companies that have US-based assets issue debt in the US market to match assets and liabilities. This reduces foreign exchange risks and rollover risks, and avoids using up bank lines for foreign currency swaps.

Second, companies are interested in diversifying their investor base. During the credit crisis, the primary market in the US remained mostly open while the EU market shut down periodically when there were disruptions. As a result, some issuers unable to access the market in Europe in 4Q08 came to the US market and were successful. This has been part of a pattern since the Euro market started: in times of stress, the Euro market closes faster and is much slower in recovering. The 2Q Euro shutdown underlined to foreign companies the value of investor diversification.

Third, local markets can be saturated as supply exceeds demand or investors are limited by concentration requirements on specific names. The US market is larger and more mature, and thus offers more sustained demand for some sectors.

Fourth, the economics of financing in USD and then converting the proceeds and future coupon payments into a local currency also plays a role. Companies can usually easily issue in a foreign market and currency, and swap back the cash flows into their local currency. They might thus be able to profit from attractive currency swaps levels to potentially reduce their borrowing costs.

As a concrete example, consider the 2.125% 2015 bond issued by France Telecom in the US market on September 7. This bond was initially priced at 82bp above US Treasuries. As the 5y swap spread was 18bp at that time, this corresponds to about $LIBOR + 64bp (as 5y Tsy + 82bp = 5y $LIBOR + 5y swap spread + 64bp). If France Telecom wanted to hedge the currency risk, it could swap $LIBOR to EURIBOR. At that time, the 5y currency swap was -25bp. Therefore, France Telecom effectively would have been able to borrow at EURIBOR+39bp (as 5y $LIBOR + 64bp + 5y currency swap = 5y EURIBOR + 39bp). Therefore, solely from the currency swap perspective, France Telecom would get cheaper funding by issuing in USD if its financing in EU was above 39bp over EURIBOR, and vice versa if the EU cost was below 39bp.

Sample



20

The basis between $LIBOR and EURIBOR is mostly driven by macroeconomic factors. The overall availability/scarcity of one of the currencies will directly drive it. In “normal” markets, the basis is thus small, as the USD and EUR currency markets are in a relatively balanced steady-state. However, the big disruptions of the credit crisis sent the basis awry. After Lehman’s default, the liquidity crisis in the US made the USD scarcer relative to the EUR. This drove the currency swap basis more negative. Currently, the basis is negative because of the relative abundance of EUR provided by the ECB.

However, an issuer’s cost of funding in a foreign market is also affected by other factors. Currently, the average USD spreads are higher than the average EUR spreads. Overall, this actually almost eliminates the benefit of the favorable currency swap basis described above. This is true in a general index, and also looking at pairs of bonds issued by the same company, with one bond in the USD and the other in the EUR markets. However, this is not true for every issuer, and issuing in USD rather than in EUR can potentially reduce cost.

The spread at which the same issuer can fund is not the same in different markets. There are a number of reasons for this. The most important are investor familiarity with the company, general demand for bonds, different regulatory and internal constraints (such as single-name limits), and the availability of alternative investments.

Exhibit 4 shows the average spread over USD and EUR swaps for HG companies in both markets, using the JULI and the JPM Euro credit index. It shows that the USD and EUR HG markets are highly correlated and that spreads are currently higher in the US, on average.

One might object that this spread gap is due to differences between the two markets regarding issuers and sectors compositions. However, the overlap between the two markets is quite significant. A set of large issuers with access to both markets forms the bulk of outstanding debt in both regions: about half of the total outstanding debt in the two areas is from issuers with bonds in each. Note that while these issuers account for half the debt, they are only 13% of the total issuer count, as large issuers have the biggest access to and stand to benefit from multiple markets. Nevertheless, as the

indices are market weighted, this considerable overlap in debt terms largely explains the significant correlation between the two markets.

To refine our analysis, we created a special index from pairs of bonds issued by the same company, with one bond in the USD and the other in the EUR markets. The conclusion is the same as before: US spreads are wider than EUR spreads. We chose only liquid bonds with similar maturity and coupon. Overall, we found about 150 pairs amounting to more than $200bn + EUR200bn of debt. This set is well diversified across ratings, tenors, and sectors.

Exhibit 3: Funding costs are lower in the USD than the EUR market as the currency swap basis is negative

-70

-60

-50

-40

-30

-20

-10

0

10

1998 2000 2002 2004 2006 2008 2010

EUR basis sw ap v s Libor

bp


Exhibit 4: HG spreads in the USD and EUR markets

0

100

200

300

400

500

600

Jan 06 Jan 07 Jan 08 Jan 09 Jan 10

USD HG creditEUR HG credit

bp, spread to sw aps

Source: J.P. Morgan

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21

The average difference between the EUR and USD bonds spreads was quite small before the credit crisis. The credit crisis drove this difference to quite significant levels, with US spreads as much as 120bp wider than EUR spreads. The current spread difference stands around -35bp for the pairs in our basket.

Therefore, while the average EU issuer might benefit from the favorable currency swap basis, the wider US spreads are unfavorable. In general, it seems that the benefit of the former almost balances the cost of the latter. However, while the average spread difference is compensated by the currency swap basis, individual Yankee issuers do find the USD funding attractive. A little less than half of the issuers in our basket do find favorable funding conditions in USD compared to EUR. The gain can be as large as 50bp for some of them.

Historically, the average spread difference has been compensated by the currency swap basis. Looking at the last four years, we find a strong relationship between the difference in the cost of funding to the currency swap (Exhibit 5). In other words, whatever benefit the average issuer derives from a favorable currency basis, it will generally pay in the form of costlier funding.

This analysis thus shows that controlling for the different composition of the two markets, there is little arbitrage a typical European-based issuer can derive from issuing in USD right now, even though some specific issuers might be able to do so. On average, the current higher cost of funding in USD makes up for the benefit of the favorable currency conversion. It also suggests that European issuers will continue to be active in the US market, as they end up paying about the same spread as issuing locally after accounting for both the market spread and the swap, but they get access to a deeper, more developed market.

Exhibit 5: Cost of funding difference (EUR-USD basis) less the currency basis tends to revert to zero

-100

-80

-60

-40

-20

0

20

40

Jan 06 Jan 07 Jan 08 Jan 09 Jan 10

Cost of funding difference (EUR-USD basis) lessthe currency basis

bp

Source: J.P. Morgan

Sample


Alex Roever CFA Chris Holmes CFAAC Josh Rudolph J.P. Morgan Securities LLC

22

Municipals

Both yields and spreads rallied this week, particularly in taxables. This correlation is FOMC-driven and has near-term legs

Supply technicals are also supportive of tighter BAB spreads in the near term. Risks to this view are lower Treasury yields and heavy 4Q supply

We provide brief updates on California, Harrisburg, and BABs extension

Moody’s placed GO ratings of New Jersey and Illinois on negative outlook; market reaction was muted

Market overview

Markets for both risk and duration traded up this week, as all financial assets would be reflated by further central bank easing (by the Fed, the Bank of England, and the Bank of Japan). Tax-exempt yields declined, but not enough to keep up with Treasuries, thus ratios increased (Exhibit 1). Taxable yields and spreads both rallied hard this week, for two reasons:

Treasury yields were bid lower as Tuesday’s FOMC statement positioned the Fed to resume asset purchases, with such an announcement likely on either November 3 (the day after Election Day) or December 14. The way the Fed opened the door to further purchases was by shifting its focus away from the level of growth and instead toward its other mandate—the level of inflation. With both observed and expected inflation levels distinctly below the Fed’s target, QE2 now seems highly likely.

BAB spreads tightened over the week (Exhibit

1), as the healthy absorption of supply is finally allowing investors to play catch-up versus corporates. A rated BABs are gaining particular traction after investors spent the past two months watching new AAA and AA deals go by without much of an A rated primary market. That changed modestly this week as AMP Ohio sold an index-eligible $300mn 2047 bond at T+215bp (15bp tighter than original price talk and now trading at T+207bp) and San Diego

Airport sold a $215mn 2040 bond at T+290 (10bp tighter than original price talk and now trading at T+270bp). Given limited supply, even after these two deals, A rated taxable yields continue to look cheap when adjusted for the levels of Treasury yields and corporate spreads (Exhibit 2).

These themes are likely to persist in the near term. Yields are supported, not only by our expectation of QE2, but also by our macro-economic outlook of tepid growth, muted inflation, and a Fed on hold for an extended period (see Treasuries). Lower-tier taxable muni spreads should be supported by a rather limited supply pipeline currently on the forward

Exhibit 2: Supply of A rated taxables has been limited, which is not reflected in relative yield levels Monthly BAB issuance ($bn) versus adjusted long maturity A rated BAB yields

0

2

4

6

8

10

12

14

A M J J A S O N D J F M A M J J A S***

AAAAAA and low er*

2009 2010

issuance v olume

A-rated y ield lev els**

(adj. for UST/corp lev els)

Source: Bloomberg, J.P. Morgan * “A and lower” includes BBB rated and non-rated, but 95% is A rated ** Model is based on rolling 1-month regressions, with the regression over the entire period defined as: 3.1111 + 0.640 * 30-year Treasury yield + 0.0037 * JULI 10-year+ spread; R2 = 82% *** September data is through 9/23

Exhibit 1: Over the week, yields declined and the 2s/10s AAA curve flattened, and AAA/Treasury ratios increased Basis points unless noted; as of close September 23, 2010; change since September 16, 2010

Tax-exempt cash market Taxable risk spreads

AAA yields/curve A-AAA spreads AAA/UST ratios

sector current chg bp current chg current chg sector current chg

2s 0.45% 0 59 0 106% 11% Long AA 161 -4

10s 2.31% -9 78 0 90% 3% Long A 245 -7

30s 3.69% -7 65 1 99% 3% Long BBB 322 -6

2s/10s 186 -9 19 0 -15% -8% MCDX.5 218 -9

10s/30s 138 2 -13 1 8% 0% MCDX.10 235 -4 Source: J.P. Morgan, Municipal Market Data, MSRB. Taxable cash spreads are 4-day moving average.

Sample



23

calendar. We note that spreads could be tested by sharply lower Treasury yields or a surge in BAB supply.

Updates

Below are updates on a few situations for which we have recently provided commentary:

California budget: Governor Schwarzenegger announced that he has “reached the framework of an agreement” with the majority and minority leaders of the Senate and the Assembly (together, the “big five”). While a few provisions are still being negotiated, there could conceivably be a more detailed announcement or even a vote in the next week or two.

Harrisburg: The first new development

occurred the Sunday just after we published our Harrisburg piece, when Governor Rendell advanced $3.6mn owed to the city later this year, allowing the city to avoid the contemplated GO bond default on 9/15. Additionally, the incinerator authority finally assembled a quorum to vote on its financial matters, and the City Council’s intention to vote this coming Tuesday, 9/28, on whether or not to hire a bankruptcy lawyer.

BABs extension: With the House passing the

small business tax incentives bill and with Congress debating defense authorization until it leaves next week, BABs extension seems all but certain to slip to the lame duck session. While the results of post-election sessions are notoriously difficult to predict, the DC analysts with whom we speak believe the extenders bill (including a one-year extension of BABs at 32%) has a 75% chance of passing.

Moody’s is moody about state ratings

With little hoopla, Moody’s placed the ratings of the general obligation debt issued by the State of New Jersey (Aa2) and by the State of Illinois (A1) on negative outlook. Moody’s now has nine states on negative outlook, while S&P has seven (Exhibit 3). Aside from wide budget gaps that were precipitated by recession-depressed declines in revenues, there was one very noteworthy common denominator associated with both downgrades: large unfunded pension liabilities.

The weakened funded status of many state and local governments has received much press this year as low equity valuations, anemic bond yields, and falling contributions crimped pension investment returns. Simultaneously, expensive benefit plans and demographic shifts have put upward pressure on pension liabilities. Regarding New Jersey, Moody’s took issue with the state’s lack of pension contributions in FY2010 and FY2011, which further deteriorated its funded ratio. Though New Jersey has enacted some measures to narrow the funding gap, these changes will be enacted gradually over the next seven years, and gaps will likely stay very wide in the first two or three years. The state has also proposed several changes to improve the health of its other post-employment obligations (OPEB), but these measures will likely face roadblocks from the legislature and affected unions, thus delaying or possibly preventing implementation. Illinois faces its own pension challenges. The state’s ability to fund its obligations rests on the Illinois Senate’s approval of a sizeable pension obligation bond offering, which Moody’s cites as a form of deficit financing. Like New Jersey, Illinois has instituted some measures to improve its pension funding situation, but these changes are considered immaterial relative to the size of its unfunded obligation.

Exhibit 3: Ratings of several states have negative outlooks Negativ e outlook by Moody 's Negativ e outlook by S&P

State current rating State current rating

Haw aii Aa1 Arizona AA-

Illinois A1 California A-

Kentucky Aa1 Florida AAA

Ohio Aa1 Illinois A+

New Jersey Aa2 Maine AA

Pennsy lv ania Aa1 Ohio AA+

Puerto Rico A3 Rhode Island AA

Rhode Island Aa2

Wisconsin Aa2

Source: Moody’s, Standard and Poor’s

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24

Market Reaction Undoubtedly, given ongoing negative headlines pertaining to the budget hardships of these states, market participants were hardly surprised by the switch to a negative outlook. Indeed, the market reaction was muted; spreads have actually compressed over the last two weeks against a backdrop of tepid supply, improving economic indicators, and better risk sentiment.

Sample


Michael FeroliAC Robert Mellman J.P. Morgan Chase Bank

25

Special Topic:

Stand and delever: the ongoing contraction in US private credit

Business and household borrowing have contracted for 7 straight quarters

Household debt, mortgages in particular, appears set for further declines

The need for businesses to tap external finance is limited

Private nonfinancial credit will likely continue to fall through end-2012

We look for a 28%-pt decline in the ratio of private nonfinancial credit to GDP by end-2012

During the Great Recession, credit extended to private nonfinancial borrowers contracted at the sharpest pace seen since modern records began in 1952, as both the supply of, and demand for, credit dried up. One year after the recession ended, credit is still contracting. While credit supply is still somewhat constricted, bank balance sheets are in a much better state and many capital markets have reopened. Although the supply of credit is gradually normalizing, demand for credit remains anemic. This state of affairs is likely to persist: we forecast that private nonfinancial credit will continue to shrink for at least the next two years.

There are three reasons to expect credit to continue contracting. First and probably most important is that, even though the economy is growing slowly, spending on credit-sensitive goods, such as housing and consumer durables, remains at depressed levels. This implies that gross credit origination is running below gross amortization for many types of credit. Second, three years after the credit crisis began, both borrowers and lenders seem to retain cautious attitudes toward new credit obligations. Finally, large write-downs are ongoing, reducing the amount of credit outstanding.

Our forecast looks for private nonfinancial credit to decline another 1.6% by the end of 2012, or about 3.4% in real terms. If realized, this would mean the ratio of

private nonfinancial credit to GDP, which peaked at 176% early last year, would fall to 148% by 4Q12. For households, the debt-to-income ratio is projected to fall to 106% by end-2012, down from a peak of 130% in 2007. The projected decline in private nonfinancial credit over the next two and a half years, about $400 billion, occurs at a time when the increase in federal debt should accumulate to more than $2.5 trillion, thereby altering the mix of final claims available to investors.

While the relationship between credit growth and economic growth is not the focus of this report, a few observations are in order on this link. First, contractions of credit that follow from a decrease in credit supply almost surely have a large, adverse effect on economic growth. Second, contractions of credit that follow from a decrease in credit demand are consistent with growth in the economy. The last four quarters bear witness to this correlation, or lack thereof: the economy did expand even as credit contracted.

When an economy is growing but credit-sensitive spending is at depressed levels, the origination of new debt will run below amortization, implying a decline of outstanding credit, even though economic growth is occurring. It is true that the boomiest expansions are accompanied by rapidly appreciating asset prices, which in turn fuel credit growth. So very robust expansions will tend to occur alongside increasing debt loads. Nevertheless, neither history nor economic theory predicts that contracting credit has to imply a contracting economy. This conclusion is implicitly embedded in the J.P. Morgan economic forecast, which looks for the next

Exhibit 1: Real private nonfinancial credit %oya

-5

0

5

10

15

52 57 62 67 72 77 82 87 92 97 02 07 12

Forecast

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26

two years of the recovery to proceed much like the first: modestly above-trend growth against a backdrop of still-contracting private credit.

The macro credit cycle

Most of this note takes a sectoral view on the determinants of credit demand—what macroeconomic factors will drive residential, consumer, and business credit needs. First, however, we step back and assess the credit cycle from a broader perspective. The notion of credit we focus on is credit extended to private nonfinancial borrowers. We exclude credit extended to public sector borrowers—primarily the federal government—because the determinants of public sector credit growth are quite different from those driving private sector leverage.

We also exclude credit extended to financial borrowers, as this amounts to double-counting credit. Over the past few decades the financial intermediation process has involved more layering. For example, whereas in the past a household mortgage may have been held on a bank’s balance sheet—and funded by depositors—now that same mortgage may have passed through many intermediaries of the shadow banking system, each of which may issue their own financial debt to fund their activities. Looking at total debt, including financial sector debt, may be useful for analysis of systemic fragility, but for thinking about the ultimate demand for credit, the credit of the nonfinancial sector is the relevant measure.

Focusing on private nonfinancial credit has the secondary advantage that this measure will likely be adopted by bank regulators—at the behest of the BIS—as the primary indicator of excessive credit growth that would trigger an increase in regulatory bank capital (see box on counter-cyclical capital buffers). As such, the properties of this variable may also be of interest to banking industry analysts and practitioners, as its behavior may determine capital requirements and thus banks’ return on equity. Like the BIS, we look at the gap between this series and its own long-run trend, which gives a rough measure of the credit cycle.

The rationale for detrending the credit-to-GDP ratio is to remove the long-run financial deepening process. One of the better-established empirical macroeconomic regularities is that the more developed an economy is—

looking at either a single economy over time or a cross-section of countries at a given point in time—the greater the amount of credit market debt per unit of GDP. Financial deepening is not a bad thing in itself. To the contrary, a well-established finding is that financial

Exhibit 2: Private sector nonfinancial credit %ch saar, except as noted

2Q10 level 3Q98- 3Q08- 3Q10-($ bn) 3Q08 2Q10 4Q12 f

Total 24,278 8.6 -1.7 -0.6

Household 13,418 9.0 -2.0 -1.3

Mortgage 10,150 10.0 -2.3 -1.4

All other 3,268 6.4 -1.2 -1.1

Business 10,860 8.1 -1.4 0.2

Memo: Federal debt 8,628 4.0 25.5 10.7

Exhibit 3: Ratio of private nonfinancial credit to GDP%

50

100

150

200

52 57 62 67 72 77 82 87 92 97 02 07 12

Forecast

Box 1: Counter-cyclical capital buffers

In order to dampen the growth of leverage during periods of rapid credit growth, the Basel Committee on Banking Supervision has proposed the introduction of counter-cyclical capital buffers. The proposal would require banks to hold more capital when credit growth is “excessive.” While details are still being worked out, “excessive” most likely means when the ratio of private nonfinancial credit to GDP is substantially higher than would be expected based on its long-term trend (the detrending recommended by BIS employs a one-sided Hodrick-Prescott filter with lambda set to 400,000). The buffer would kick in when credit to GDP is at least 2%-pts above its trend. If credit to GDP is 10%-pts or more above its trend, banks’ capital ratio requirements could increase by as much as 2.5%-pts.

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27

deepening tends to promote economic growth. At the same time, when that deepening occurs rapidly, it is often the destabilizing companion of a run-up in asset prices. An implication of the long-run trend of financial deepening is that there is no equilibrium or normal level of the credit-to-GDP ratio.

The gap between credit growth and its trend is a simple but fairly robust measure of credit cycles. While they have been discussed for over a century, there are only a few credit cycles in the modern measured era. Looking outside the US only marginally broadens that data set. Most large postwar credit booms occurred in emerging economies with fixed exchange rate regimes. Probably the most relevant comparison for the US is the Nordic economies of the early 1990s. All three Nordic economies experienced a significant increase in household indebtedness in the late 1980s. After the Nordic credit cycle turned, the ratio of credit to GDP declined for six years, by an average of 39%-pts in the three countries. In the US, so far credit to GDP has declined for a year, and the ratio has declined 7%-pts, from 176% to 169%. We look for a 28%-pt decline by 2012 (the end of our forecast horizon), but after that, even if credit growth resumes, it’s conceivable that nominal GDP will grow faster than credit and, hence, that the ratio of credit to GDP will fall in line with the Nordic experience.

More generally, a few observations can be made about credit cycles:

They occur with asset price booms. The relationship is bidirectional: more available credit fuels asset prices, and higher asset prices require more credit to fund their purchase.

They have a lower frequency than business cycles. While all credit cycles are associated with business cycles, not all business cycles are associated with credit cycles.

They display significant persistence. When credit is on the upswing or the downswing, it generally continues moving in the same direction for a few years.

While credit cycles may share some features, each has its own story. The recent credit cycle in the US is no different. As the accompanying charts illustrate, the increase in private credit was mostly a story about residential mortgage credit, which followed and also

The burden of household debt

It may seem obvious that household debt can lead to unwanted outcomes. But starting from first principles, that wouldn’t be entirely apparent. The reason is that the creation of a financial liability implies the creation of a financial asset. For every borrower, there is a lender. Because the household sector ultimately owns the business sector, after consolidating balance sheets, the household sector’s net wealth should not have been affected by the increase in leverage that occurred during the years of the housing boom. This “net” view is an oversimplification for three reasons:

The US is not a closed economy. During the boom years, the increase in household credit was aided by massive current account deficits, and so consolidating across domestic, private sectors of the economy left a residue of greater indebtedness in the US private sector to foreigners that remains a persistent financing burden.

There is no homogenous “representative” household. During the credit boom, households weren’t uniformly building up financial assets and obligations. Rather, some were building up assets, and others—particularly the young and homeowners—were building up obligations.

The same net wealth position becomes more unstable at higher levels of leverage. Smaller percent declines in asset prices are more likely to leave households underwater when leverage increases. This effect becomes magnified when considered in conjunction with the preceding point that the increased indebtedness was not uniformly realized across demographic groups.

Exhibit 4: Financial deepening % of GDP

50

100

150

200

52 57 62 67 72 77 82 87 92 97 02 07

Priv ate nonfinancial credit

Trend

Sample



28

reinforced the path of rising house prices. Less appreciated is the fact that nonresidential household debt also increased briskly and that business debt rose at an above-trend clip.

The credit cycle has turned: private nonfinancial credit has contracted in each of the past seven quarters. This turn has brought the BIS credit gap measure back below its long-run trend. But we project that this turn in the credit cycle is not yet complete, and credit could continue contracting in the medium term as private spending units reduce the leverage in their balance sheets. The remainder of this note looks first at households and then at businesses in order to gauge where private credit may be headed.

The household balance sheet

To examine the household sector’s demand for credit, we first take a holistic look at household credit demand and then, in a parallel approach, examine the demand for various types of credit.

Neither history nor economic theory provides a firm guide to where household leverage “should” be heading. Some measures of leverage, however, have shown more stationarity than others. For example, leverage measured as household debt relative to assets has a more stable average value than household debt relative to income. By one measure, the household debt service burden, some degree of normalcy has returned, as this is back down to pre-boom levels. However, that is only because interest rates are at historic lows, and if interest rates move up, further deleveraging probably needs to take place.

To get some sense of how leverage could evolve if present trends continue, it is first helpful to look at the link between leverage and saving. The crucial part of this link is the two equivalent ways of defining saving:

saving = income - outlays

. . . or . . .

saving = asset accumulation - debt accumulation

The former definition is more familiar to economic data users, but the latter is more useful when thinking about credit growth. A household could save $100 by acquiring $100 of assets and incurring no debt, by acquiring $500

Exhibit 5: BIS credit gap Percent deviation of credit/GDP from its trend

-10

-5

0

5

10

15

52 57 62 67 72 77 82 87 92 97 02 07

Exhibit 6: Private nonfinancial credit % of GDP

0

20

40

60

80

52 57 62 67 72 77 82 87 92 97 02 07

Business

Residential mortgage

Other household, inc. consumer credit

Exhibit 7: Household leverage %, debt/assets

10

12

14

16

18

20

22

24

60 65 70 75 80 85 90 95 00 05 10

Sample



29

of assets partly financed with $400 of new debt, by running down assets $200 and decreasing debt loads $300, or an infinite variety of other combinations of gross asset and liability flows.

What is interesting about recent household saving is that for every quarter since 4Q08, households have saved by reducing liabilities, often to such an extent that assets were also run down. This is particularly striking when one considers that for every quarter prior to 4Q08—data collection began in 1Q52—US households saved by accumulating both assets and liabilities. In the following section, we look at the types of liabilities on the household balance sheet and conclude that the recent pattern—households using saving to reduce debt—is likely to persist for some time to come.

Forecasting mortgage debt outstanding

The manifold ways in which saving can translate into household asset and liability positions can be seen in housing investment. While a typical home purchase involves some saving—the down payment—most of the asset accumulation is matched by debt accumulation, thereby levering up balance sheets. With home sales and home prices now at much more modest levels, that levering process has effectively halted.

This is particularly important since household mortgage debt outstanding accounts for almost 80% of the credit market debt of the household and nonprofit sector. The rate of growth of the total amount of household mortgage debt shifted from sustained double digits over many

years to a 3.0% decline in the year ended 2Q10. In our analysis of this category, we start with mortgage debt excluding borrowing against home equity.

The change in mortgage debt outstanding over the next few years will depend on the new financing that is extended to home buyers. But it will also depend on the mortgage debt that is erased through amortization payments, foreclosures, and other payments. Estimates of each of these components is necessarily approximate. But it is hard to escape the general conclusion that continued modest percentage declines in mortgage debt outstanding

Exhibit 8: Gross asset and liability flows of the household sector % of disposable income

-10

0

10

20

30

52 57 62 67 72 77 82 87 92 97 02 07

Asset accumulation

Debt accumulation

4Q08-2Q10

Exhibit 10: Forecast of residential mortgage debt$ bn, except as noted; ex home equity loans

2009 2010 2011 2012New home sales (000s, saar) 374 340 374 411

Existing home sales (000s, saar) 5,160 5,150 5,408 5,678

Average price ($000s) 220 220 220 220

Dollar spending on houses 1,217 1,208 1,272 1,340

Loan to value 0.75 0.75 0.75 0.75

Share of purchases with mortgage (%) 0.95 0.95 0.95 0.95

Mortgage loan originations 867 861 906 954

Amortization+curtailment 199 187 185 183

Home sellers' cancellation 484 483 508 533

Net foreclosure cancellation 345 344 361 379

- Total repayments 1,028 1,015 1,054 1,095

+Cash-out refis 70 40 40 40+Other 6 6 6 6=Change in regular mortgage debt -85 -108 -101 -95

Mortgage debt outstanding (ex home equity) 9,353 9,245 9,143 9,049

Percent change -0.9 -1.2 -1.1 -1.0

Exhibit 9: Household mortgage debt and disposable income%oya

-10

0

10

20

30

40

00 01 02 03 04 05 06 07 08 09 10 11

Home equity loans

All other

Sample



30

will continue over the next year or two, even if home sales start to revive.

Exhibit 10 incorporates one method of adding up the likely new financing that will be used for home purchases and the reduction of existing debt through amortization payments, foreclosures, and the like. Values for many of the parameters’ underlying calculations were chosen with the advice of the J.P. Morgan mortgage research group. But one message from the exercise is that the forecast is relatively insensitive to the precise values chosen for these parameters.

Mortgage loan originations: The first part of the forecast is a summing up of the funds required to finance total home sales. The dollar value of home sales is total unit home sales (the sum of new and existing home sales) times the average price of a house. The table incorporates actual 2009 values for nominal homes sales, provides values for this year based on readings to date, and supplies a baseline scenario for sales and prices through 2012. The scenario assumes that new home sales rise 10% from low levels in both 2011 and 2012, that existing home sales rise 5% both years, and that average house prices are unchanged.

The total increase in mortgage debt to finance the dollar value of home sales depends on the loan-to-value ratio. The forecast assumes an average loan-to-value ratio of 75% for each year. It might seem like this would be too high in the current credit environment, since virtually no conforming mortgages these days allow more than 80% loan-to-value ratios. But the FHA provides financing for nearly 20% of homes sold, often with a very small down payment required. There is also an adjustment to account for the fact that a small share of homes are purchased without a mortgage. The table shows new financing supplied of $867 billion in 2009, and this figure is expected to increase to $954 billion by 2012.

Repayment of outstanding debt: The value of mortgage debt outstanding did not increase by $867 billion in 2009 because there was also substantial repayment of existing debt. Guidance from mortgage research analysts suggests that amortization payments plus curtailments (monthly payments in excess of what is required under the mortgage agreement) amounts to about 2% of outstanding mortgage debt per year. Amortization and

curtailment payments combined are estimated at almost $200 billion in 2009.

The purchase of an existing home requires new financing, but the sales proceeds are also used in part to erase the debt of the seller. And the repayment of the seller’s debt must also be accounted for in the calculations. The average amount of debt paid off will vary, partly depending on whether the sale is a conventional sale or a foreclosure sale. About 30% of current existing home sales are foreclosure or other distressed sales, and this share looks likely to be maintained for the next couple of years, given the large number of homes already owned by banks and the large number of homeowners who are seriously delinquent on mortgage payments.

Exhibit 11: New home sales and Case-Shiller house price index Mn units, saar Sa, 1Q00=100

0.3

0.5

0.7

0.9

1.1

1.3

90 95 00 05 10

70

110

150

190New home sales

House prices

Exhibit 12: Value of cash taken out in mortgage refinancings $ bn ar, Freddie Mac estimates for prime conventional mortgage

0

70

140

210

280

350

95 96 97 98 00 01 02 03 05 06 07 08 10

Sample



31

One difference between usual sales and foreclosure sales is the sales price. Sales of homes in foreclosure are priced on average about 25% lower than sales by owners, and this is incorporated in the calculation of underlying estimates in the table. The other important difference for this exercise has to do with the seller’s equity in the home. The Fed’s Flow of Funds indicates that the average homeowner has mortgage debt equivalent to 62% of the home’s value and equity equivalent to 38%. Since many homeowners are underwater, and since these owners are much less likely to sell than others, sellers of existing homes are assumed to have a higher 45% equity stake in their homes; on average 55% of the seller’s home value is financed by mortgage debt that is erased at the time of the sale.

The three categories of repayments combined (amortization and curtailment; repayment of sellers’ debt in non-foreclosure sales; and repayment of debt in foreclosure sales) show total repayments in 2009 of $1,028 billion, a sum greater than mortgage originations. Repayments are expected to rise gradually over the forecast horizon and continue to exceed the value of mortgage loan originations.

Finally, two other lines are inserted in the table on the previous page. Mortgage cash-out refinancings also add to mortgage debt. Cash taken out in the process of refinancing is down enormously from the years of the housing boom. It appears to have declined to about $70 billion in 2009 on its way to $40 billion in 2010 and 2011. Homeowners are not in the mood to leverage up the way they did in the past. Moreover, many households do not have the equity in their homes to serve as collateral for home equity loans. And bank lending standards have gotten tougher. There is also a line in the table marked “Other” that is a small residual to force the 2009 sum to add up to the $85 billion decline in mortgage debt (ex. home equity loans) as shown in the Fed’s Flow of Funds estimates for 2009. This residual is assumed to remain constant over time.

Exhibit 13: Forecast of residential mortgage debt, with stronger sales growth $ bn, except as noted

2009 2010 2011 2012New home sales (000s, saar) 374 340 408 490

Existing home sales (000s, saar) 5,160 5,150 6,180 7,416

Average price ($000s) 220 220 242 266.2

Dollar spending on houses 1,217 1,208 1,594 2,104

Loan to value 0.75 0.75 0.75 0.75

Share of purchases with mortgage (%) 0.95 0.95 0.95 0.95

Mortgage loan originations 867 861 1,136 1,499

Amortization+curtailment 199 187 185 185

Home sellers' cancellation 484 483 775 1,023

Net foreclosure cancellation 345 344 232 293

- Total repayments 1,028 1,015 1,192 1,500

+Cash-out refis 70 40 40 40+Other 6 6 6 6=Change in regular mortgage debt -85 -108 -10 45

Mortgage debt outstanding (ex home equity) 9,353 9,245 9,235 9,280

Percent change -1.3 -1.2 -0.1 0.5

Exhibit 14: Nominal value of new home sales $ bn, saar

50

120

190

260

330

400

90 95 00 05 10

Exhibit 15: Share of mortgage loans in foreclosurePercent, nsa

0

1

2

3

4

5

90 95 00 05 10

Sample



32

The conclusion of this exercise is that, given expectations about home sales, home prices, and foreclosure rates, mortgage debt outstanding is likely to decline through 2012.

Growth won’t boost lending soon

The combination of historically low new home sales and historically high foreclosures means that mortgage debt likely will not grow in the near future. Exhibit 13 shows results from a scenario in which home sales and home prices rise appreciably in 2011 and 2012. In this scenario, both new and existing home sales are assumed to increase 20% next year; in 2012, average home prices are assumed to rise 10% each year, and foreclosure sales to decline to only 15% of total existing home sales. Even under these very bullish projections for the housing market, outstanding mortgage debt fails to grow next year and rises only slightly in 2012. Of course, if home sales fall, or what seems more likely, house prices fall further, then private nonfinancial credit will fall even more than we forecast.

Growth of mortgage debt is especially sensitive to nominal sales of new homes, because none of the proceeds are used to reduce the home mortgage debt of the seller. But the decline in both home sales and house prices over the past few years means that financing for new home sales is running dramatically below the average over the past decade. And even after a year of assumed good growth in 2011, nominal sales and new financing would still be at relatively low levels.

Similarly, home mortgage repayments (or, more appropriately, reductions in outstanding debt) are especially sensitive to foreclosures. Foreclosure rates are significantly above prior norms, just as nominal home sales are significantly lower. It would take much lower foreclosure rates, a distant prospect, to bring the effect of foreclosure cancellations back to historical norms.

No growth for home equity loans, either

The discussion of mortgage debt above ignored home equity loans, a category of mortgage debt that has grown explosively over the past 20 years. Federal tax law repealed the tax deduction for non-mortgage interest payments in 1986 and households, at least households with equity in their homes, found mortgage debt to be the dominant tax-advantaged (and thus lower cost) means of

Exhibit 16: Home equity loans and their share of total home mortgage debt $ bn, saar Percent

200

400

600

800

1000

1200

93 96 00 03 06 10

6.5

7.5

8.5

9.5

10.5Home equity loans

outstanding

Share of home

mortgage debt

Exhibit 17: Non-mortgage consumer credit $ tn

0.3

0.4

0.5

0.6

0.7

0.8

0.9

99 01 03 05 08 10

Credit

Auto

Exhibit 18: Non-mortgage consumer credit $ tn

0.0

0.1

0.2

0.3

0.4

0.5

0.6

99 00 01 02 03 04 05 06 07 08 09 10 11

All other consumer credit

Student loans

Sample



33

borrowing. Similarly, lenders found that mortgage debt collateralized by home equity to be generally safer than other debt.

Over the last decade when mortgage debt for home purchases was growing very rapidly, home equity loans were increasing even more rapidly. The value of outstanding home equity loans more than doubled between 4Q02 and 4Q06 (up an average 20.8% annually), and over this time home equity loans increased from 7.8% of all home mortgage debt to 10.2%.

Just as home equity loans grew much more rapidly than other mortgage debt during the housing boom, outstanding home equity loans have declined much more rapidly than other mortgage debt more recently. Total mortgage debt outstanding peaked in early 2008. In the two years through 2Q10, the value of outstanding home equity lines declined 11.6% while all other home mortgage debt outstanding declined 4.4%.

The ups and downs of home equity loans seem to move with swings in other mortgage debt, suggesting that they respond to similar influences. High levels of consumer and lender confidence, which tends to be buoyed by low and falling unemployment, boosts lending. Low borrowing rates tend to lift lending. And high levels of equity in the home tend to promote more lending. Borrowing rates are low and expected to remain relatively low for some time. But confidence levels are depressed. And homeowners have an unusually low share of equity in their homes. For the foreseeable future, the pendulum is likely to continue to swing from the prior rapid growth of household debt in the direction of household deleveraging.

Consumer credit also set to decline further

Of the remaining 20% of household sector debt that is not mortgage credit, most falls in the broad category known as “consumer credit.” Within this category, about 30% is auto loans, 32% is credit card debt, 22% is student loans, and the remaining 15% is other forms of consumer credit, including consumer installment loans. Since 2008, each category of consumer credit, except for student loans, has been contracting.

We begin our discussion of the outlook for consumer credit by looking at auto loans. In many ways, the auto loan story is similar to the one for residential mortgages: with sales still at a depressed level, the origination of new auto loans is running below the amortization of a stock that reflects higher sales in the past.

Generally, each quarter about 10% of the stock of outstanding auto loans amortizes or is otherwise reduced. New originations of auto loans, not surprisingly, track fairly well the pace of light vehicle sales. Given the J.P. Morgan forecast for vehicle sales, which sees the annual pace of sales gradually moving past the 12 million mark in the middle of next year, we would expect the decline in auto loans outstanding to finally come to a halt by the middle of 2012. Outstanding consumer credit for auto loans, which peaked at $830 billion in late 2005, stood at

Exhibit 19: Auto sales and auto loan originations Mn, saar $bn

8

10

12

14

16

18

20

99 01 03 05 08 10

20

40

60

80

100

120

140Light v ehicle sales Auto loan originations

Exhibit 20: Change in auto debt outstanding $ bn, quarterly rate

40

60

80

100

120

140

99 00 01 02 04 05 06 07 09 10 11 12

Forecast

New originations

Amortization and

other pay dow ns

Sample



34

$702 billion in 2Q10, and is expected to drift lower to $676 billion by the middle of 2012.

Turning to credit cards, the outstanding volume of this form of consumer credit ramped up in 2007 and 2008 to peak at $866 billion at the end of 2008. Anecdotally, some of the surge in credit card debt occurred as households turned to plastic to fund everyday expenses when the economy and labor markets turned down. As the downturn grew into a financial crisis, lenders cut back on the number and amount of credit available through credit cards. Reduced demand probably also contributed to a decline in credit card debt, and by the second quarter of this year, credit card debt was down to $744 billion.

Looking ahead, the prospects for the volume of credit card debt will hinge in part on how regulators, card issuers, and card networks respond to new regulation. In the middle part of the last decade, credit card debt grew more slowly than nominal GDP—in spite of one of the greatest credit booms in living memory. During this same period, debit card use surged. Consumers’ demand for credit cards turned out to be more about the convenience of card payments, rather than the need for credit per se.

If and when normalcy returns to the economy, it is natural to expect the trend in debit vs. credit card use to continue, which would limit credit card debt. Recent legislation gives regulators the power to cap debit card fees, and so its possible that issuers and payment networks may incentivize consumers to return to credit cards. This remains a wild card: its not certain how aggressive regulators will be. Moreover, issuers and networks could incentivize consumers toward less regulated charge cards, which on average carry relatively low credit balances. While acknowledging regulatory uncertainties, our baseline outlook is that the still-limited number of credit cards, along with the still-growing preference for debit cards, means it is more likely that credit card debt will continue to contract or else grow slowly.

Over the past decade the category of consumer credit that has grown the most is student loans, increasing over 400%. This growth has been the function of a number of factors: increasing college costs, a demographic increase in the number of college-age persons, and perhaps most importantly, a number of legislative changes that have

eased the conditions for obtaining federal student loans. Looking ahead, some of these trends should continue to support student loan growth. In recent years, student loan growth has moderated to around an 8% pace, we look for that trend to continue. The remaining category of consumer credit—all other loans—has been stagnant to declining for most of the past decade. We see no compelling reason to expect a meaningful change from that trend.

All told, we look for household debt to decline by about 3-1/4% in the two and a half years between mid-2010 and the end of 2012, with about equal percent declines in mortgage and consumer credit. If realized, that would take the ratio of household debt to disposable personal income to 106% by the end of 2012, down from 118% currently and 130% in 3Q07.

Exhibit 22: Credit card accounts opened and closed Mn, over prior 12 months

50

120

190

260

330

400

00 02 04 06 08 10

Closed

Opened

Exhibit 21: Number of credit card accountsMn

350

400

450

500

99 01 03 05 08 10

Sample



35

Business credit growth

Discussions of the leveraging or deleveraging of the US economy often focus on the household sector, and yet growth in business credit has been quite robust as well over the past 15 years. We first present some simple metrics on the measures of business indebtedness. In the aggregate data, the business sector is broken up into two subsectors: the corporate and the noncorporate. In terms of gross value added, the output of the corporate business sector ($6.8 trillion) is nearly three times that of the noncorporate business sector ($2.4 trillion). Yet for some categories of credit—such as C&I lending and commercial mortgages—the noncorporate business sector is actually more important than the corporate sector.

We present the indebtedness of the business sector in two ways: relative to national income (GDP) and relative to the assets of the respective subsector.

Looking at these two subsectors in these two ways, three points stand out. The most striking one is the continued long-run increase in business leverage. The trend is more consistent for both business subsectors when leverage is measured relative to GDP rather than to business assets. This is partly because the rise in asset prices that tends to coincide with increases in business debt masks the increase in leverage, at least so long as asset prices remain elevated.

The second thing that stands out is that when looked at relative to GDP, business leverage tends to be pro-cyclical, though with a long lag: leverage only picks up after recessions with a lag of several quarters to a few years.

Finally, and perhaps somewhat surprisingly, the leverage of the noncorporate business sector is greater than that of the corporate sector. Although corporate business has easier access to capital markets, noncorporate business has obtained ready access to collateralized funding: 73% of noncorporate business liabilities is commercial mortgages, as opposed to 12% for corporate business.

Projecting business credit demand

In normal times, business demand for credit will reflect the need for investable funds versus the ability of business to generate those funds internally. In addition,

Exhibit 23: Ratio of household debt to disposable personal income %

20

40

60

80

100

120

140

52 57 62 67 72 77 82 87 92 97 02 07 12

Forecast

Exhibit 24: Business debt % of GDP, both scales

25

30

35

40

45

50

55

60 65 70 75 80 85 90 95 00 05 10

5

10

15

20

25

30

Corporate

Noncorporate

Exhibit 25: Business leverage Debt as a % of assets

10

15

20

25

30

35

40

60 65 70 75 80 85 90 95 00 05 10

Noncorporate

Corporate

Sample



36

balance sheet considerations can affect whether firms deploy internal cash for investment projects or for retiring debt or equity. Our model for business debt growth incorporates these factors. In particular:

Capital spending: Both fixed investment and inventory investment positively affect the growth of business debt. The main force arguing for stronger business credit is capital spending growth. Through the first year of the expansion, business capital spending has been the stand-out performer of the economy. With corporate profit margins high and the cost of capital (internal and external) low, the outlook for investment spending growth remains solid. While we do not expect the heady capital spending growth of the first half of 2010 to be repeated, we do think business investment outlays will continue to grow at a pace in the high single digits.

Leverage: All else equal, when business leverage is high—as it is now—business debt growth is slower, as firms seek to bring their leverage down to more manageable levels.

Cash: Higher cash balances imply slower growth in business debt, as more investment projects can be met with internal stockpiles of cash. It should be noted that the current buildup of cash is not just a few tech and pharma companies, but rather a phenomenon that is observed across a wide range of industry groups.

Distance from recession: Shortly after recessions, business debt growth is slow, but picks up as expansions mature, even when holding constant other cyclical variables such as capital spending. There is a natural explanation for this phenomenon: although capital spending growth can be strong early in expansions, the level of capital spending is usually still quite depressed. That is the case now, and can be easily seen when one compares capex to internal funds. Even though business investment outlays have risen sharply early in this expansion, their level is still well below the pace at which firms are generating cash.

The J.P. Morgan outlook sees conflicting forces arguing for stronger and weaker business credit growth. Our econometric model, which incorporates these various forces, points to very weak business demand for credit. In sum, we expect credit market debt of the nonfinancial corporate business sector to be

about flat next year, and in 2012 to experience only very modest growth, around 2%.

Generally, the trend in noncorporate business credit tracks the trend in corporate business credit. However, there are reasons to believe that demand for credit from the noncor-porate business sector could be even weaker than that from the corporate sector. The main reason relates to the composition of noncorporate business debt. As mentioned earlier, a much greater share of noncorporate business debt is commercial mortgages: 73% of noncorporate credit market debt is commercial mortgages, as opposed to 12% for the corporate sector.

Unlike residential real estate, for commercial real estate there are few timely statistics on unit volumes of transactions and only a handful of commercial real estate price metrics. Because of this, it is difficult to perform

Exhibit 26: Credit growth and capital spending % ch, saar

-20

0

20

40

60 65 70 75 80 85 90 95 00 05 10

Nominal capital

equipment spendingCredit ex tended to

corporate business

Exhibit 27: Credit growth and inventory investment % ch, saar % of GDP

-10

0

10

20

30

60 65 70 75 80 85 90 95 00 05 10

-2

-1

0

1

2

3Credit ex tended to

corporate businessBusiness inv entory

inv estment

Sample



37

the same sort of projections we performed for residential mortgage debt to gauge where commercial mortgage debt outstanding may be headed. The same forces, however, are likely to be at work limiting the growth of commercial mortgages. In particular, commercial real estate prices are down significantly, so the value of new commercial mortgage origination is likely to run below the amortization and retirement of commercial mortgages.

Our forecast for growth of credit extended to the noncorporate business sector assumes commercial mortgage debt outstanding grows at the same rate as residential mortgage debt outstanding. For the remaining quarter of noncorporate business credit that is not commercial mortgages, we assume credit growth is the same as that for the corporate business sector. These projections imply that credit extended to the noncorporate business sector should decline about 2% over the next two and a half years. Together with our assumptions for corporate business debt—which sees about a 1.5% increase over that same period—we project that total credit extended to the business sector will increase 0.5% by the end of 2012, essentially unchanged from where it is now.

Adding it all up

Mortgages account for almost 60% of all credit extended to the private nonfinancial sectors. With property prices and sales well below their peaks, mortgage debt outstanding is likely to continue to contract. This fact alone is reason to expect overall private nonfinancial credit also to contract. Moreover, there are other forces at work that are leaning in the same direction. Consumer spending on durables remains at depressed levels, business balance sheets are already heavily levered, and more generally, in the aftermath of financial crises, credit usually contracts for several years. Not all the macroeconomic forces currently playing out point to credit contraction: the economy is growing, which will gradually bring with it an expansion of business and household credit demand. However, overall private nonfinancial credit growth seems unlikely to resume in the medium term.

Exhibit 28: Business cash assets % of GDP

0

2

4

6

8

10

12

60 65 70 75 80 85 90 95 00 05 10

Corporate

Noncorporate

Sample


Srini RamaswamyAC J.P. Morgan Securities LLC

38

Forecasts & Analytics

Interest Rate Forecast

Swap spread forecast*

Sep 24, 2010 Dec 31, 2010 Mar 31, 2011 Jun 30, 2011 Sep 30, 2011

Q4 10 Q1 11 Q2 11 Q3 11

Rates Forecast Forecast Forecast Forecast

Fed funds target 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25

3-month Libor 0.29 0.28 0.28 0.28 0.28

3-month T-bill (bey) 0.15 0.15 0.15 0.15 0.15

2-year T-note 0.44 0.55 0.55 0.55 0.55

5-year T-note 1.35 1.25 1.25 1.25 1.25

10-year T-note 2.61 2.25 2.25 2.25 2.25

30-year T-bond 3.79 3.50 3.50 3.50 3.50

Curves

3m T-bill/3m Libor 14 13 13 13 13

2s/5s 91 70 70 70 70

2s/10s 217 170 170 170 170

2s/30s 335 295 295 295 295

5s/10s 126 100 100 100 100

5s/30s 244 225 225 225 225

10s/30s 118 125 125 125 125

* Fed funds assumed to be 0.125% for Fed funds/3m Libor calculation.

Sep 24, 2010 Oct 24, 2010 Dec 23, 2010 Mar 23, 2011

1 M 3 M 6 M

Forecast Forecast Forecast

2-year sw ap spread 16 20 25 30



30-year sw ap spread -37 -33 -25 -25

*Forecast uses matched maturity spreads

Sample



39

Economic forecast

Credit spread forecast

Gross fixed-rate product supply*

%ch q/q, saar, unless otherw ise noted

10Q2 10Q3 10Q4 11Q1 11Q2 11Q3 2009* 2010* 2011*

Gross Domestic Product Real GDP 1.6 1.5 2.0 2.5 2.5 3.0 0.2 2.2 3.0

Final Sales 1.0 2.0 2.0 2.2 2.5 3.0 -0.3 1.5 2.9

Domestic Final Sales 4.3 1.4 1.7 2.0 2.5 2.8 -1.4 2.2 2.8

Business Inv estment 17.6 6.1 4.7 5.4 7.8 8.3 -12.7 9.0 7.9

Net Trade (% contribution to GDP) -3.4 0.6 0.3 0.2 0.0 0.2 1.1 -0.7 0.1

Inv entories (% contribution to GDP) 0.6 -0.5 0.0 0.3 0.0 0.0 0.4 0.7 0.1

Prices and Labor Cost Consumer Price Index -0.7 1.7 1.3 0.8 1.0 1.1 1.5 0.9 1.1

Core 0.9 1.2 0.7 0.4 0.6 0.8 1.7 0.7 0.7

Producer Price Index -0.3 1.5 1.0 0.7 0.7 0.8 1.5 2.6 0.9

Core 1.7 1.5 0.8 0.6 0.5 0.5 0.9 1.6 0.6

Employ ment Cost Index 2.2 1.6 1.2 1.0 1.2 1.3 1.5 1.9 1.2

Unemploy ment Rate (%, sa) 9.7 9.6 9.8 9.9 9.8 9.7 - - -

* Q4/Q4 change

CurrentYear-end

2010

10Y Swaps 0 1030Y current coupon MBS L-OAS 43 2510Y AAA 30% CMBS (non-TALF eligible) 295 2505Y AAA Credit Cards floating 30 25JULI I-Spread to Treasury 170 140High Yield Index 666 650Emerging Market Index 305 275Corporate Emerging Market Index (Broad) 322 300

0

50

100

150

200

250

300

350

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

ABS CMBS MBS Corporate Agency

* amount in $ billions

Sample



40

Client surveys

DurationLong Neutral Short Changes

Sep 20, 2010 27 57 16 10Sep 13, 2010 33 51 16 163-month average 22 63 16 12

Credit

Corporate Bond Weighting

Cash Position

Spread Outlook

Sep 9, 2010 1.36 1.11 1.40Aug 11, 2010 1.43 0.96 1.443-month average 1.42 1.01 1.60

*Corporate bond w eighting index is the ratio of the sum of ov erw eights and neutral

positions to the sum of underw eights and neutral positions; the cash position index

is the ratio of the sum of high and medium cash positions to the sum of low and

medium positions; the spread outlook index is the ratio of the sum of positiv e and

neutral outlooks to the sum of negativ e and neutral outlooks.

2 3 4

5 6 7

MBSOverweight Flat Underweight

July 2010 18% 16% 66%June 2010 28% 12% 59%3-survey average 23% 15% 61%

Treasury Client Survey

Credit Client Survey

-20

-10

0

10

20

30

May 09 Aug 09 Nov 09 Mar 10 Jun 10 Sep 10

Longs minus shorts

0.6

0.8

1.0

1.2

1.4

1.6

Feb 08 Aug 08 Feb 09 Aug 09 Mar 10 Sep 10

Corporate Bond Weighting

MBS Investor Survey

-60%

-40%

-20%

0%

20%

40%

Jul 09 Oct 09 Dec 09 Mar 10 May 10 Jul 10

Ov erw eight - Underw eight

Sample

1May 7, 2010

US Fixed Income Weekly

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Sample

US Fixed Income Strategy US Fixed Income Weekly New York, September 27, 2010

Market Movers

27 Sep Dallas Fed survey (10:30am) Sep Auction 2-year note $36 bn

28 Sep S&P/Case-Shiller HPI (9:00am) Jul 2.9% Consumer confidence (10:00am) Sep 54.0 Richmond Fed survey (10:00am) Sep Auction 5-year note $35 bn Atlanta Fed President Lockhart speaks on the economy in Tennessee (5:30pm)

29 Sep Auction 7-year note $29 bn Minneapolis Fed President Kocherlakota speaks in London (10:15am) Philadelphia Fed President Plosser speaks on the economy in New Jersey (12:30pm) Boston Fed President Rosengren speaks in New York (1:15pm)

30 Sep Initial claims (8:30am) w/e prior Sat 460,000 Real GDP (8:30am) 2Q third 1.7% Chicago PMI (9:45am) Sep KC Fed survey (11:00am) Sep

1 Oct Personal income (8:30am) Aug 0.3% Real consumption 0.2% Core PCE deflator 0.04%(1.3%oya) Consumer sentiment (9:55am) Sep final 67.0 ISM manufacturing (10:00am) Sep 54.0 Construction spending (10:00am) Aug -0.6% Light vehicle sales Sep 11.9mn New York Fed President Dudley speaks at SABEW conference in New York (8:30am) Dallas Fed President Fisher speaks on US economy in Vancouver (3:15pm)

4 Oct Pending home sales (10:00am) Aug Factory orders (10:00am) Aug

5 Oct ISM nonmanufacturing (10:00am) Sep

6 Oct ADP employment (8:15am) Sep

7 Oct Initial claims (8:30am) w/e prior Sat JOLTS (10:00am) Aug Consumer credit (3:00pm) Aug Chain store sales Sep Announce 3-year note $32 bn Announce 10-year note (r) $21 bn Announce 30-year bond (r) $13 bn

8 Oct Employment (8:30am) Sep Wholesale trade (10:00am) Aug

11 Oct Columbus Day Bond market closed

12 Oct NFIB survey (7:30am) Sep FOMC minutes Auction 3-year note $32 bn Kansas City Fed President Hoenig speaks on economy at NABE in Denver (11:45am)

13 Oct Import prices (8:30am) Sep Federal budget (2:00pm) FY10 Auction 10-year note (r) $21 bn

14 Oct Initial claims (8:30am) w/e prior Sat PPI (8:30am) Sep International trade (8:30am) Aug Auction 30-year bond (r) $13 bn

15 Oct Retail sales (8:30am) Sep CPI (8:30am) Sep Empire State survey (8:30am) Oct Consumer sentiment (9:55am) Oct preliminary Business inventories (10:00am) Aug Fed Chairman Bernanke speaks at Boston Fed conference (8:15am)

“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.”

__________________________________________________________________________________________________________________________

Analyst Certification: The strategist(s) denoted by (AC) certify that: (1) all of the views expressed herein accurately reflect his or her personal views

about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the

specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the

views expressed.

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