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US Fixed Income Strategy2 May 2011

AC

Indicates certifying analyst. See last page for analyst certification and important disclosures.

US Fixed Income Weekly

Cross Sector Srini Ramaswamy, Kimberly Harano We remain cautiously overweight risky assets given our expectation of an

improvement in economic growth, strong corporate profits, and ongoingstimulative monetary policy. Two exceptions are high grade and high yield

markets, where we take a neutral stance in the near term.

Governments Terry Belton, Meera Chandan, Kim Harano, Renee Park

Expect higher rates, targeting 3.60% in 10-year yields. Expect 7s/10s and 7s/30s

curve steepening into supply. We like 8% Nov-21s more than 2.5% Apr-15s and

6.625% Feb-27s. Stay long TIPS breakevens.

Investment-Grade Corporates Eric Beinstein

We stay tactically cautious as near-term risks are skewed more to the downside.

However, positive fundamentals highlighted by recent earnings reports keep us

bullish in the longer term, and we keep our YE spread target of 120bp.

Municipals Alex Roever, Chris Holmes, Josh Rudolph

Issuance is likely to pick up in May, but heavy June coupon and redemption

income should help mitigate some of the supply-induced cheapening.

Special Topic: The Domino Effect of a US Treasury TechnicalDefault T. Belton, S. Ramaswamy

We explore the systemic risks that would result from a technical default in the US

Treasury market. While unlikely, a default would have large systemic effects with

long-term adverse consequences for Treasury finances and the US economy.

Contents

Cross Sector Overview

Economics

Treasuries

Agencies

Corporates

Municipals

Special Topic

Forecasts & Analytics

Market Movers

Terry Belton

Srini Ramaswamy

Alex RoeverAC



US Fixed Income StrategyUS Fixed Income WeeklyMay 2, 2011

Srini RamaswamyAC

Kimberly L. HaranoJ.P. Morgan Futures Inc., J.P. Morgan Securities LLC

2

Cross Sector Overview

We remain cautiously overweight risky assets

given our expectation of an improvement in

economic growth, strong corporate profits, and

ongoing stimulative monetary policy

Risks to our positive view include higher energy

prices as well as renewed concerns about

peripheral Europe; in most spread product

sectors we view these risks as being outweighed

by the positives and we remain overweight on

balance. Two notable exceptions are high grade

and high yield markets, where we take a neutralstance in the near term

Stay bearish on duration; the rally over the past

month has provided attractive entry levels, and

we expect rates to rise as the supply/demand

imbalance worsens, Fed commentary likely turns

more hawkish, and carry trades are unwound in

front of payrolls

Wedding bells and warning bells

In the two weeks since we last published, a number of

historic events have taken place. First, Standard & Poor’srevised its US sovereign ratings outlook to negative

(while also preserving the current rating). S&P also

lowered its ratings outlook on Fannie Mae, Freddie Mac

and several Federal Home Loan Banks, as well as its

ratings outlook for Japan. Second, Wednesday’s FOMC

statement was followed by the first ever post-FOMC

meeting press conference, where Chairman Bernanke

fielded questions from the media. Third, Greek bond and

CDS spreads widened to record highs. All of these events

seemed to be eclipsed by the British royal wedding on

Friday, however, with equities as well as bonds rallying

globally. The celebratory mood proved insufficient to

spur a rally in fixed income spread product, however;

over the past two weeks, most spreads are modestly

wider, while peripheral Europe spreads widened by

considerably larger amounts (Exhibit 1).

Meanwhile, the tone of data has improved somewhat.

The preliminary 1Q GDP report showed that the

economy grew at a 1.8% annualized rate, better than our

forecast for 1.4% growth, while personal consumption

rose 2.7%, much stronger than expected. In addition,

housing data looked better, with housing starts, existing

home sales, and new home sales all rising in March,

though house price indices continued to decline. On the

Exhibit 1: Bonds and equities rallied, while credit

spreads widened over the past two weeksCurrent level,* change since 4/15/11, QTD change, and change over 1Q11 for various market variables

Current Chg from 4/15 QTD chg 1Q11 chg

Global Equities (level)

S&P 500 1360.5 40.8 34.7 68.2

E-STOXX 2977.6 58.5 66.7 118.1

FTSE 100 6068.2 72.1 159.4 8.8

Nikkei 225 9849.7 258.2 94.6 -473.8

Sovereign par rates (%)

2Y US Treasury 0.586 -0.102 -0.185 0.197

10Y US Treasury 3.416 -0.092 -0.122 0.148

2Y Germany 1.760 -0.073 0.033 0.939

10Y Germany 3.277 -0.147 -0.119 0.391

2Y JGB 0.190 -0.010 -0.005 0.034

10Y JGB 1.262 -0.088 -0.042 0.138

5Y Sovereign CDS (bp)

Greece 1560 258 468 86

Spain 232 1 -1 -116

Portugal 659 51 67 101

Italy 144 3 -3 -86

Ireland 683 96 21 57

Funding spreads (bp)

2Y EUR par swap - par gov't spd 57.4 0.8 -4.5 -18.3

2Y USD par swap - par gov't spd 19.6 2.6 1.1 -3.8

EUR FRA-OIS spd 21.5 -4.9 -4.7 -7.2

USD FRA-OIS spd 16.4 1.0 -4.3 1.3

1Y EUR-USD xccy basis -16.3 3.6 9.9 22.7

Currencies

EUR/USD 1.482 0.040 0.063 0.092

USD/CHF 0.873 -0.022 -0.042 -0.023

USD/JPY 81.62 -1.50 -1.15 1.46

JPM Trade-weighted USD 77.03 -1.18 -2.03 -1.71

Spreads (bp)

30Y CC MBS L-OAS 33.5 0.6 5.3 -2.4

JULI spd to Tsy 131.3 -1.8 -4.2 -11.7

JPM US HY index spd to worst 521.6 3.5 4.6 -66.0

EMBIGLOBAL spd to Tsy 303.9 4.1 5.1 10.3

MAGGIE (Euro HG spd to govies) 42.2 0.8 0.1 -6.8

US Financials spd to Tsy 148.6 0.2 -7.9 -13.7

Euro Financials spd to govies 144.6 2.3 -5.1 -29.4

10Y AAA muni/Tsy ratio (level) 84% -6.1% -6.4% -3.0%

30Y AAA muni/Tsy ratio (level) 104% -3.1% -2.7% -0.9%

Commodities

Gold futures ($/t oz) 1517.10 44.70 93.30 17.90

Oil futures ($/bbl) 112.86 2.64 6.14 15.34

* 4/28/11 level for Europe and US corporate credit spreads, Europe and Japan yields, UK andJapan equities, and the J.P. Morgan trade-weighted USD index; 4/29/11 level for all others.




Srini RamaswamyAC


3

other hand, the improvement in labor markets seems to

have slowed, as initial claims rose to 429K in the latestweek. Overall, however, the tone of data has improved,

leading our index of economic data surprises to rebound

from its lows, though it remains in negative territory

(Exhibit 2).

Going forward, we expect risky assets to continue to

outperform, for several reasons. First, we expect growth

to accelerate through the remainder of the year; we think

1Q growth was held back by severe winter weather and

rising energy prices, so we expect growth to pick up as

we move into the second half of the year.

Second, despite weaker growth of the overall economy,corporate profit growth remains robust. As Exhibit 3

shows, so far in the reporting season, earnings have been

beating estimates by about 7%, which is a larger margin

than the previous two quarters. Indeed, our equity

strategists have raised their full-year 2012 EPS estimate

for the S&P 500 by $3 to $105. As a result, they have

also raised their year-end target for the S&P 500 from

1425 to 1475. A continued rally in equities as we expect

will likely help other risky assets outperform as well.

Finally, monetary policy appears likely to remain

stimulative for some time. While this week’s FOMC

statement acknowledged that “inflation has picked up inrecent months,” it also noted that “the unemployment

rate remains elevated, and measures of underlying

inflation continue to be somewhat low.” The statement

also maintained its “extended period” language. Finally,

Chairman Bernanke’s comments in the post-meeting

press conference were generally in line with the view that

the Fed will maintain monetary stimulus for some time.

Thus, we expect monetary policy to remain supportive,

and as we have often noted, stimulative monetary policy

amidst tame core inflation and positive growth (even if

somewhat lackluster) makes for a supportive

macroeconomic backdrop for risky assets.

To be sure, risks to our positive view remain. First, the

ongoing crisis in the Middle East remains far from

resolved, and the risk of a further increase in energy

prices remain a headwind for economic growth.

However, our Middle East crisis index suggests that the

situation is stabilizing rather than worsening (Exhibit 4).

Second, peripheral Europe returned to the spotlight this

week, with Greece spreads widening significantly (by

258bp to 1560bp) as markets continue to anticipate an

eventual debt restructuring. However, contagion from

Greece seems limited thus far, since spreads in Spain and

Italy have remained rangebound. As a result, thesensitivity of US spread markets to peripheral European

risks has declined to near zero (Exhibit 5). Last, to the

extent that political deadlock around increasing the debt

ceiling intensifies in coming weeks, it poses a risk.

Although we fully expect the debt ceiling to be increased

by late June or early July (see Special Topic), the

absence of a quick and immediate resolution is likely to

temper risk appetite in the near term.

Exhibit 2: The tone of economic data has improved

somewhatJ.P. Morgan EASI*; level

-40

-30

-20

-10

0

10

20

30

Apr 10 Jul 10 Sep 10 Dec 10 Feb 11 Apr 11

* EASI is the J.P. Morgan Economic Activity Surprise Index and measures the number of positive surprises minus the number of negative surprises divided by the total number of data releases over the past 6 weeks.

Exhibit 3: 1Q earnings have been beating estimates byabout 7%% beat actual EPS vs. forecast for S&P 500; 1Q11E % beat is median % beat of companies reported so far; 1Q11E as of 4/28/11; %

-60%

-40%

-20%

0%

20%

1Q06 1Q07 1Q08 1Q09 1Q10 1Q11E




Srini RamaswamyAC


4

In some sectors such as high grade, we think these risks

balance the positive factors, so we are currently neutralon corporates (see Corporates). Similarly, in high yield,

we remain somewhat agnostic toward high-yield bonds at

these levels over the near term as spreads remain wide

relative to the expected default rate on one hand, but low

yields and mounting risks leave prices vulnerable (see

High Yield).

In most other sectors, however, we remain cautiously

overweight. In CMBS, although we do not see a near-

term catalyst for a rally, we expect the top of the capital

structure to continue grinding tighter and expect

investors to add exposure to wider-spread A4s, 2006/7

vintage AMs, and 2005/6 vintage AJs. In ABS, our firstConsumer ABS investor survey showed that investors

generally believe that credit losses would decrease and

that spreads would be flat to tighter this year. We remain

overweight subordinates, particularly in Non-Prime Auto

Loan and expect spreads to set new tights this year. We

also keep our overweight view on MBS, highlighting

stronger demand from banks and REITs, and a continued

benign prepayment environment.

In Treasuries, we stay bearish on duration. We view this

month’s rally as providing an attractive entry level to

reset short duration positions, and we think next week is

likely to bring a worsening supply/demand imbalance inTreasuries, more hawkish Fed commentary, and unwinds

of carry trades in front of payrolls (see Treasuries).

Exhibit 4: Our Middle East crisis index suggests that

the situation is stabilizingRolling front Brent oil futures price versus Middle East crisis index*;$/bbl level

80

90

100

110

120

130

Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Brent oil price

Middle East crisis index

* Index calculated as -1* [Middle Eastern stock index** – (15.95 * S&P 500 index) + (2.084 *DAX Index) – (101.318 * Front Crude Oil Px) +2126.85]/1938. Higher values of the indexindicate a worsening of the crisis.** Weighted average of Bahrain, Israel, Kuwait, Nigeria, Oman, Qatar and Saudi Arabiabenchmark stock indices in USD terms. Weights determined by market values of the indices(in USD terms) as of year-end 2010.Source: Bloomberg, J.P. Morgan

Exhibit 5: US markets have become insensitive toperipheral Europe concernsRolling 3-month beta of 2-week changes in our cross-sector spread index*regressed against index of peripheral CDS spreads**;Level

-3

-2

-1

0

1

2

3


-0.0005

0.0000

0.0005

0.0010

0.0015

0.0020

Peripheral spread index

Beta

* Cross-sector spread index is calculated as average of 2-year z-scores for 5-year swapspreads, JULI I-spd to Treasury, JPM Domestic HY index spread to worst, 10Y AAA CMBSspread to swaps, 2Y AAA credit card ABS spread to swaps and EMBIGLOBAL strip spreadto Treasury.** In-sample z-score of 5-year sovereign CDS for Greece, Ireland, Portugal and Spain.



Economic ResearchUS Fixed Income WeeklyMay 2, 2011

Robert MellmanAC

Michael Feroli

J.P. Morgan Chase Bank

5

Economics

Real GDP growth slows to 1.8% in 1Q11 with

weakness concentrated in construction

Forecast looks for 3.0% growth this quarter;

higher fuel prices and supply-chain problems

pose risks

Forecast looks for a drop to 59.7 in ISM mfg, rise

to 58.0 in ISM non-mfg, payrolls slowing to

165,000

The government’s first estimate of 1Q11 real GDP shows

that growth slowed from 3.1% saar in 4Q10 to 1.8% last

quarter and domestic final sales slowed from 3.2% to

only 0.9%. The forecast had looked for 4.0% growth as

recently as February, so the outcome was well below

relatively recent expectations. The continued rise in fuel

prices through the quarter dampened real consumer

spending, and the other major reason for the

disappointing outcome was a downturn in construction

activity that was at least partly weather-related. Output of

nonresidential construction plunged last quarter, and

housing activity fell as well. In addition, real government

spending had its weakest quarter since 1983, declining5.2% saar (that included a 19.0% saar plunge in real

government construction activity).

Drags on 2Q growth from fuel prices, supply-chain

disruptions: The forecast views much of the weakness in

construction to be weather-related and looks for GDP

growth to return to a 3.0% growth path through the rest

of this year. To be sure, the news so far this quarter has

tended to highlight downside risks to this forecast. The

continued squeeze on real income from rising fuel prices

threatens the forecast of 2.5% growth in real consumer

spending this quarter. And shortages of parts sourced in

Japan are leading to significant production cutbacks inthe auto output this quarter. The recent upturn in initial

jobless claims, including this week’s unexpectedly large

increase to 429,000, hints that supply interruptions in the

auto industry may be spreading to supplier industries (or

that effects of higher fuel prices are starting to weigh on

labor markets).

Exhibit 1: Tracking the 1Q11 slowdown in real GDP

Q/q saar 4Q 1Q 2011 1Q 2011

2010 Feb. forecast actual

Real GDP 3.1 4.0 1.8

Final sales 6.7 2.8 0.8

Consumption 4.0 3.5 2.7

Equip. investment 7.7 11.0 11.6

Nonres. constr. 7.7 0.0 -21.8

Res. constr. 3.3 10.0 -4.1

Government -1.7 -0.6 -5.2

Net trade contr. 3.3 -0.6 -0.1

Inventory contr. -3.4 1.2 0.9

Memo: IP, manuf. 3.5 4.5 9.1

Exhibit 2: Retail price of gasoline and initial joblessclaimsDollars per gallon, nsa '000s, sawr

3.10

3.40

3.70

4.00

Jan 11 Feb 11 Mar 11 Apr 11

370

395

420

445

Price of gasoline

Claims

Exhibit 3: Stock prices and value of the dollarIndex Real broad index, 2000=100

1000

1100

1200

1300

1400

Jul 10 Sep 10 Nov 10 Jan 11 Mar 11 May 11

74

76

78

80

82

84

86S&P 500

Trade-weighted dollar




Robert MellmanAC

Michael Feroli


6

Support for 2Q growth from higher equity prices, a

weaker dollar: Meanwhile, the upside risks to growththis quarter, while real, are more amorphous.

Construction should bounce back from weather-

depressed 1Q11 levels, but the size of the bounce is still

highly uncertain. March construction figures (out

Monday) will provide some early guidance. In addition,

the financial markets could well provide some lift.

Wealth and confidence effects of stock market gains may

boost consumer spending. And the lower dollar should be

helping exports, although it is unclear how much

acceleration we might get this quarter.

Upcoming data important

Upcoming early reports on activity in April should

condition views on activity this quarter (with the caveat

that upbeat ISM surveys, increased auto sales, and

improved payroll growth were misleading guides to

growth last quarter). The ISM manufacturing survey is

forecast to decline 1.5pts to 59.7 and the

nonmanufacturing survey is forecast to increase 0.7pt to

58.0. Industry guidance points to April car and light truck

sales of 13.0mn saar, about equal to the 1Q11 average.

And the forecast looks for nonfarm payroll employment

to slow to 165,000 from 216,000 in March, reflecting

some effects of higher fuel prices on overall activity and

of supply-chain disruptions on manufacturingemployment.

Cross-currents hitting the consumer

Real consumer spending rose 2.7% saar last quarter,

about in line with the 2.9% growth of real disposable

income. Nominal disposable income had been boosted by

the reduction in payroll taxes starting in January, but

two-thirds of the acceleration in nominal disposable

income last quarter was offset by higher inflation.

Disposable income will not have the benefit of tax cuts

again this quarter but will face a drag from the continuedrise in the price of oil to date. Thus, the forecast of 2.5%

saar growth of real consumer spending will likely require

some decline in the saving rate to be realized. In addition,

supply disruptions and associated shortages of new motor

vehicles (especially Japanese nameplates) will likely

depress auto sales modestly in May and June. While

there are obvious downside risks to the spending

forecast, they are not overwhelming. Real consumer

spending did rise 0.2% in March, providing a decent

trajectory into the quarter. And wealth effects from

equity market gains provide reason to expect a lower

saving rate. The S&P 500 is now 13% (not annualized)

above its 4Q10 average.

The core PCE price index rose 0.13% in March and is

up 1.5% saar in 1Q11 and only 0.9%oya. While the

passthrough of higher commodity prices and an end to

declining rents is lifting core prices, the continued

slowing in the price of medical care is providing an

offset. The PCE price measure for medical services had

been averaging about 3.5% growth through the previous

expansion but is down to 1.7%oya and only 0.8% saar

in 1Q11.

More disappointing news on housing

March pending home sales increased 5.1% samr

following a downwardly revised 0.7% increase the

month before. This news points to at least modest near-

term increases in existing home sales. This 11.1% pop

in March new home sales from upwardly revised levels

also seems to send an encouraging message, but this is

only relative to the dismal report in February. The trend

in new home sales is still flat at very low levels,

consistent with readings from the Homebuilders survey.

Moreover, two earlier hints of stronger housing markets

did not pan out:

Mortgage applications for purchase had been trending

higher through the week of April 15, and it had been

unclear whether this rise reflected the front-loading of

Exhibit 4: Price of medical services

%ch saar, PCE price index

0

1

2

3

4

5

6

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

From previous quarter




Robert MellmanAC

Michael Feroli


7

sales ahead of the April 18 increase in FHA insurance

premiums or a genuine uptrend in housing demand.The 13.6% decline in purchase applications in the

week of April 22 indicates that the rise had been

merely a front-loading of sales.

The 4Q10 Census survey of housing vacancies had

shown a sharp acceleration to a 1.9% saar increase in

occupied housing units, a like-sized increase in

household formation, and a decline in the housing

vacancy rate. Evidence that an improving economy

was leading to a sustained acceleration in household

formation would be good news for the housing market.

But the 1Q11 housing vacancy report shows a partial

reversal of the prior quarter’s progress. The number of

occupied housing units and households declined 1.0%

saar, and the housing vacancy rate fully reversed the

prior quarter’s drop.

Labor cost increases holding at 2%

Labor costs are being closely watched for signs of any

change in this important influence on inflation and

household income. The latest quarterly reading of the

employment cost index shows this fixed-weight measure

of hourly labor costs continuing to rise at about a 2.0%

trend. The ECI for all workers rose 0.6% saqr in 1Q11

and has held in the 1.9%-2.0%oya range for the last four

quarters. The ECI for private sector workers rose 0.5%

saqr and 2.0%oya, within the 1.9%-2.1%oya range for

the past four quarters.

Hourly wages and salaries for all workers rose 0.4%saqr

and 1.6%oya in 1Q11. Benefits rose 1.1% saqr and 3.0%

saar. The above-trend rise in benefits last quarter appears

to reflect unusually large non-production bonuses, an

item that can make for volatile 1Q readings. Benefits also

rose 1.1% last year but rose only 0.1% saqr in recession

quarter 1Q09. The trend in employer costs of health

benefits (reported only on an over-year-ago basis) slowed

from 4.5%oya in 1Q10 and 5.0%oya in 4Q10 to only3.4%oya last quarter. This result fits with the slowing

trend in the PCE price index for medical services.




Terry BeltonAC

Meera Chandan

Kimberly L. Harano

J.P. Morgan Futures Inc., J.P. Morgan Securities LLC

8

Treasuries

We increase our duration shorts as this month’s

rally is likely to retrace quickly; next week should

show signs of a worsening supply/demand

imbalance in Treasuries, more hawkish Fed

commentary, and unwinds of carry trades in front

of payrolls

This week’s disappointing 7-year auction showed a

significant drop in foreign sponsorship in

intermediate Treasuries; while one bad auction

does not make a trend, the drop has occurred as

headline risk on the debt ceiling has moved to theforefront and as public statements from foreign

officials on the need to diversify their FX reserves

has increased

Expect a steeper 7s/10s and 7s/30s curve heading

into supply

Buy 8% Nov-21s versus a weighted combination

2.5% Apr-15s and 6.625% Feb-27s

Stay long TIPS breakevens

Market views

The Treasury market performed strongly during the lasttwo weeks, with 2-year yields declining 12 bp, 5-yearyields declining 19 bp, 10-year yields declining 11 bp, and30-year yields declining 6 bp. The rally, which occurreddespite increased investor risk appetite and a pickup inasset allocation flows from fixed income into equities(Exhibit 1), was supported by investors adding exposureto yield curve carry trades and by economic data thatgenerally confirmed the modest pace of economic growth.With rates now falling for 3 consecutive weeks, 10-yearyields have moved back towards the bottom of this year’strading range, having closed below its current level of 3.29% on only three days this year.

Economic data over the last 2 weeks generally confirmedthis year’s slowdown in U.S. growth but, on balance, wasmodestly better than expected with our economic activitysurprise index increasing 14 points. Thursday’s advanceestimate of real GDP showed growth of 1.8% in 1Q11,above our 1.4% forecast and helped by a better thanexpected 2.7% increase in real consumption.Manufacturing survey data confirmed that industrial

production has slowed but still suggests solid growthgoing into 2Q; the Philadelphia Fed survey fell to 57.3 and

durable goods orders rebounded, rising 2.5% in Marchfollowing weak reports in January and February. CorePCE prices rose 0.13% m/m, a little softer than we hadexpected and leaves the annualized 3-month run rate at1.5%. Despite the slightly elevated core inflation numbers,longer-term inflation expectations have softened over thelast few weeks with the University of Michigan’s measureof 5-year ahead inflation expectations falling 30 bp to2.9%. Similarly, the Fed’s measure of 5Yx5Y forwardinflation expectations from the TIPS market has fallen 20

Exhibit 2: Medium-term inflation expectations havemoved lower over the last few weeks but remainabove their 1-year averageFed’s measure of the 5Yx5Y breakeven inflation rate; %

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

Jul 10 Oct 10 Jan 11 Apr 11

Source: Federal Reserve

Exhibit 1: Risk appetite has increased as inflows intoequities have increased while bond fund inflows have

been mutedWeekly mutual fund flows; $mm

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

US equities HY+IG Treasuries Munis

This week

YTD average

Source: EPFR Global




Terry BeltonAC

Meera Chandan

Kimberly L. Harano


9

bp to 2.98% over the last two weeks but is still 20 bpabove its 1-year average (Exhibit 2). The biggestdisappointment of the week was initial jobless claims,which rose 25 thousand to 429 thousand; the 4-week

average increased to 409 thousand and is at its highestlevel since mid-February.

Looking ahead, we maintain our outlook for modestlyhigher Treasury rates, and view this month’s rally asproviding an attractive entry level to reset duration shorts.Four near-term factors suggest this month’s rally is duefor a pause as we look for 10-year yields to move back towards 3.60% by mid-year (Exhibit 3).

First, we expect an uptick in fixed income duration supplyin May as corporate issuance accelerates from the lightlevels seen in April. Corporate issuance has accelerated inMay in nine out of the last ten years, with May typically

being the heaviest month of the year for overall fixedincome duration supply (Exhibit 4).

Second, we view the combination of increased headlinerisk around the debt ceiling (see Special Topic), andworsening inflation pressures in Asia as a growingnegative for foreign sponsorship of Treasuries. Althoughone bad auction does not make a trend, this week’ssurprisingly poor results in the 7-year auction, whereforeign sponsorship has been quite strong, raises a red

Exhibit 3: J.P. Morgan interest rate forecast%

Actual 1m ahead 2Q11 4Q11 1Q12

29 Apr 11 29 May 11 30 Jun 11 31 Dec 11 31 Mar 12

Rates

Effective funds rate 0.09 0.10 0.10 0.12 0.12

3-mo LIBOR 0.27 0.22 0.22 0.30 0.35

3-month T-bill (bey) 0.04 0.05 0.05 0.15 0.25

2-yr Treasury 0.61 0.70 0.75 0.90 1.20

5-yr Treasury 1.97 2.15 2.30 2.50 2.85

10-yr Treasury 3.29 3.45 3.60 3.70 3.90

30-yr Treasury 4.41 4.55 4.70 4.70 4.70

Exhibit 4: After a light April, fixed income durationsupply is poised to increase in May Monthly duration supply via MBS, Municipal, investment grade corporates,Treasuries and Agency debt markets averaged by month between 2007 and2010; $bn of 10-year equivalents

180

190

200

210

220

230

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

Exhibit 5: Public comments by Chinese officialssignaling potentially weaker demand for USTreasuries have become more frequent recently

Date Speaker Comments

27-Apr Wen Jia Bao

(Premier)

"We need to progressively reform RMB exchange rate,

strengthening its flexibility. We need to consistently reform RMB

exchange rate, implementing manageable floating exchange rate

system. RMB should no longer only peg USD, but a basket of

currencies. According to market condition, we need to

strengthen its flexibility. However, we must be careful and the

reform should be step by step."

18-Apr

Zhou Xiao Chuan

(Governor, People's

Bank of China)

"Foreign exchange reserves have exceeded the country's

reasonable demand. It caused excessive liquidity and increased

the pressure of the central bank. The state council has

mentioned that we need to reduce excess FX reserves. We need

to manage it well. One way to manage is diversification."

19-Apr

Hu Xiao Lian

(Vice Governor,

People's Bank of

China)

"Curbing inflation is our primary task. We should strengthen the

flexibility of RMB exchange rate and reduce imported inflation. "

26-Apr

Fan Gang

(Vice

Commissioner of

China Economic

System Reform

Commission)

"Expect RMB will appreciate 5%-7% this year. Recommend

diversifying foreign currency reserve and reduce the

dependence on the US dollar."

19-Apr

Xia Bin

(Member of Central

Bank Currency

Policy Commission;

Director of Finance

Research of State

Council)

" We need to adjust our FX reserve Investment regulation,

increase strategic investment, especially investing in natural

resources and technology projects. To curb inflation, RMB

appreciation is one way, but not the only method. ...$1 trillion of

FX reserves is sufficient"

23-Apr

Tang Shuang Ning

(Chairman of China

Everbright Group,

member of CPPCC

National

Committee)

"The amount of foreign exchange reserves should be restricted

to between 800 billion to 1.3 trillion U.S. dollars"




Terry BeltonAC

Meera Chandan

Kimberly L. Harano


10

flag. Indirect bids in the 7-year auction fell to 39% (thelowest since June 2009) while indirects in the 2-yearauction increased to 38%, suggesting foreign investors arereducing risk by moving further in the curve. Publicstatements by Chinese officials highlighting increasedsupport for faster RMB appreciation and diversifyingaway from the USD have also picked up markedly, withsix different senior officials commenting on the topicsince April 18 (Exhibit 5). Finally, we note that seasonalpatterns also support weaker sponsorship in the near term.Fed custody data show central bank buying of Treasuriestypically slows in the spring, with May the weakest monthof the year on average during the last 10-years.

Third, despite the recent decline in medium-term inflationexpectations evident in both survey and market-basedmeasures, we expect commentary from Fed officials toremain somewhat hawkish in the coming weeks as theyattempt to keep inflation expectations well anchored. The

FOMC central tendency forecasts for core inflationreleased this week show a 0.3 percentage point increasefrom January, with core PCE projected between 1.3 and1.6 percent for 2011 and between 1.3 and 1.8 percent for2012. As discussed in our last publication (see US Fixed

Income Weekly, 4/15/11), Fed speeches following FOMCmeetings have had a clear bearish bias this year as coreinflation has drifted higher. While the Chairman’scomments did not produce much of a market response this

week, comments from the rest of the FOMC have beendecidedly more hawkish this year (Exhibit 6) and weexpect that pattern to hold next week. Beginning with

Kansas City Fed President Hoenig’s speech on Tuesday,13 different FOMC members will speak in the next twoweeks.

Finally, position squaring leading into next week’s labormarket report is supportive of higher yields. While realmoney investors still appear to be short, CFTC dataindicate net speculative positions are the longest they havebeen since November. These positions are likely to bepared back next week, biasing yields higher. On average,

Exhibit 6: The Chairman’s press conference was not a

market mover this week but upcoming speeches fromthe rest of the FOMC should have a more hawkish tiltFed sentiment index* excluding Bernanke versus Bernanke’s sentiment index;bp

-50

-45

-40

-35

-30

-25

-10

-5

0

5

10

15

20

25

30

35

Jul 10 Oct 10 Jan 11 Apr 11

Bernanke's sentiment indexFed sentiment index, ex Bernanke

* The Fed sentiment index is computed as the cumulative sum of yield changes in 5YTreasury futures in the 15-minute period following the first Fedspeak headline onBloomberg, since 7/3/06. Fedspeak is defined as any speech, FOMC statement, or FOMCminutes.

Exhibit 7: With spec longs at the highest since

November, position squaring biases yields higher intonext week’s payrolls reportPar 5-year Treasury yields averaged in the business days around last four payroll releases; %

2.08

2.10

2.12

2.14

2.16

2.18

2.20

2.22

2.24

-10 -8 -6 -4 -2 0 2 4 6 8 10

Number of business days around payroll release

Source: CFTC

Exhibit 8: The 7s/30s curve hedged for 2s is close toits flattest level this year…Par 30-year - 7-year + 0.6 * 2-year Treasury rate; %

2.06

2.08

2.10

2.12

2.14

2.16

2.18

2.20

2.22

2.24





Terry BeltonAC

Meera Chandan

Kimberly L. Harano


11

5-year yields have risen 12 bp in the week leading intopayrolls this year as investors unwind front-end carrytrades (Exhibit 7).

Next week, Treasury is scheduled to announce the detailsof the May Quarterly Refunding. We expect Treasury tokeep coupon sizes unchanged, and expect $32bn, $24bnand $16bn of new-issue 3-, 10- and 30-year Treasuries.Trading around auctions continues to be an interestingtheme, in our view. Given that 2-, 5- and 7-year supply is

now behind us, and long-end supply on the horizon, weexpect 7s/30s steepening. This curve is currently on theflatter end of its range this year (Exhibit 8), and hashistorically steepened going into nine out of the lasttwelve long-end auctions (Exhibit 9) by an average of 7.7bp. In a similar vein, we expect 7s/10s steepening aswell, hedged for the level of rates. This weighted spreadhas steepened by an average of 2.7bp in the week after the7-year auction. Moreover, this steepening occurred aftereach of the last six 7-year auctions.

At the long end of the curve, we also like 8% Nov-21s

more than 2.5% Apr-15s and 6.625% Feb-27s. The 10- to

11-year sector of the bond curve has cheapened relative to

the wings in recent weeks, and the yield errors of these

bonds indicate they are at the cheaper end of their six

month trading range.

TIPS

Over the past two weeks, the TIPS breakeven curve

flattened sharply. Five-year breakevens (Apr-15 TIPS)

widened 12.5bp, while 10-, 20-, and 30-year breakevens

narrowed 4.4bp, 9.1bp and 9.4bp, respectively. Last

week’s 5-year auction was somewhat poorly received: the

bid-to-cover ratio was the lowest for a 5-year auction

since October 2008, and the issue tailed 2.5bp. Despite the

poor auction performance, the resurgent rally in oil prices

helped 5-year TIPS and the front end of the breakevencurve outperform.

With the 5-year auction now behind us, we maintain our

bullish view on breakevens for several reasons. First, our

bearish view on nominal rates will likely be supportive of

wider breakevens. Second, breakevens have tracked the

S&P 500 very closely since the middle of last year

(Exhibit 10); given that our equity strategists have raised

Exhibit 9: …and has historically steepened going into

long-end supplyPar 30-year - 7-year + 0.6 * 2-year Treasury rate averaged in business daysaround the last twelve 30-year auctions; %

206

208

210

212

214

216

-10 -8 -6 -4 -2 0 2 4 6 8

Business days around 30y auction

Exhibit 11: The 10s/30s breakeven curve has flattenedto close to multi-year lows…10s/30s hot-run breakeven curve; bp

0

20

40

60

80

100

120

Apr 08 Dec 08 Jul 09 Feb 10 Sep 10 Apr 11

Exhibit 10: TIPS breakevens have closely tracked

equities since late last year10-year TIPS breakevens versus S&P 500;bp level

140

160

180

200

220

240

260

280


1000

1100

1200

1300

1400

10Y breakeven

S&P 500




Terry BeltonAC

Meera Chandan

Kimberly L. Harano


12

their year-end S&P target to 1475, we think breakevens

can continue to track equities wider. Finally, carry in longTIPS breakeven positions remains highly attractive.

As for the breakeven curve, as Exhibit 11 shows, the

10s/30s breakeven curve has flattened to close to multi-

year lows, which may tempt investors to expect breakeven

curve steepening. However, once we account for the shape

of the nominal curve as well as oil prices, which impact

shorter-maturity TIPS more than longer-maturity TIPS,

the curve looks fairly priced (Exhibit 12). Furthermore,

given that our oil strategists believe that the risks to oil

prices remain to the upside, we think the 10s/30s

breakeven curve could continue to flatten. Thus, we would

caution against expecting breakeven curve steepening atthis time, unless they are hedged for oil prices.

Exhibit 12: …but looks fairly priced relative to the10s/30s nominal curve and oil prices10s/30s hot-run breakeven curve regressed against rolling front WTI futurescontract price and the 10s/30s hot-run nominal curve; past 1 year; bp

-30

-20

-10

0

10

20

60 70 80 90 100 110 120

Y = 0.29(Nominal curve) - 0.78(oil) + 63.6

R-sq = 79%

Rolling front WTI futures contract price; $/bbl

Current




Meera ChandanAC

Renee Park

J.P. Morgan Securities LLC

13

Agencies

Agency valuations are at record tight levels

versus Treasuries, while liquidity in the Agency

market has worsened…

…Thus, we stay underweight Agencies versus

Treasuries

Market views

Since we last published two weeks ago, the Agency

spread curve versus swaps steepened while the

performance of Agencies versus Treasuries was mixed.

On the spread curve versus Treasuries, 2-, 10- and 30-

year Agencies cheapened by 0.5bp, 2bp, and 1.5bp,

respectively. On the spread curve versus swaps, 2-year

Agencies richened by 2bp, while 10- and 30-year

Agencies each cheapened by 2.5bp. The mixed

performance of Agencies versus Treasuries came amidst

headlines of S&P’s downward revision of their ratings

outlook on FNMA, FHLMC, and 10 of 12 FHLB banks

to negative from stable.

Technicals continue to be a key support for the Agency

market. As is well known, the Agency debt marketremains in shrinkage mode, with net issuance again

negative this month. We estimate that net issuance for

FNMA, FHLMC, and FHLB totaled -$39bn in April,

negative for the 10th consecutive month, bringing the

amount of debt outstanding to its lowest level in 8 years

(Exhibit 1). Indeed, given the strong technicals in the

Agency market, it has become relatively less sensitive to

headlines; spreads barely reacted to the revision of S&P

ratings outlook to negative, and ended up tightening even

further in the subsequent days.

Notwithstanding supportive technicals, however, we find

little value in owning Agency debt versus Treasuries atcurrent valuations, for three reasons. First, with 5-year

Agencies at around a mere 18bp spread to Treasuries,

valuations are close to record tight levels, and are rich

relative to our estimates of fair value. Second, Agency

debt also now looks rich to other comparable asset

classes such as Agency MBS: as seen in Exhibit 2, the

Agency debt/ MBS basis is now at its widest level this

year. Last, liquidity has begun to deteriorate, with the 3-

Exhibit 1: The Agency debt market is now at its

smallest size in 8 yearsFNMA, FHLMC, FHLB debt outstanding* ($bn)

2000

2200

2400

2600

2800

3000

3200

Nov 02 May 04 Nov 05 May 07 Nov 08 May 10 * Note that April 2011 is an estimated number based on monthly net issuance

Exhibit 3: Trading volumes have dropped to the lowestlevels in a decade3-month moving average of coupon Agency debt daily trading volumes ($bn)

10

15

20

25

30

35

2002 2005 2008 2011 Source: Federal Reserve

Exhibit 2: The Agency debt/ MBS OAS basis haswidened to its widest level since DecemberCC 30-year MBS Libor OAS minus 5-year Agency spread to swaps (bp)

14

16

18

20

2224

26

28

30

32

34

36





Meera ChandanAC

Renee Park


14

month moving average of daily trading volume now at its

decade low for coupon Agency debt (Exhibit 3). This istrue even adjusted for the size of the market. While not a

high frequency driver of spreads, the likely slow

deterioration in liquidity represents a longer term threat

to valuations. This is seen in Exhibit 4, which compares a

liquidity metric for various high quality markets to their

valuations (for further details, see US Fixed Income

Markets Outlook 2011, 11/24/10). In sum, given the

richness of Agency debt valuations relative to history,

relative to our fair value estimates and relative to other

related asset classes, and also given the longer term threat

to valuations from declining liquidity, we find little value

in Agency bullets versus Treasuries at current valuations

despite favorable technicals.

Exhibit 4: Our framework of scoring liquidity in high-quality markets suggests poorer liquidity results incheaper valuations, both within and across markets1-month moving average of matched-maturity asset swap spreads (bp) versusliquidity scores across various asset classes and maturities*

30y MBS

15y MBS

Pre-re 8y

Pre-re 5y

Pre-re 2y

Off Tsy 20y

Off Tsy 10y

TIPS

Tsy 30y

Tsy 10y

REFCO

FDIC

30y Agy

10y Agy

5y Agy

2y Agy

-40

-20

0

20

40

60

80

100

0 5 10 15 20Liquidity score

* based on the J.P. Morgan framework for scoring liquidity in high-quality markets (US Fixed

Income Markets Outlook 2011, 11/24/10). Note that pre-refunded munis are labeled as “Pre-re,” on-the-run treasuries are labeled as “Tsy,” and off-the-run Treasuries are labeled as “Off Tsy.”



High Grade StrategyUS Fixed Income WeeklyMay 2, 2011

Eric BeinsteinAC

Dominique D. Toublan

Miroslav Skovajsa Anna Cherepanova


15

Corporates

HG bond spreads have been mostly stable thisweek, underperforming equities, but stillreturning to their YTD low

We lowered our view on HG credit to Neutral lastweek on the back of tight valuation and risks,which we believe are skewed more to thedownside than upside

These include higher energy prices negativelyimpacting economic growth, rising spreads inperipheral Europe, low UST yields, and higherbond supply YTD than originally expected

The positive fundamentals highlighted by recentearnings reports and still strong technicals for allspread products keep us bullish in the longerterm, however, and we keep our YE spread targetof 120bp

Two weeks ago we turned tactically Neutral on HGbond spreads, and we maintain this view. There are

several reasons which, combined, contribute to our view

that in the near term spreads are unlikely to tighten and

could widen 5-10bp before resuming their tighteningtrend later in the year. One of the reasons for caution we

noted two weeks ago has proven incorrect as, after a slow

start to earnings season, equities have rallied on the back

of strong earnings. Still, we believe that other factors

remain a threat, and valuations are quite full already, so

the upside/downside risk seems unfavorable in the near

term. The factors on which we are focused include:

1) Energy prices remain a threat to growth. Brent

averaged $87.50/bl in 4Q10, $105.60/bl in 1Q11 and

$122.9/bl MTD in April. First quarter growth was

negatively impacted by the jump in energy prices, which

has become even more of a headwind since.

Despite the rise in energy prices we continue to believe

that growth will accelerate from 1Q to 2Q. About one

month ago, JPMorgan reduced its 2Q and 3Q US GDP

growth forecast from 3.5% to 3.0%, which would still

constitute a rebound from growth of 1.8% in 1Q. High

energy prices place downside risks on the magnitude of

the rebound. Our perspective is that a fundamental

improvement in private sector spending and hiring took

hold last quarter but overall growth was tempered by

drags related to winter weather, public sector spending,

and rising energy prices. The intensity of these drags is

expected to fade as we move toward mid-year, helping to

lift growth back toward 3%. However, this quarter will

also likely deliver a sharp downshift in industry even as

global GDP rebounds. The recent disconnect between

production and GDP performance will thus remain in

place as production and business surveys move lower this

quarter.

2) European peripheral debt spreads have recentlyrisen sharply, and the restructuring debate is heating

up once again. Greece, Ireland, and Portugal have each

about EUR $150bn of sovereign market debt outstanding

not owned by the ECB. JPMorgan continues to believe

Exhibit 2:… while those of Spain and Italy have notchanged appreciably

100

150

200

250

300

350

400


Spain CDS

Italy CDS

bp

Spain: 249bp

Italy: 153bp

Exhibit 1: Peripheral European debt spreads have

soared recently…

300

500

700

900

1,100

1,300

1,500

1,700


Greece CDS

Po rtugal CDS

Ireland CDS

bp Greece: 1,609bp

Portugal:683bp

Ireland:695bp




Eric BeinsteinAC




16

that a restructuring is neither the best outcome nor our

base case—over the next two years, at least. However,market commentators and some officials are increasingly

discussing this option. Our view, as outlined by recent

research notes from our European Economists, is

summarized below.

The debate around a near term debt restructuring in

Greece continues, with the latest stories in the Greek

press about the government asking the IMF and EU to

restructure its debt. We believe that a near term

restructuring of Greek market debt makes little sense and

that there is a misunderstanding in some of the press

about what the issues on the table are. There are

different kinds of debt (market and official), which canbe restructured in a variety of ways (delayed coupon or

principal payments, or reductions in coupons or principal

amounts), by a number of different means (voluntary or

involuntary with varying degrees of coercion). However,

we doubt very much that the Greek government is trying

to get an agreement to restructure its market debt in the

near term. A “voluntary” restructuring of market debt is a

bit of an oxymoron, and would not achieve very much;

an “involuntary” restructuring of market debt would be

very disruptive to both Greece and the rest of the region.

Over the past year, we have taken something of a

minority view about the likelihood of a substantial“involuntary” restructuring of Greek market debt. We

have argued that a path does exist which would avoid

such an event, and that policymakers will try and take

that path. As we argued in our Global Issues Report

published last December—“A way out of the EMU fiscal

crisis”—this path involves a significant fiscal

consolidation in Greece and ever more concessional

liquidity support from the core (lower borrowing costs

and longer maturities). The latter is both a restructuring

of the official debt and a fiscal transfer.

Recent developments suggest that the likelihood that the

region takes this alternative path is declining (many

would argue that the likelihood was never that high in the

first place). The Greek government remains committed to

delivering the required fiscal consolidation. Indeed, in

the new medium term fiscal strategy published last

Friday, the government repeated its commitment to

achieve sustained primary surpluses of close to 6%,

which are embedded in the IMF/EU program. This is

clearly a long journey from last year’s primary deficit of

around 3.5% of GDP, but it is worth remembering that

the Greek primary deficit did narrow by around 6.5%-pts

last year. But, equally important is the political mood in

the core countries. The election result in Finland on

Sunday suggests a growing opposition to the fiscaltransfers that are implied by concessional liquidity

support. If the Finnish election result is any kind of

portent of things to come in the core countries, it is

worrying. For Greece to avoid an “involuntary”

restructuring of its market debt, not only does Greece

have to put in a lot of hard work, but in addition the rest

of the region has to be pretty generous too. It looks

Exhibit 4: Government cutbacks at the state and local levelhave already been evident in the monthly employmentdata. The impact of potentially significant cuts at theFederal level have yet to be felt

28,000

-35,000

-15,000

-26,000

-46,000

-14,000

-60,000

-40,000

-20,000

0

20,000

40,000

Oct 10 Nov 10 Dec 10 Jan 11 Feb 11 Mar 11

Monthly change in Government employment

Exhibit 3: JPMorgan has revised the forecast on Japan

GDP downwards for the first half of 2012 but upwards forthe second half of 2011

1.02.0 2.0

-1.0

-3.5

6.5

2.5

7.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

1Q11 2Q11 3Q11 4Q11

previous Japan GDP forecast

current Japan GDP forecast

%

Note: previous forecast is as of 12/30/10




Eric BeinsteinAC




17

increasingly challenging for the rest of the region to

deliver the kind of fiscal transfers that are necessary.

3) Japanese growth has been hit harder thanoriginally expected from the earthquake and nucleardisaster. Estimates of the economic impact of the

earthquake and tsunami have continued to become more

negative; we revised our 1Q Japan’s GDP growth

forecast to -1.0% last week. The flipside is that a deeper

“V” shaped recovery is now expected, with a sharp

contraction followed by a sharp rebound. JPMorgan’s

current and prior quarterly GDP growth forecasts are

illustrated in Exhibit 3.

4) Fiscal stimulus likely to decline. Governmentspending has been reduced at the state and local level,

and federal spending seems poised for a cutback as well.

The 2010 fiscal year budget, on which agreement was

reached a couple of weeks ago, called for about $40bn of

spending cuts. Some of these cuts involved the

cancellation of spending authorizations that were

unlikely to have been actually spent in any event, so the

economic impact will likely be limited. As we move into

an intensifying period of fiscal debate around increasing

the debt ceiling, however, the likelihood is that

agreement will be reached on cutting fiscal deficits more

drastically. These cuts would likely not start until the

new fiscal year begins October 1, and the timing of thecutbacks is unknown. These are not likely to impact

near-term growth, but depending on the size of the cuts,

will impact growth expectations for 2012.

5) Rhetoric and posturing in Washington on the debtceiling debate are increasing and may remain heated

until the last minute. In a note published on April 19,

our colleagues in Rates research explored the systemic

risks that would result from a technical default in the US

Treasury market. Though we view a default as extremely

unlikely, assessing these tail risks is an important part of

risk management and is useful in understanding how

markets might behave in advance of a potential default.

Our analysis suggests that any delay in making a coupon

or principal payment by Treasury would almost certainly

have large systemic effects, with long-term adverse

consequences for Treasury finances and the US

economy. A technical default raises the risk of a flight to

liquidity out of government money funds; because daily

liquidity and stable NAV are of paramount importance to

these investors; a Treasury default could trigger an

increase in redemptions similar to that seen in 2008.

Repo market haircuts would likely rise sharply, causing

deleveraging in lending markets. Foreign demand for

Treasuries could be adversely impacted; a worrisome

precedent is the 40% decline in foreign holdings of GSE

debt following conservatorship, despite Treasury

assurances that it stands behind the GSEs.

Risky assets would all likely suffer in such a scenario, as

markets access both the unknown consequences of a

technical default on other market participants, and the

negative message of our government’s inability to avoid

such an outcome. High grade credit would likely suffer

less than other markets, both because of its status as a

safe haven versus riskier assets, and because of higher

yields from wider Treasury spreads. Still, we would

expect spreads to widen. See Special Topic.

6) HG bond supply has been heavier than expected

and we raised our 2011 supply estimate a couple of weeks ago to $710bn from $625bn. YTD there has been

$303bn of supply issued, or 43% of our new forecast.April has been a slower month for issuance, as is usually

the case, but supply in May is likely to accelerate. This is

both because companies will have reported 1Q earnings

so will not be constrained by blackout periods, and low

all-in yields will be tempting. Supply is not usually a

driver of spread widening—supply comes when there is

demand, but an expected pickup in supply is likely to

Exhibit 5: 2011 issuance has exceeded 2010 supply inevery month so far this year. Last year May issuance was

light due to the European sovereign crisis, but May 2011 islikely to see greater supply than this month as earningsblackout restrictions fade

0

20

40

60

80

100

120


2010 gross HG issuance

2011 gross HG issuance

$bn




Eric BeinsteinAC




18

limit spread tightening and contributes to our Neutral

view.

On the positive side, earnings have been strong andthe rally in equities is supporting all risky markets. Most sectors are exceeding EPS estimates, though

revenue growth has outperformed expectations by less.

From a HG credit perspective the strong earnings

reported will likely mean that credit metrics improved

further from their already strong levels last quarter.

Domestic non-financial net debt issuance was near flat in

1Q, so higher earnings and EBITDA will mean that

leverage has likely declined further, interest coverage

will have gotten stronger, and cash balances will have

increased. While this is positive, fundamentals for HGcredit were already widely perceived as very strong and

this is therefore already mostly priced into current

spreads, we believe.

Overall maintain our view that caution is warrantedin the near term regarding HG bond spreads. They

tightened 1bp on the week even with the S&P up 1.9%.

The negatives of rapidly rising energy prices and

increasing peripheral European stress outweigh the

positive earnings for HG credit, in our view. Spreads are

already pretty fully valued, and are at risk for some

softening, perhaps after the pace of earnings reports

slows next week.

Weakening dollar has positive and negative impact on

HG credit

The US dollar has weakened 10.2% on an inflation-

adjusted, trade-weighted basis since the Fed's QE2

announcement last August alone. This is through March;

when April data becomes available the weakness will

likely have intensified. The dollar at the end of March

stood about 2% above its weakest level since the end of

the Bretton Woods era of fixed exchange rates in 1973.

The drivers of the weakness are both the large current

account deficit and worsening international investment

position, as well as extremely easy US monetary policy

compared to the rest of the world. Since August the

dollar has weakened against most currencies, including

14% vs. the Euro, 10-12% vs. Canada, Korea, Taiwan,

Brazil and Mexico, and 5% against China.

From the perspective of US corporates the weak dollar is

mostly positive for credit fundamentals and negative for

technicals. On the fundamental side, an estimated 30% of

the revenue of S&P500 companies comes from non-domestic sources. These exporters are getting a boost

both from the increased competitiveness of their products

from the weak USD exchange rate and the translation

benefits of converting non-USD profits into their USD

financial statements. The average USD real effective

exchange rate was 4% lower in 2010 vs. 2009 while the

non-Financial companies in our HG bond index had

revenue growth of 11.4% over this period. Already in

2011 the USD is 6% weaker than the 2010 average (as

the dollar weakened throughout last year), and this is

supporting the strong revenue and EPS growth for many

companies being reported now. It takes time for a weaker

currency to translate into greater export strength, so USexporters should benefit further from the rapidly

weakening currency over the past eight months in future

quarters. On the technical side, the weakening dollar is

likely contributing to the slowdown in foreign buying of

USD corporate bonds over the past couple of months, as

reported in the TIC data by the Treasury. It is not a

compelling argument, from a non-US investor's

perspective, to buy bonds yielding about 4.5%/year in a

currency which is depreciating near 1%/month. More

importantly, however, the low rate environment that is

contributing to the weak dollar is also contributing to low

HG bond yields from the perspective of US-based

investors. With USD corporate credit fundamentals quitestrong, it is these low yields which are limiting further

spread tightening.




Alex Roever CFA

Chris Holmes CFAAC

Josh Rudolph


19

Municipals

The strong rally in munis can only be explainedby continued limited supply. With economic dataweakening, public pension liabilities coming intofocus, and fund outflows continuing, this rally iswell over-done

Issuance is likely to pick up in May, but we lowerour 2011 supply forecast to $260bn from $300bn.Heavy June coupon and redemption incometotaling $50bn should help mitigate—but noteliminate—supply induced cheapening

We don’t expect advanced refunding volume todecline drastically if the US Treasury closes theSLGS issuance window to delay reaching the debtceiling

Wednesday Week

Casual observation of recent trading levels would showthat muni rates have declined alongside Treasuries(Exhibit 1). But the specific drivers behind the munimarket can be isolated by looking more closely atWednesday’s market activity. These observations

collectively show that not only is the muni marketpricing away from fundamentals, but the rally is alsobeing driven by only one side of the technicalequation (i.e. low supply rather than low demand).

Tax-exempts traded into their lowest yields YTD

Despite Treasury rates increasing by 5-6 basis points onWednesday, munis richened, breaking through theirYTD lows (Exhibit 2). Moreover, this rally hassignificantly outpaced Treasuries, with 10-year and 30-year tax-exempt/Treasury ratios now down to 87% and104%, respectively (Exhibit 1).

Sizable bid-wanted lists emerged

With rates having fallen so much recently, someinvestors on Wednesday looked to profit from the rallyby releasing sizable bid-wanted lists. With limitedprimary market supply available to purchase (Exhibit 3),a small handful of buyers did not shy away from quicklyabsorbing this secondary market supply (bid lists).

Exhibit 3: Primary market supply remains depressedWeekly municipal bond issuance ($bn)

0

5

10

15Tax-exempt

Taxable

Jan Feb Mar Apr MayJunJul Aug SepOctNovDec Jan

2011

**

*

* *

*

*

*

*

2010

FebMar

**

Apr

Less than $3bnweekly averagetax-exemptissuance

*

* Holiday weekSource: Bloomberg CDRA

Exhibit 1: The tax-exempt rally has out-paced Treasuriesover the past two weeksYields as of closing on Friday 4/29/11; change since closing on Thursday 4/14/11

AAA tax-exempts Treasuries AAA tax-exempts / UST

Year Yield Change Yield Change Yield Change

2 0.57% -6bp 0.60% -9bp 95% +3.9%

5 1.50% -22bp 1.97% -15bp 76% -5.0%

10 2.85% -30bp 3.29% -12bp 87% -5.8%

30 4.58% -20bp 4.40% -7bp 104% -2.9%

Source: Thomson MMD, J.P. Morgan

Exhibit 2: Tax-exempt 10s and 30s broke through theirYTD interest rate lows on Wednesday%

2.80

2.90

3.00

3.10

3.20

3.30

3.40

3.50

03 Jan 24 Jan 14 Feb 07 Mar 28 Mar 18 Apr

4.55

4.60

4.65

4.70

4.75

4.80

4.85

4.90

4.95

5.00

5.055.1010y AAA MMD yield

30y AAA MMD yield

Source: Thomson Municipal Market Data




Alex Roever CFA

Chris Holmes CFAAC

Josh Rudolph


20

New Jersey was downgraded

The rating agencies are in the process of increasing theweight they place on unfunded pension and OPEBliabilities and they have decided to make an example outof New Jersey. S&P downgraded the state on February 9(from AA to AA-) and Moody’s followed suit this week on Wednesday (from Aa2 to Aa3). One hour later, Fitchrevised its outlook from stable to negative (currentlyrated AA). All three agencies’ press releases prominentlyfeatured the scale of the state’s unfunded liabilities.

In fact, by our calculations (discounting liabilities at thestates’ respective cost of capital and including futureincreases in workers’ service and salaries), New Jersey is

not the most leveraged state (six other states have morecombined on and off balance sheet debt relative to thesize of their respective economies). But because NewJersey has not been making its full annual requiredcontribution, the necessary fiscal adjustment issignificant (only two states will need more fiscalconsolidation). New Jersey’s total state and local taxburden is already the highest in the country, at 12.2% of personal income, and by our calculations, it would haveto increase another 1.4%-pt to fully fund the pensionsystem (unless either other resources are dedicated topaying for pensions or benefits are reduced for existingemployees).

But New Jersey is certainly not alone in having to facethis issue. We expect other states and cities withsignificant off balance sheet leverage to see downgradesin the coming months. The market shrugged off Wednesday’s downgrade, exemplifying the fact that off balance sheet leverage is not yet priced into the munibond market.

The Fed held a press conference

Another important event on Wednesday for all USfinancial markets was Ben Bernanke’s first ever post-FOMC press conference. The Fed Chairman hewed

closely to previous Fed communications, but oureconomists made a few interesting observations:

Overall success: Bernanke succeeded inmaking this a relatively friendly and uneventfulday. His goal was probably to establish a newcommunications forum that will be useful as theFed approaches its exit strategy, withoutproviding any major changes to FOMC viewson the likely timing and path of that exit.

QE3 unlikely: For those hawkishly inclined, the

Chairman did say that “the tradeoffs are gettingless attractive,” meaning that a new QE3 isunlikely, as is a tapering off of QE2. Instead,QE2 is expected to come to a full stop in June.

A “couple” meetings: As expected, the FOMCdid not change the “extended period” language.But Bernanke did comment on what exactly itmeans when they do eventually remove thatlanguage. He said it would mean that theCommittee is “a couple of meetings probably”away from subsequent action. Although he alsoexplained that the Fed intentionally uses suchvague terminology because it’s uncertain howquickly tightening will actually be required.Nevertheless, the phrase “a couple” raisedeyebrows in the market because beforeWednesday the only useful precedent wasChicago Fed President Evans periodicallysaying that an “extended period” means “threeto four meetings.” Thus, market economistsimmediately whipped out their dictionaries asBernanke was speaking to look up the precisedefinition of “a couple.” Apparently, it onlynecessarily means “two” when specificallyreferring to people. Otherwise, it simply means“and indefinite small number.” Thus all we can

conclude is that the Chairman avoided spellingout the exact timeframe of the monetary exit.

Reinvestment signaling: Another newdevelopment noted by our economists was thatBernanke said that the eventual decision to stopreinvesting proceeds (coupon and interestpayments from the Fed’s already substantialbalance sheet holdings) into additional Treasurypurchases would itself represent a monetarytightening event. This characterization elevatesthe communication significance of this decisionwhen it does come, thus raising the bar for the

FOMC to alter its current reinvestment policy.

Core inflation in 2012: The most interestingchange our economists noticed in the revisedFOMC economic forecast was the 0.3%-pointuptick in 2012 core PCE inflation (to 1.55%).This is important, because changes in monetarypolicy need to come in accordance with theFOMC’s forecasts. Our economists noted thathigher core inflation in 2012 is hard to justify on




Alex Roever CFA

Chris Holmes CFAAC

Josh Rudolph


21

the grounds of either headline pass-through or a

reduction in resource slack. The hawkishexplanation for the revised forecast would bethat the Committee is concerned that the nowelevated level of headline inflation will pull upinflation expectations. The dovish explanationwould be that the higher 2012 inflation wouldbe the result of continued easy policy. We won’tknow which explanation is correct until theminutes are released in three weeks time.

For more details, see Economics.

Thursday mattered too: GDP growth lower, claimshigher, outflows continue

The events on Wednesday illustrate the themes drivingthe municipal bond market: rates continue to fall asinvestors reach to the secondary market to find bonds,despite weakening fundamentals and weak underlyingdemand.

The weakness of underlying demand was illustrated onThursday by another week of outflows from mutualfunds, now totaling nearly 10% of fund holdings over thepast six months. Weak fundamentals are not limited tounfunded public pension liabilities, but also include thelatest economic data (which is an important leading

indicator for state and local revenue growth). Thursdaysaw 1Q11 GDP growth come in low at 1.8% and joblessclaims come in high at 428k (Exhibit 4).

June coupons and redemptions

Muni investors will enjoy a spike in their cashflows inJune due to the seasonal influx of redemptions andcoupon payments. We estimate that $33.6bn of tax-exempt bonds will mature in the month of June inaddition to $17bn of coupon payments for a total of $50.6bn (Exhibit 5), which is a significant increase fromthe $23.3bn monthly average year to date, and 8% higherthan June 2010. The added cash will help support anincrease in issuance volume expected in May and June.

How much the added cash will impact muni relativevalue will largely depend on the amount of new bondssold over the next couple of months. The visible supplycalendar is meager, but we foresee more issuance on thehorizon, especially given that long maturity muni yieldsare at the lowest level of the year. Nonetheless, thedrastically slow pace of issuance through the end of April

leads us to reduce our 2011 forecast from $300bn to$260bn (Exhibit 6); simply, we do not expect a near-termcatalyst that would jump-start issuance to the magnitudenecessary to reach our previous target.

Investors’ risk sentiment will be another key factor indetermining how they invest June cash flows. Munisentiment has stayed negative over the last six months asindicated by investors’ unabated exodus from tax-exemptmutual funds. Meanwhile, equities have been hot, andwill likely stay that way for the remainder of the year,according to J.P. Morgan equity strategists, who onThursday raised their 2011 year-end target for the S&Pindex from 1425 to 1475. Strong equities will likelyseduce some retail muni investors to park their muni

Exhibit 4: Claims are suddenly heading in the wrongdirection

State quarterly tax receipt growth (%), initial weekly jobless claims (k)

200

300

400

500

600

700-10%

-5%

0%

5%

2005 2006 2007 2008 2009 2010

State tax receipt growth

Initial jobless claims

Source: US Census Bureau, Bloomberg

Exhibit 5: Tax-exempt coupon payments and maturitieswill spike in JuneEstimate of monthly tax-exempt bond coupon payments and maturities in 2011; $bn

0

10

20

30

40

50

60


Tax-exempt maturities Tax exempt coupon payments

Source: Bloomberg




Alex Roever CFA

Chris Holmes CFAAC

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22

coupon and redemption cash in stocks instead of tax-

exempt bonds, which is a trend we have alreadywitnessed anecdotally over the last six months.Moreover, negative news headlines on the fiscalhardships of states might intensify as we near the fiscalyear-end of June 30.

The June cash injection should help mitigate supplyinduced cheapening, but it will be just one factor in thecocktail of independent variables. This idea is evidentwhen examining historical data; despite the typicalseasonal increase in coupon payments, there is noconsistent trend in relative valuations in the weeksaround June 1 of the last ten years.

Pre-re bonds and the debt ceiling

The federal debt ceiling debacle has sparked questionsover its potential impact on the pre-refunded bondmarket, and this week there was a sharp increase in thenumber of institutional sized transactions of pre-refundedbonds (Exhibit 7), and a corresponding tightening of pre-refunded yields relative to MMD (Exhibit 8).

A common question regarding pre-refunded bonds andthe debt ceiling is; what will happen if the Treasurytemporarily stops issuing State and Local GovernmentSeries (SLGS) to delay reaching the federal debt limit(which is expected to be reached by May 16 without

extraordinary measures)? In a letter to Congress lastJanuary, Treasury Secretary Timothy Geithner outlinedseveral extraordinary measures that the federalgovernment could take to extend the date the debt ceilingis reached to July 8. One of these measures involvesclosing the SLGS issuance window. The federalgovernment has resorted to this measure on six differentoccasions since 1995, when it faced the unwelcomeprospect of reaching the debt limit.

As described on the Treasury Direct website1, eachperiod that the SLGS window was closed in the past isunique and the Treasury might have special procedures

relating to the administration of unredeemed SLGS. Forexample, unredeemed Demand Deposit securities haveusually been rolled over into special 90-day certificatesof indebtedness, issuers (that invest in SLGS) were ableto redeem SLGS early before the window closed, andmore importantly, the Treasury continued to pay debtservice on outstandings.

1 http://www.treasurydirect.gov/govt/resources/faq/faq_slgs.htm

Exhibit 7: Trading activity in pre-refunded bonds spiked5-day moving average of daily count of trades > $1mn of pre-re bonds

40

80

120

160

200

4/29/10 6/29/10 8/29/10 10/29/10 12/29/10 2/28/11 4/29/11

Source: MSRB

Exhibit 6: Total 2011 issuance forecast reduced from

$300bn to $260bnActual and estimated 2011 monthly municipal bond issuance (excluding Notes); $bn

0

5

10

15

20

25

30

35


Total : $260bn

Source: J.P. Morgan

Exhibit 8: Pre-refunded bonds have outperformed5-year pre-refunded yields minus 5-year AAA MMD; bp

-8

-6

-4

-2

0

2

4

6

4/28/09 8/28/09 12/28/09 4/28/10 8/28/10 12/28/10 4/28/11

Source: Municipal Market Data




Alex Roever CFA

Chris Holmes CFAAC

Josh Rudolph


23

Recent speculation is that advanced refunding issuance

would be hampered if the SLGS issuance window isclosed, which would be a positive for pre-re valuations.This notion was likely one of the catalysts behind theincreased transaction volume and richening of pre-reyields this week.

However, we do not expect advanced refunding volumeto decline significantly if the US Treasury decides toclose the SLGS issuance window.

The reason is that despite tougher bidding requirementsof Treasuries and some administrative challenges, issuerscan opt to buy marketable Treasuries or Agencies insteadof SLGS to fund escrows. Of the six prior periods that

the SLGS window was closed for debt ceiling reasons,advanced refunding supply was actually higher on threeoccasions than it was in the similar period the previousyear (Exhibit 9).

Moreover, advanced refunding issuance, like most typesof munis, has already been very light this year, falling44% from 2010 levels. Hence, a potential drop in volumewould not be a sudden shock to a market already subduedby light volumes.

The current focus is on the potential decline in pre-reissuance if the Treasury embarks on extraordinary

measures to delay reaching the debt ceiling. However, if the debt ceiling were eventually reached, the potentialrepercussions would be more severe given thatoutstanding SLGS could experience a technical default,which would clearly have negative implications forholders of outstanding pre-refunded bonds. At this point,however, we view the likelihood of a technical default asextremely unlikely2.

2 See Special Topic

Exhibit 9: Advanced refunding volume did not always declinein previous periods when the SLGS issuance window wasclosed by the US TreasuryAdvanced refunding issuance and change in 5-year Pre-re spreads over MMD duringprevious periods when SLGS* issuance window was closed by the Treasury

Ch g i n 5y Pr io r year Issu an ce

sp read , b p p er io d d iff. $m n

10/18/95 - 3/28/96 8,597 10 10/18/94 - 3/28/95 1,758 6,839

5/15/02 - 7/7/02 1,281 -1 5/15/01 - 7/7/01 2,819 -1,538

2/19/03 - 5/26/03 4,445 1 2/19/02 - 5/26/02 2,665 1,780

10/14/04 - 11/21/04 2,332 -2 10/14/03 - 11/21/03 979 1,353

2/16/06 - 3/16/06 2,408 0 2/16/05 - 3/16/05 7,558 -5,151

9/27/07 - 9/28/07 83 0 9/27/06 - 9/28/06 632 -549

Issuance,

$mn

SLGS suspension

period

Issuance

$m n

Source: Thomson Reuters, MMD, www.Treasurydirect.gov* SLGS: State and local government series




Terry BeltonAC

Srini Ramaswamy

Meera Chandan Alex Roever CFA

Kimberly L. Harano


24

Special Topic:

The Domino Effect of a US Treasury Technical Default

We explore the systemic risks that would result

from a technical default in the US Treasury

market; although we view a default as extremely

unlikely, assessing these tail risks is an important

part of risk management and is useful in

understanding how markets might behave in

advance of a potential default

Our analysis suggests that any delay in making a

coupon or principal payment by Treasury would

almost certainly have large systemic effects with

long-term adverse consequences for Treasury

finances and the US economy

A technical default raises the risk of a flight to

liquidity out of government money funds;

because daily liquidity and stable NAV are of

paramount importance to these investors, a

Treasury default could trigger an increase in

redemptions similar to that seen in 2008

Repo market haircuts would likely rise sharply,

causing deleveraging in lending markets

Foreign demand for Treasuries could be

adversely impacted; a worrisome precedent is the

40% decline in foreign holdings of GSE debt

following conservatorship, despite Treasury

assurances that it stands behind the GSEs

A 20% decline in foreign demand would have a

dramatic impact on Treasury borrowing costs;

we estimate Treasury yields would rise 50bp,

causing growth to slow and deficits to rise

Overview

In an April 4 Letter to Congress, Treasury Secretary

Geithner wrote that without congressional action,

Treasury would reach the statutory debt limit on May 16,

and that only extraordinary measures would allow the

Treasury to avoid defaulting on its obligations until

July 8.1 He further warned that “default would cause a

financial crisis potentially more severe than the crisisfrom which we are only now starting to recover.”

In this research note, we explore the systemic risks that

are likely to follow a technical default in the US Treasury

market. By technical default, we mean a situation where

the failure to raise the debt ceiling causes the Treasury to

miss a coupon or principal payment on an outstanding

obligation, but where the delay is quite short-term (less

than a few days) and is not viewed by the market as

reflecting a real deterioration in the solvency of the US.

Although we view a default as extremely unlikely,

assessing these tail risks is an important part of risk

management and is useful in understanding how marketsmight behave in the period leading up to a potential

Treasury default.

Our analysis suggests that any delay in making a

coupon or principal payment by the Treasury—even

for a very short period of time—would almost

certainly have large systemic effects with long-term

adverse consequences for Treasury finances and the

US economy. These effects would be transmitted

through three primary channels: US money funds, the

Treasury repo market, and the foreign investor

community, which holds nearly half of all Treasury

securities. Our main conclusions are as follows:

A technical default raises the risk of a flight to

liquidity out of government money funds, potentially

triggering an increase in redemptions similar to that

seen in 2008

Repo markets will be severely disrupted as haircuts

are raised and could result in a significant

deleveraging event

Even if the technical default is cured immediately,

foreign demand for Treasuries could be permanently

impaired. As a case in point, we note that even withoutany kind of default, Fannie Mae and Freddie Mac’s

move into conservatorship has led to permanently

lower foreign sponsorship of GSE debt.

We explore these channels in detail in the discussion

below. Finally, we emphasize that even if the debt

ceiling is ultimately raised before a technical default

1 http://www.treasury.gov/connect/blog/Pages/letter-to-congress.aspx




Terry BeltonAC

Srini Ramaswamy


Kimberly L. Harano


25

occurs, the delay in raising the debt ceiling is likely to

negatively impact markets, as investors undertakerisk-management actions in preparation for a

potential Treasury default. Delay could also reaffirm

the notion that the political compromise necessary to

forge longer-term fiscal solutions is lacking, something

that S&P noted in its decision to move its US ratings

outlook to negative on Monday the 18th of April.2

Lehman 2.0: money markets and the

risk of redemptions

Government money funds currently hold $760 bn of

Treasury and Agency securities and repo. Given that

these investors are primarily concerned with liquidity,they are likely to be most impacted by a technical

default, regardless of how quickly it cures. While we

believe that a technical Treasury default would not

automatically trigger selling, concern over a possible

surge in shareholder redemptions would probably lead

funds to build cash or limit investing to overnight

obligatons. As the report of the President’s Working

Group on Money Market Funds Reform3 noted, “[money

market funds’] history of maintaining stable value has

attracted highly risk-averse investors who are prone to

withdraw assets rapidly when losses appear possible.”

A potential adverse reaction from money marketinvestors appears likely to stem from two sources. First,

while we think most funds would continue to buy short-

dated bills and roll over Treasury repo, demand for

Agencies could falter, much as it did in late 2008, and

yields would climb as a result. This reflects our best

judgment that short-dated Treasury securities will remain

relatively more liquid than Agencies (which are

implicitly supported by Treasury) in the event of a

technical default. Nor would the Agency product be

alone, as liquidity across all money market instruments

would likely be impaired following a Treasury default,

even one viewed as temporary.

The second concern stems from the impact of rising

yields on net asset values (NAV). If yields rise enough,

asset values could theoretically “break the buck.” To

2 “United States of America ‘AAA/A-1+’ Rating Affirmed; Outlook

Revised to Negative,” Nikola G Swann, et al, Standard & Poor’s,

4/18/11. 3 http://www.sec.gov/rules/other/2010/ic-29497.pdf

be sure, the hurdle for NAVs to fall below the $0.995

threshold is high, and Agency or Treasury yields would

have to spike by a considerable amount. But while the

average government fund has a weighted average

maturity (WAM) of only about 45 days, some funds

have weighted average lives (WAL) as long as between

110 and 120 days, reflecting a higher concentration

of Agency FRNs (Exhibit 1). For these funds, a150-175 bp spike in front-end yields could lower NAVs

below $0.995.

Even if yields don’t rise enough to cause funds to break

the buck, the pressure of liquidating assets at a NAV

below $1.00 could put extreme pressure on fund sponsors

and possibly lead one or more to halt redemptions.

Because daily liquidity and a stable NAV are what

money fund shareholders care most about, a halt in

redemptions at one fund is likely to cause broader

outflows, even if the Treasury’s technical default is

recognized as temporary and not a credit issue.

In the two days following the Lehman failure in 2008,

the Reserve Primary Fund, which held less than $1bn

(1.5% of its $62bn in assets) in Lehman debt, received

redemption requests totaling $40bn. The fund quickly

ran through its cash reserves and then sought to liquidate

portfolio holdings, further depressing the price of those

securities. The fund announced on September 16 that

they had broken the buck with an NAV of $0.97. As a

Exhibit 1: Some government money funds that hold a

higher proportion of Agency FRNs have WALs close to120 daysDistribution of weighted average life for government money funds as of February2011; %

0%

5%

10%

15%

20%

25%

30%

0-12 12-

24

24-

36

36-

48

48-

60

60-

72

72-

84

84-

96

96-

108

108-

120

120+

# of days

Source: Crane Data




Terry BeltonAC

Srini Ramaswamy


Kimberly L. Harano


26

result, prime institutional money market funds faced

enormous redemption pressure. In the week followingthe Lehman bankruptcy, over $300bn of assets exited

prime institutional money market funds as institutional

investors no longer felt safe holding their money in these

funds, and these outflows eventually reached nearly

$500bn before recovering (Exhibit 2). On September

17, Putnam’s institutional money market fund, due to

significant redemption pressure, announced they would

close the fund; one week later Federated announced it

was acquiring the Putnam fund, ultimately preventing

losses to the investors.

The run on prime money funds was halted only by

extraordinary measures undertaken by Treasury and theFederal Reserve. On September 19, the Treasury and

the Fed jointly announced a temporary guarantee of

money market funds (TGP), and a liquidity facility

extending credit to banks to finance their purchases of

ABCP (AMLF). These actions helped stabilize the

outflows and by mid-October, prime money funds

began to again see inflows.

In sum, while most money market investors will likely

not view a technical default as a credit issue, a technical

default may nonetheless trigger a flight to liquidity that

could ultimately be profoundly disruptive.

Deleveraging in Treasury repo markets

Treasuries have historically been viewed as the highest

quality and safest asset, a status which has made them the

vehicle of choice in collateralized lending agreements.

We estimate that over $4 trillion of Treasuries—nearly

half of the outstanding stock—are used as collateral for

repo agreements, futures clearinghouses and OTC

derivatives (Exhibit 3). A sharp repricing of this

collateral in response to a Treasury default would

likely increase haircuts, potentially leading to

significant margin calls, some forced deleveraging,

and a decline in lending capacity in financial markets.

In the event of a default, we would expect to see haircuts

rise on Treasuries as higher volatility forces lenders to

increase collateral requirements. We estimate that the

average haircut for Treasury repo (across all durations) is

currently 0.5%, but we could see haircuts rise toward

1.5%, the average level during the financial crisis. Other

related collateral would likely be affected as well: during

the repo market crisis of 2008, haircuts on Agency MBS

doubled from 5% to 10%, causing significant

deleveraging by investors, and this activity caused

mortgage spreads to widen 150 bp (Exhibit 4).

Although leverage among market participants is

considerably lower than in 2008, we would still expect

to see some forced deleveraging as a result of increased

haircuts. For example, REITs, which finance their

MBS purchases with repo, would likely need to

delever; their selling of MBS would likely push

mortgage rates higher, potentially inducing others tosell. In addition, we think relative value hedge funds

and Asian banks may also delever.

Regardless of the initial magnitude, we emphasize that

any deleveraging activity may be damaging for markets:

as we saw in 2008, forced deleveraging begets further

deleveraging, as declining prices force more and more

investors to liquidate their positions.

Exhibit 2: A single fund halting redemptions could

trigger a broader run on money funds, similar to theaftermath of the Lehman failurePrime money market fund balances (Taxable funds); $ bn

1500

1600

1700

1800

1900

2000

2100

Jun 07 Oct 07 Mar 08 Aug 08 Jan 09 Jun 09

Source: iMoneyNet

Exhibit 3: Over $4tn of Treasuries are used ascollateral in the repo and derivatives marketsEstimated Treasury securities in use as collateral; $ bn

Repo agreements 3,943

OTC derivatives 114

Listed derivatives 118

Total 4,175

Source: Repo data are for primary dealers as reported to the Federal Reserve Bank of NewYork; OTC derivatives are from 2010 ISDA Margin Survey; listed derivatives are estimated

from clearinghouse margin data and J.P. Morgan




Terry BeltonAC

Srini Ramaswamy


Kimberly L. Harano


27

Impact on Treasury funding costs

When assessing the potential impact of a default on

Treasury yields, we think it is useful to differentiate

between the immediate market response and the likely

long-term consequences. In the short run, a technical

default will likely push yields higher as investors absorb

negative headlines. Even if such a near-term rise in yields

is retraced after an eventual increase in the debt ceiling,

however, it could leave lasting damage in its wake due to

a permanent decline in foreign demand, which will likely

lead to higher borrowing costs and larger deficits.

To gauge the near-term impact, we look to other

examples of technical sovereign defaults that have curedrapidly. Over the past twenty years, there have been four

such “grace period defaults,” and in each case, the

default was accompanied by a ratings downgrade

(Exhibit 5). Only one of these defaults was not directly

related to a solvency issue, however, making it somewhat

analogous to the current US situation—the Peru

experience of 2000. In that event, Peru chose to not pay

a coupon on September 7 in order to avoid deleterious

consequences in its legal battle with the hedge fund

Elliott Associates; once the lawsuit was settled, however,

the coupon was promptly paid. As a result of the missed

payment, Peru’s credit rating was lowered from Ba3 to

B1 and then restored to Ba3 immediately after thecoupon payment was made.

Even without ratings agency action, we would expect to

see an immediate rise in yields on the back of a technical

default. Although it is difficult to isolate the impact of

the missed coupon on yields, given the political scandal

around President Fujimori that erupted shortly thereafter,

the Peru experience nonetheless gives us some guidance;

based on the widening of Peru spreads in the immediate

aftermath of the missed coupon, and the narrowing after

the coupon was paid, we estimate the short-term impact

on yields to be about 50bp (Exhibit 6).

This estimate is also roughly in line with investors’

current expectations of the impact of a potential Treasury

technical default. We asked 45 of our large rates clients

how much they thought 10-year Treasury rates would

increase if Treasury temporarily missed a coupon

payment but announced it planned to make payment as

soon as the debt ceiling is raised, and the mean response

was a 37 bp increase in yields, although uncertainty was

very high (Exhibit 7). Notably, however, foreign

investors expected a significantly larger initial increase—

55 bp—than domestic investors.

Exhibit 4: During the repo market crisis of 2008, the

doubling of Agency MBS haircuts led to significantdeleveraging and a sharp widening of spreadsVol-adjusted Agency haircuts* and MBS nominal spreads to Treasuries;% bp

4

6

8

10

12

Jan 07 Aug 07 Mar 08 Oct 08 May 09 Dec 09

0

50

100

150

200

250

Haircut

MBS nominal spreads

* J.P. Morgan estimate for 1-month term repo.

Exhibit 5: Past grace period defaultsSummary of past grace period defaults*

Co untr y Date Rati ng s acti on Deter io rati ng cr ed it?

Pakistan Nov-98 Downgraded: B3 to Caa1 Yes

Peru Sep-00 Downgraded: Ba3 to B1 No

Moldova Jun-01 Downgraded: B3 to Caa1 Yes

Dominican Republic Jan-04 Downgraded: B2 to B3 Yes

* Indicates that the default was cured within the grace period

Exhibit 6: We estimate that the missed coupon inSeptember 2000 caused Peruvian yields to rise about50bpPeru government bond index strip spread to Treasuries in 2000; %

4.5

5.0

5.5

6.0

6.5

7.0

7.5

01 Sep 08 Sep 16 Sep 24 Sep 02 Oct 10 Oct

Scandal

breaks

Missed

coupon

Peru settles, pays




Terry BeltonAC

Srini Ramaswamy


Kimberly L. Harano


28

Beyond any potential near-term impact, the long-term

damage is likely to come in two forms. One is the risk of ratings downgrades down the road. We have previously

estimated that a 1-notch downgrade could trigger a

100 bp rise in yields (see Treasuries, US Fixed Income

Weekly, January 21, 2011). A congressional deadlock

around increasing the debt ceiling could be viewed as

increasing the long-term risk of inaction on fiscal policy

reform, something S&P already has alluded to in

explaining its decision to move the US sovereign ratings

outlook to negative.

Even more significant, however, is the risk of lasting

damage from a loss of sponsorship from foreign

investors, similar to what happened to GSE debtholdings after the Agencies entered conservatorship.

Despite Treasury’s assurances that the US stands behind

GSE debt, foreign investors liquidated nearly 40% of

their holdings of GSE debt in the year following the

placement of Fannie Mae and Freddie Mac under

conservatorship, and these investors never returned.

As Exhibit 8 shows, foreign holdings of Agency debt

steadily declined after conservatorship, and they have

held steady at around half the size of their 2008 peak.

Even a modest decline in foreign holdings of

Treasuries following a default would have a dramatic

impact on Treasury borrowing costs. We estimate thata 20% decline in Treasury holdings by foreign investors

completed over a 1-year period would push Treasury

yields higher by 50-60 bp (see grey box). A 50 bp

increase in yields would increase annual deficits by

$10bn in the short run, and by $75bn per year over time

as outstanding debt rolls over.

The impact on economic growth

Beyond the impact on borrowing costs, the failure to

raise the debt ceiling in a timely fashion and a potential

default would have real negative consequences for

growth. Although it is difficult to quantify the totalimpact on GDP from a technical default, we can estimate

the impact of the associated rise in rates as well as the

wealth effects of an accompanying sell-off in equities. A

Federal Reserve paper on the macroeconomic

implications of changes in term premium4 suggests that a

100 bp rise in term premium lowers GDP by 0.8%; thus,

if Treasury yields were to rise 50 bp as we project, GDPwould likely be reduced by about 0.4%. In addition, the

equity market would likely sell off sharply in response to

a technical default, as it did on the day that Congress

initially failed to pass TARP in September 2008. On that

day, the S&P 500 fell 9%; using this as a rough guide, we

4“Macroeconomic Implications of Changes in the Term Premium,”

Glenn D. Rudebusch et al, Federal Reserve Bank of St. Louis Review,

July/August 2007.

Exhibit 7: Our clients expect a 37 bp rise in rates in

the event of a technical defaultEstimated increase in 10-year Treasury rates following technical default; % of respondents in each category

8

10

12

14

16

18

20

<10 10-20 20-30 30-40 40-50 50-75 >75

Mean increase = 37 bp

Std. dev = 36 bp

Projected change in 10-year Treasury yields; bp

Exhibit 8: We think the bigger risk to the Treasurymarket is from foreign investors; the experience withGSE debt in 2008 suggests a technical default couldpermanently impact demandEstimated foreign holdings of Agency debt* around the announcement of GSEconservatorship; $bn

300

400

500

600

700

800

Jun 06 Mar 07 Dec 07 Sep 08 Jun 09 Mar 10 Dec 10

Conservatorship initiated

* Agency debt holdings are the TIC annual survey data for release dates (June 30) for eachyear through 2010; data between release dates is estimated using weekly Agency custodyholdings data released by the Federal Reserve




Terry BeltonAC

Srini Ramaswamy


Kimberly L. Harano


29

estimate that a decline of a similar magnitude on a

sustained basis in the aftermath of a default would take

an additional 0.5% off of GDP growth due to lower

consumption. Thus, the quantifiable effects of a default

alone would likely take about 1% off of GDP growth,and the ultimate damage could be far greater.

The impact of the battle over the debt

ceiling, even without a default

Even if Treasury avoided a default, we think the delay in

raising the debt ceiling is likely to negatively impact

markets, as investors undertake risk-management actions

in preparation for a potential Treasury default. Already,some market indicators are showing considerable odds

that the debt ceiling won’t be raised by July (Exhibit 9).

Because the tail risks from a technical default are so

large, a prolonged delay in raising the debt ceiling

seems likely to impact markets well before a default

actually occurs. These effects could include liquidity

shortages over the late June/July period as borrowers

attempt to raise additional cash and increase the tenor of

Measuring the impact of foreign selling: J.P. Morgan

long-term model for 10-year Treasury yields

To estimate the impact of a structural change in foreign demandon Treasury yields, we use the parameter estimates from ourlong-term model of 10-year yields. The model, which isestimated using 20 years of data, models 10-year Treasury yieldsas a function of (a) core inflation, (b) the real funds rate, (c)one-year ahead consensus growth forecasts and (d) the budgetdeficit as a percentage of GDP. As shown in the table below,increases in the real funds rate, core inflation, the consensusgrowth outlook, and the budget deficit all result in higher10-year Treasury yields.

Since increases in the budget deficit lead to an increase inTreasury supply, we can use the model to estimate the yield

impact from a net supply shock due to foreign selling of Treasuries. Specifically, our model suggests that an increase inTreasury supply of $148bn annually (i.e. 1% of GDP) or $12 bnper month is likely to cheapen 10-year Treasuries by 6.6bp. A20% decline in foreign holdings over 1-year amounts to a netincrease in monthly supply of $100 bn ($65 bn per month of selling versus $35 bn per month of buying currently). Thisimplies an increase in the fair value of 10-year yields of 56 bp(6.6 x 100/12).

10-year Treasury yield model parameters:*

Variable Current level Coefficient T-statistics

Intercept - 0.37 1.4

Core CPI yoy*; % 1.01 1.21 25.0

Real funds rate**; % -0.64 0.44 12.8Real GDP forecast***; % 3.34 0.38 6.1

Budget deficit ; % of GDP+ 8.33 0.066 3.7

Model estimated over last 20-years. R2= 80%; Std. error of regression =* 3-month moving average of yoy core CPI rate** 3-month moving average of the real funds rate as measured by rate implied by 1stEurodollar contract minus yoy core CPI*** 3-month moving average of 1-year ahead Blue Chip real GDP growth forecast+ 3-month moving average of budget deficit as percentage of GDP

Exhibit 9: With the caveat that trading volumes are not

large, one online market suggests there areconsiderable odds that the debt ceiling won’t beraised by June 30 Odds that the debt ceiling won’t be raised by June 30 as implied by Intradecontract*

0

10

20

30

40

50

28 Jan 15 Feb 05 Mar 23 Mar 10 Apr 29 Apr

* Contract payoff is $10 if Congress approves increase in US debt ceiling to $15.1T or morebefore midnight ET 30 Jun 2011; $0 otherwise.Source: www.Intrade.com

Exhibit 10: Delays in scheduled bond auctions havehistorically caused Treasuries to underperformAverage spread between 3- and 10-year US Treasury yield minus Bund yields(%) versus 3- and 10-year swap spreads (bp) in 1995% bp

0.15

0.20

0.25

0.30

0.35

0.40

0.45

20 Oct 28 Oct 05 Nov 14 Nov 22 Nov 01 Dec

24

25

26

27

28

29

30

Avg of 3Y and 10Y

Tsy/bund spread

Avg of 3Y and 10Y swap

spread (inverted axis)




Terry BeltonAC

Srini Ramaswamy


Kimberly L. Harano


30

their borrowings, large auction concessions especially if

Treasury were to postpone an auction, increases in optionvolatility that cover the June/July period, and generally

weaker demand for Treasury securities as uncertainty on

whether the debt ceiling will be raised grows. Indeed,

when the government shut down in November 1995 due

to similar debt ceiling issues, Treasury delayed the 3-year

and 10-year note auctions by eight days. As a result, 10-

year Treasuries cheapened 25 bp (Exhibit 10).

Finally, we highlight that these seemingly prudent risk-

management activities in preparation for a potential

default could unintentionally bring about the very run on

liquidity that these activities are meant to prevent, as one

firm raising additional cash provokes similar action byother large firms.




Srini RamaswamyAC


31

Forecasts & Analytics

Interest Rate Forecast

Swap spread forecast*

Apr 29, 2011 May 29, 2011 Jun 30, 2011 Dec 31, 2011 Mar 31, 2012

1m ahead 2Q11 4Q11 1Q12

Rates Forecast Forecast Forecast Forecast

Effective funds rate 0.09 0.10 0.10 0.12 0.12

3-month Libor 0.27 0.22 0.22 0.30 0.35

3-month T-bill (bey) 0.04 0.05 0.05 0.15 0.25

2-year T-note 0.61 0.70 0.75 0.90 1.20

5-year T-note 1.97 2.15 2.30 2.50 2.85

10-year T-note 3.29 3.45 3.60 3.70 3.90

30-year T-bond 4.41 4.55 4.70 4.70 4.70

Curves

3m T-bill/3m Libor 23 17 17 15 10

2s/5s 136 145 155 160 165

2s/10s 268 275 285 280 270

2s/30s 379 385 395 380 350

5s/10s 132 130 130 120 105

5s/30s 243 240 240 220 185

10s/30s 111 110 110 100 80

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

Apr 29, 2011 May 29, 2011 Jul 28, 2011 Oct 26, 2011

1 M 3 M 6 M

Forecast Forecast Forecast

2-year sw ap spread 17 18 20 21



30-year sw ap spread -24 -21 -18 -14

*Forecast uses matched maturity spreads




Srini RamaswamyAC


32

Economic forecast

Financial markets forecast

Gross fixed-rate product supply*

%ch q/q, saar, unless otherwise noted

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

Gross Domestic Product

Real GDP 2.6 3.1 1.8 3.0 3.0 3.0 0.2 2.8 2.7

Final Sales 0.9 6.7 0.8 2.5 3.2 3.1 -0.3 2.4 2.4

Domestic Final Sales 2.6 3.2 0.9 2.2 3.0 3.2 -1.4 2.9 2.3

Business Investment 10.0 7.7 1.8 7.5 9.5 9.5 -12.7 10.6 7.0

Net Trade (% contribution to GDP) -1.7 3.3 -0.1 0.3 0.2 -0.1 1.1 -0.5 0.1

Inventories (% contribution to GDP) 1.6 -3.4 0.9 0.5 -0.2 -0.1 0.4 0.4 0.3

Prices and Labor Cost

Consumer Price Index 1.4 2.6 5.2 3.6 2.0 1.4 1.5 1.2 3.0

Core 1.1 0.6 1.7 1.4 1.0 0.8 1.7 0.6 1.2

Producer Price Index 1.1 6.8 12.5 3.0 0.8 1.3 1.5 3.9 4.3

Core 2.1 -0.2 3.7 2.0 0.5 1.0 0.9 1.4 1.8Employment Cost Index 1.8 1.8 2.5 1.7 1.6 1.5 1.4 2.0 1.8

Unemployment Rate (%, sa) 9.6 9.6 8.9 8.8 8.7 8.6 - - -

* Q4/Q4 change

Credit Spread CurrentMid-year

2011

10Y swap spread* 5 7

30Y current coupon MBS L-OAS** 33 30

10Y AAA 30% CMBS (2007 vintage)** 180 140

3Y AAA Credit Cards fixed** 21 15

JULI I-Spread* 131 130High Yield Inde x* 521 515

Emerging Market Index* 302 250

Corporate Emerging Market Index (Broad)* 275 260

* spread to Treasuries

** spread to swaps

CurrentMid-year

2011

S&P* ($) 1360 1475

Brent** ($/bbl) 125.2 118.0

Gold** ($/oz) 1539 1450

EUR/USD 1.48 1.43

USD/JPY 81.5 80* S&P500 fo recast is for year-end 2011

** 2Q11quarterly average forecast

0

50

100

150

200

250

300

350

Apr 08 Jul 08 Oct 08 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11

ABS CMBS MBS Corporate Agency

* amount in $ billions




Srini RamaswamyAC


33

Client surveys

Duration

Long Neutral Short Changes

Apr 25, 2011 6 65 15 4

Apr 18, 2011 6 65 15 8

3-month average 10 69 17 13

Credit

Corporate Bond

Weighting

Cash

Position

Spread

Outlook

Apr 14, 2011 1.22 0.75 1.22

Mar 9, 2011 1.28 0.90 0.82

3-month average 1.38 0.82 1.27

*Corporate bond weighting index is the ratio of the sum of overweights and neutral

positions to the sum of underweights 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 negative and neutral outlooks.

6 7 8

3 4 5

MBSOverweight Flat Underweight

April 2011 37% 48% 15%

March 2011 29% 53% 18%

3-survey average 38% 42% 20%

Treasury Client Survey

Credit Client Survey

-20

-10

0

10

20

30

Apr 10 Jun 10 Sep 10 Nov 10 Feb 11 Apr 11

Longs minus shorts

0.6

0.8

1.0

1.2

1.4

1.6

1.8

Mar 08 Nov 08 Jun 09 Jan 10 Sep 10 Apr 11

Corporate Bond Weighting

MBS Investor Survey

-60%

-40%

-20%

0%

20%

40%

Jul 09 Oct 09 Feb 10 May 10 Aug 10 Nov 10 Feb 11 Apr 1

Overweight - Underweight



US Fixed Income StrategyUS Fixed Income Weekly

New York, May 2, 2011

34

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US Fixed Income StrategyUS Fixed Income WeeklyNew York, May 2, 2011

Market Movers

2 May

ISM manufacturing (10:00am)Apr 59.7Construction spending(10:00am) Mar -0.1% Senior loan officer survey(2:00pm) 2Q

3 May

Factory orders (10:00am)Mar 2.3%Light vehicle salesApr 13.0mn

Kansas City Fed President Hoenigspeaks to community bankers inWashington (8:30am)

4 May

ADP employment (8:15am)Apr ISM nonmanufacturing(10:00am) Apr 58.0

Announce 3-year note $32 bnAnnounce 10-year note $24 bnAnnounce 30-year bond $16 bn

Boston Fed President Rosengrenspeaks at a Real Estate Conference inBoston (8:00am)SF Fed President Williams speaks onpolicy in Los Angeles (3:30pm)Dallas Fed President Fisher speaks inNew Mexico (4:00pm)Atlanta Fed President Lockhartspeaks on US economic outlook in

Atlanta (7:00pm)

5 May Initial claims (8:30am)w/e prior Sat 435,000Productivity and costs (8:30am)1Q preliminary 1.7% (1.2%oya)Unit labor costs 0.9% (1.3%oya)Chain store salesApr

Chicago Fed President Evans(9:15am) and Fed Chairman Bernankespeak at Chicago Fed bankingconference (9:30am)Minneapolis Fed PresidentKocherlakota speaks on monetarypolicy in California (1:15pm)

6 May

Employment (8:30am)Apr 165,000Unemployment rate 8.8%Average weekly hours 34.3Consumer credit (3:00pm)Mar

Fed Vice Chair Yellen speaks onEconomic growth at Bank of Finlandconference in Helsinki, Finland(7:30am)NY Fed President Dudley speaks at aregional economic briefing in NewYork (10:00am)St. Louis Fed President Bullardspeaks to bankers in Little Rock, AR(11:45am)

9 May 10 May

NFIB survey (7:30am)Apr Import prices (8:30am) Apr Wholesale trade (10:00am)Mar

Auction 3-year note $32 bn

Fed Governor Duke speaks oncommunity development in St. Louis(9:30am) Richmond Fed President Lacker speaks on US economic outlook in

Arlington, VA(12:45pm)

11 May International trade (8:30am)Mar JOLTS (10:00am) Mar Federal b udget (2:00pm)Apr

Auction 10-year note $24 bn

Atlanta Fed President Lockhartspeaks on US economic outlook inAtlanta (12:15pm)Minneapolis Fed PresidentKocherlakota speaks on monetary

policy in New York (1:00pm)

12 May Initial claims (8:30am)w/e prior SatRetail sales (8:30am) Apr PPI (8:30am)Apr Business inventories(10:00am) Mar

Auction 30-year bond $16 bnAnnounce 10-year TIPS (r) $11 bn

Philadelphia Fed President Plosser

speaks on US economic outlook inFlorida (8:30am)

13 May

CPI (8:30am)Apr Consumer sentiment (9:55am)May preliminary

16 May

Empire State survey (8:30am)MayTIC data (9:00am)Mar NAHB survey (10:00am) May

17 May

Housing starts (8:30am)Apr Industrial production (9:15am)Apr

18 May FOMC minutes(economic projections)

St. Louis Fed President Bullardspeaks in New York (7:00pm)

19 May Initial claims (8:30am)w/e prior SatExisting home sales (10:00am)Apr Philadelphia Fed survey(10:00am)MayLeading indicators (10:00am)Apr

Auction 10-year TIPS (r) $11 bn Announce 2-year note $35 bn Announce 5-year note $35 bn

Announce 7-year note $29 bn

Chicago Fed President Evans speaksat forum in Chicago (1:30pm)

20 May

“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

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jpm fi weekly 5-2

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