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US Fixed Income Strategy 1 February 2012
US Fixed Income Weekly

Cross Sector Srini Ramaswamy, Kimberly Harano
We remain positive on risky assets given reduced fears around Europe, a stimulative Fed and strong demand. In addition, spread carry now looks attractive vs. yield curve carry on a risk-adjusted basis.
Contents
Cross Sector Overview Economics Treasuries Agencies Corporates Municipals Special Topic Forecasts & Analytics Market Movers 2 5 8 13 17 23 29 36 40
Governments Terry Belton, Meera Chandan, Kim Harano, Renee Park

We continue to expect higher rates targeting 2.25% in 10-year yields. Forward OIS is now extremely rich relative to the FOMCs own rate forecast. Watch for 2/3s curve steepening and 3/7s flattening. Overweight intermediate Agencies, but underweight 2s versus Treasuries.
Investment-Grade Corporates Eric Beinstein

The arguments for the current rally are strong including LTRO reducing European risks, solid credit fundamentals, and light January supply. However, we are near our 1Q spread target and we maintain a neutral view.
Municipals Peter DeGroot, Josh Rudolph

Yields remain low against the backdrop of manageable supply, but this may be challenged should we see an uptick in volume.
Special Topic: Limiting Greek Contagion Saul Doctor

We present our view on how to restructure Greek government debt and prevent contagion to other markets. The situation is delicate but manageable.
Terry Belton Srini Ramaswamy Alex RoeverAC
AC
Indicates certifying analyst. See last page for analyst certification and important disclosures.
US Fixed Income Strategy US Fixed Income Weekly February 1, 2012 Srini RamaswamyAC Kimberly L. Harano J.P. Morgan Securities LLC
Cross Sector Overview

In the FOMC statement this week, the Fed stated that it expects the funds rate to remain exceptionally low at least through late 2014, in line with market expectations prior to the meeting However, the details of the individual views within the committee arguably send a less bullish signal. We estimate that the center of the FOMC expects a 47bp funds rate by the end of 2014 Thus, given the substantial (and, in our view, unjustified) rally in response to the FOMC statement, the fact that Treasuries have repriced the least to the improved market backdrop, and poor technicals, we retain a bearish bias on duration We remain positive on risky assets given reduced near-term fears around Europe, a stimulative Fed and strong demand. In addition, spread carry now looks attractive relative to yield curve carry on a risk-adjusted basis Turn overweight EM sovereigns
Exhibit 1: A dovish message from the Fed helped both risky assets and Treasuries rally
Current level,* change since 1/6/12, quarter-to-date change, and change over 4Q11 for various market variables
Current Chg from 1/20 QTD chg 4Q11 chg Global Equities (level) S&P 500 E-STOXX FTSE 100 Nikkei 225 Sovereign par rates (%) 2Y US Treasury 10Y US Treasury 2Y Germany 10Y Germany 2Y JGB 10Y JGB 5Y Sovereign CDS (bp) Greece Spain Portugal Italy Ireland Funding spreads (bp) 2Y EUR par swap - par gov't spd 2Y USD par swap - par gov't spd EUR FRA-OIS spd USD FRA-OIS spd 1Y EUR-USD xccy basis Currencies EUR/USD USD/CHF USD/JPY JPM Trade-weighted USD Spreads (bp) 30Y CC MBS L-OAS 10Y AAA CMBS spd to swaps JULI (ex-EM) Z-spd to Tsy JPM US HY index spd to worst EMBIGLOBAL spd to Tsy MAGGIE (Euro HG spd to govies) US Financials spd to Tsy Euro Financials spd to govies 1316.3 2436.6 5733.5 8841.2 0.220 1.977 0.165 1.933 0.129 0.881 11171 352 1599 398 635 102.9 31.8 59.2 38.1 -62.3 1.313 0.919 77.08 80.72 43.9 250.0 206.8 671.9 409.8 202.7 278.7 291.6 0.9 9.7 4.9 74.9 -0.038 -0.128 -0.030 -0.041 0.001 -0.033 3812 -21 199 -64 -48 2.5 -2.1 1.1 -4.1 7.1 0.021 -0.016 -0.13 -0.78 4.8 0.0 -10.4 -14.6 -2.9 -8.3 -19.9 -18.8 58.7 120.1 161.2 385.9 -0.044 0.034 0.063 0.040 0.001 -0.025 3677 -30 421 -89 -118 -18.1 -14.9 -11.9 -17.6 37.6 0.021 -0.025 -0.63 -1.53 -2.1 -25.0 -28.4 -52.2 -16.5 -25.2 -52.0 -60.6 126.2 136.9 443.8 -244.9 -0.032 -0.080 -0.406 -0.046 -0.017 -0.089 1555 -1 -36 13 12 21.8 18.6 7.7 12.3 -27.3 -0.051 0.037 0.95 0.23 -0.6 -90.0 -14.0 -83.9 -38.6 16.6 -3.4 25.1
Market views
The past week saw both a continuation of recent themes and one new, noteworthy development. First, the positive momentum in measures of European stress remained intact as funding spreads, the cross-currency basis, and the level of EUR/USD all showed improvement again this week (Exhibit 1). Second, economic data were more mixed than in past weeks, but were not weak enough to cause us to revise our growth forecast. On the positive side, the Richmond, Chicago, and Kansas City Fed activity indices all were stronger than expected in January, durable goods orders were solid in December, and the University of Michigan confidence survey ticked up to its highest level since February 2011. On the other hand, housing data were weaker than expected, with pending home sales and new home sales declining in December, and initial jobless claims rose from 356K to 377K. The first estimate for 4Q11 GDP growth printed at 2.8%, below our expectations of 3.0%. Notably,
10Y AAA muni/Tsy ratio (level) 90% 2.6% -4.7% -15.6% 30Y AAA muni/Tsy ratio (level) 105% -2.4% -17.2% 1.6% Commodities Gold futures ($/t oz) 1726.70 72.20 185.80 -74.60 Oil futures ($/bbl) 99.56 1.23 0.73 19.63 * 1/26/12 level for Europe and US corporate credit spreads, and the J.P. Morgan tradeweighted USD index; 1/27/12 level for all others.
inventories contributed 1.9% of GDP growth last quarter, which could weigh on growth early this year.
Exhibit 2: The center of the FOMC expects to stay on hold until 2014
FOMC participants assessment of the appropriate timing of first policy tightening; number of participants
Exhibit 3: Fed funds forecasts of FOMC voting members (except Lacker) suggests that the center of the FOMC expects a 47bp funds rate by year end 2014
Number of voting members (excluding Lacker) versus their forecast for the Fed funds target rate at the end of 2014
6 5 4 3 2 1 0 2012
Source: Federal Reserve
4
5 4 3 3 2
3 2 1 0 12.5 50
Mean=47 bp
75
100
2013
2014
2015
2016
Source: J.P. Morgan
Target funds rate by year-end 2014; bp
Some disappointments in economic data were not enough to derail the risky asset rally, however, as the Fed validated market expectations of stimulative monetary policy over a multi-year horizon. At the FOMC meeting this week, the Fed was dovish, stating that it expects to keep the Fed funds rate exceptionally low at least through late 2014 as opposed to the at least through mid-2013 language used in prior statements. In addition, the Fed gave more details on its projections for the path of monetary policy for the first time and released additional information on the dispersion of views within the committee. Last week, we noted that the OIS curve was mostly priced to a Fed on hold until late 2014 (see Treasuries, US Fixed Income Weekly, 1/20/12). The Feds projections merely validated this view, showing that the center of the committee expects to stay on hold until 2014 (Exhibit 2). However, rates markets rallied significantly on the back of the FOMC releases. Fiveyear Treasury yields have fallen 16bp on the week, with most of the decline coming after the FOMC meeting. This market reaction is somewhat surprising, particularly considering that the individual views within the committee arguably sends a less bullish signal. Based on our best guess for how the voting members of the FOMC cast their forecasts, we estimate that the center of the FOMC expects a 47bp funds rate by the end of 2014 (Exhibit 3; see Treasuries for more details). Thus, in our view, the rally in rates markets appears overdone. Moreover, yield levels have also retraced the least as European concerns have begun to recede (Exhibit 4).
Exhibit 4: Treasury yields have retraced the least despite reduced concerns around Europe
Current level (as of 1/26/12), worst level since 6/30/11, best level over 1H11, and percent retracement to the best level; bp unless otherwise indicated Worst level Best level % retrace-
Current 5Y Tsy yld (% ) 10Y Tsy yld (% ) 30Y Tsy yld (% ) EMBIGLOBAL spd to Tsy US Financials spd to Tsy JULI portfolio spd to Tsy JPM US HY index spd to worst 10Y AAA CMBS spd to swaps 5Y CDX.HY spd 5Y CDX.IG spd 10Y AAA muni/Tsy ratio (% ) S&P 500 (points) level 0.77 1.93 3.09 408 297 215 672 250 564 101 89 1318
since 6/30/11 0.77 1.71 2.76 490 379 262 864 400 911 151 123 1099
over
ment to
1H11 best level 2.40 0% 3.72 4.76 266 167 144 501 170 380 79 80 1364 11% 17% 37% 39% 39% 53% 65% 65% 69% 80% 83%
Note: For yields and S&P 500, the worst level is the minimum level and the best level is the maximum level; it is the opposite for all others.
Thus, given an exaggerated (and arguably unjustified) response to the FOMC statement, the fact that Treasuries have repriced the least to the improved market backdrop, and also given poor technicals, we retain a bearish bias on duration (see Treasuries). In spread product markets, we retain a positive bias. As already mentioned, improving sentiment in Europe and an accommodative Fed are strong supports for spread product. In addition, demand for risky assets has been
very robust so far this year. As Exhibit 5 shows, equities and high yield have seen substantial inflows over the past four weeks, while less risky sectors such as govies have seen outflows. This contrasts sharply with the risk-off flows we saw in 2011. Finally, we find that spread carry now looks more attractive than yield curve carry on a risk-adjusted basis (Exhibit 6). Thus, fundamental and technical factors are supportive for risky assets. Indeed, in high yield we highlight that the FOMC statement as well as comments by Chairman Bernanke suggesting that the bar for QE3is not too high further bolsters the case the asset class, especially given wide spreads relative to a low default rate. Similarly, in emerging markets, we moved from neutral to overweight in EM sovereigns and from underweight to neutral in EM corporates given our expectation that EM will catch up to other risky asset classes. In ABS, we are cautiously optimistic, and we remain overweight on subordinate card and auto ABS, AAA retail cards and non-prime auto ABS. In corporates, we are more cautious and maintain our neutral call on the market. On one hand, reduced fears around Europe, positive technicals, and solid credit fundamentals are supportive, but on the other hand, spreads have already tightened substantially, and low bond yields may curb demand (see Corporates). Similarly, in CMBS, we think further upside may be limited and we like taking this opportunity to reduce risk in weaker credits, which have rallied substantially from their 2011 lows.
Exhibit 5: The riskiest sectors such as equities and high yield have seen substantial inflows so far this year
Flows into mutual funds summed over the past four weeks and the 2011 average for 4-week flows; $bn
20 16.1 15 10 5 0.6 0 0.0 -5 -2.8 All equities US equities HY IG -0.7 US gov't -1.1 Munis 9.9 6.9 3.02.8 0.2 3.5 Past 4 weeks 2011 avg 4 weeks
Source: EPFR Global
Exhibit 6: Risk-adjusted carry from credit spreads now appears attractive relative to yield curve carry
Return/risk* and the 6-month change in the return/risk for Treasuries and select spread products
0.2 0.1 0.0 -0.1 -0.2

MBS 30Y CC 10Y Tsy High Yield HG credit 10Y Agy 2Y Tsy 5Y Tsy 7Y Tsy
Current 6m change
EMBIGLOBAL
4
*This is calculated as spread or loss-adjusted spread, if applicable, divided by (duration * risk * 2). Risk is the 5-year standard deviation of 6-month changes in spread. Calculation for spread products based on spreads to Treasuries, and for Treasuries and Agencies it is yield minus OIS.
Economic Research US Fixed Income Weekly February 1, 2012 Robert MellmanAC Michael Feroli J.P. Morgan Chase Bank
Economics
Composition of 4Q11 GDP reinforces the forecast of near-term slowing; GDP forecast for 1Q12 still 2.0% Business fixed investment slowed abruptly in 4Q11, but latest signals are more encouraging Payroll employment expected to rise a belowtrend 115,000 in January as temporary lifts unwind
Exhibit 1: Real GDP and real final sales

(%ch, saar)
5 4 3 2 1 0
Real GDP Real final sales
The governments advance report indicates that real GDP increased 2.8% (saar) last quarter, the most rapid quarterly growth in a year and a half. Yet, it also printed a negative for activity early this year. A large increase in the rate of inventory accumulation accounted for twothirds of the output growth in 4Q11, while real final sales slowed to only 0.8% (saar) from 3.2% in 3Q11. The two key messages from the report are that the final sales trend is modestly weaker than we previously thought, even after discounting what looks like unusual 4Q weakness in specific components, including government military purchases (-12.5%, saar). And inventory accumulation was unusually strong in 4Q11, pointing to at least a modest inventory correction ahead. The forecast had already been expecting slowing in real GDP growth this quarter to 2.0%. The GDP report certainly reduces upside risks to that forecast, as does some of the more timely incoming data. For example, real consumer spending (by far the largest component of GDP) appears to be tracking below the forecast of 1.7% (saar) growth this quarter. Real consumer spending likely declined 0.1% in December (release Monday), and the latest industry reports on both auto sales and chain store sales point to another weak month for spending in January. Not all the news has been negative, however. Initial claims are trending lower, business surveys for January generally improved, and core capital goods orders rebounded 2.9% in December. Overall, it still seems likely that the economy will expand at a moderate 2.02.5% pace in 1H12 rather than anything much weaker or stronger.
2010
2011
Exhibit 2: Real private inventories and major components

(Ch, $2005bn, saar)
Total Nonfarm Manufacturing Wholesale Retail
4Q10 38.3 44.7 39.7 16.5 -13.7
1Q11 49.1 59.7 33.3 22.3 -0.7
2Q11 39.1 51.0 24.2 39.0 -20.5
3Q11 -2.0 5.5 11.3 6.4 -12.7
4Q11 56.0 63.6 34.1 24.8 -9.5 -16.6 7.1
Motor vehicles -17.7 -9.1 -23.0 -11.1 All other 4.0 8.4 2.5 -1.6 Note: Components do not add up to total in chain-weight calculations
Perceptions of near-term growth will be influenced by upcoming reports on activity in January. Forecasts expect: Temporary boost to December payrolls unwinds: Non-farm payrolls increased 200,000 in December. But, the total was boosted by temporary distortions, including the seasonal hiring of roughly 40,000 couriers to deliver holiday presents and the boost in construction employment due to mild weather. As these increases reverse in January, payroll growth should shift from an above-trend 200,000 increase in December to a belowtrend 115,000 increase in January. This reading, if realized, would indicate that the trend in hiring has improved to an average of 158,000 in December-January from an average of 112,000 over the previous six months. The unemployment rate has declined 0.5% in the past three months, despite only moderate economic growth. The forecast looks for the unemployment rate to hold at 8.5% in January.
Another rise in ISM manufacturing: There are lots of reasons to think that manufacturing growth will moderate this quarter, including an expected inventory correction, weak export markets, and a response to the sharp slowdown in domestic final sales in 4Q11. But, the regional manufacturing surveys generally improved in January and the forecast looks for a third consecutive increase in the ISM manufacturing survey to 55.0 in January from 53.9 in December. Auto sales stall: Auto sales have been trending higher since supply shortages depressed sales last May and June. Industry guidance suggests auto sales merely held Decembers 13.5 million pace in January. Auto dealers are the one major sector with declining inventories, and the stall in sales might be related to low inventories and aggressive pricing.
Exhibit 3: Real business fixed investment, equipment and structures

(%ch, saar) 30
Equipment and software
20 10 0 -10 -20 -30 2010 2011 Structures
Exhibit 4: Regional Fed surveys, capital spending plans

(sa) simple average of January surveys already released
Business spending comes off the boil

The big stories in the 4Q11 GDP report are the build in inventories and the sharp slowing in domestic final sales, to only 0.9% (saar) from 2.7% in 3Q11. The slowing in domestic spending was not broad-based. Real consumer spending accelerated modestly to 2.0% from 1.7% (saar) in 3Q11. Housing accelerated more sharply to 10.9% (saar) from 1.2%. Real government spending had an unusually weak quarter, down 4.6% (saar) on the back of a sharp drop in military spending, but military spending tends to be volatile from quarter to quarter, and a similarsized decline in military spending in 1Q11 was followed by a 7% rebound the following quarter and the forecast expects a partial rebound this quarter as well. The major news in the report that could force a rethinking of the forecast is the sharp slowdown in real business fixed investment from double-digit growth in both 2Q11 and 3Q11 to growth of only 1.7% (ar) last quarter. Business spending on equipment and software moderated to 5.2% in 4Q11 from an average growth of 11.2% in the two prior quarters. But the major story is the sharp reversal in the trend of business investment in structures, to -7.2% (saar) in 4Q11 from average growth of 18.5% in 2Q and 3Q. Spending on buildings slowed to a standstill, and spending on oil and gas explorations abruptly shifted from rapid growth to outright decline. The forecast views the trend in capital spending as somewhere between the boom in the middle of the year
30 25 20 15 10 5 2010 2011 2012
Exhibit 5: Durable goods orders

(%ch, saar, 3m/3m) 25
20 15 10 5 0 Jan 11
Core capital goods Total ex transportation
Jul 11
and the much slower growth last quarter and looks for business fixed investment to grow at an 8% pace in 1H12. In this view, some of the 4Q11 weakness was a breather following a couple of boomy quarters and some was a lagged response to declines in confidence and equity prices during the summer, declines that have been reversed. The latest data have been on the encouraging side. Core capital goods orders and shipment both rebounded 2.9% (saar) in December after a couple of weak reports. And, the regional Fed surveys show a sharp recovery in capital spending plans for manufacturers over the past few months.
Mixed messages on orders for durables

Total durable goods orders rose 3.0% (samr) in December and soared 33.8% (saar) in the last three months. A good part of the strength is accounted for by a rebound in orders for civilian aircraft and motor vehicles. But even excluding transportation equipment, new orders for durable goods increased 3.1% in December and accelerated to 18.2% (saar) over the past three months. While data to date show continued solid growth in overall manufacturing, the trends for the capital goods industries are not so clear. Core capital goods orders indeed bounced 2.9% (samr) in December, but the trend slowed to 2.8% (saar) over the three months through 2Q11. Manufacturing detail of next weeks payroll report will provide the next information on activity in overall manufacturing and in the capital goods industries.
US Fixed Income Strategy US Fixed Income Weekly February 1, 2012 Terry BeltonAC Meera Chandan Kimberly L. Harano J.P. Morgan Securities LLC
Treasuries
We remain biased for moderately higher rates still targeting 10-year yields to reach 2.25% this quarter The outperformance of intermediates following the FOMC statement appears overdone with forward OIS rates now extremely rich to the FOMCs own rate forecast; we watch for 2s/3s curve steepening in expectation of a cheapening of forward OIS We also expect 3s/7s curve flattening on account of the richness of forward OIS as well as strong cyclical patterns around FOMC meetings We expect Treasury to leave coupon sizes unchanged in the upcoming refunding announcement T-bill net issuance will stay relatively low in the near term, but will likely accelerate after midFebruary Stay tactically neutral on TIPS breakevens, but look to initiate wideners at better entry levels as we head into supply
Exhibit 1: J.P. Morgan interest rate forecast

%
Actual Rates Effective funds rate 3-mo LIBOR 3-month T-bill (bey) 2-yr Treasury 5-yr Treasury 10-yr Treasury 30-yr Treasury 1Q12 2Q12 3Q12 4Q12 27 Jan 12 31 Mar 12 30 Jun 12 30 Sep 12 31 Dec 12 0.08 0.55 0.05 0.21 0.75 1.90 3.06 0.06 0.55 0.02 0.27 1.10 2.25 3.30 0.06 0.50 0.02 0.30 1.25 2.50 3.60 0.06 0.43 0.02 0.30 1.25 2.50 3.60 0.06 0.35 0.02 0.30 1.25 2.50 3.60
Exhibit 2: Levered investors have covered the short duration position they held in 4Q11
J.P. Morgan index of levered investor bond positions*
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5
Market views
The Treasury market rallied sharply this week with 2-year yields falling 3 bp, 5-year yields falling 16 bp, 10-year yields falling 13 bp, and 30-year yields falling 4 bp. The rally followed a more dovish than expected statement by the FOMC as investors responded to the Feds low rate guidance by extending out the curve. The move pushed 5year Treasury rates down to 75 bp, a new record low for this part of the yield curve. Economic data was light but slightly weaker than expected this week. The GDP report for 4Q11 disappointed, increasing 2.8% with the weaker consumption and stronger inventories in the report creating downside risk to our 1Q12 GDP forecast of 2%. Initial jobless claims rose 21 thousand reversing some of last weeks move; the fourweek moving average, however, declined 3,000 to 378,000 and has held in a narrow range over the past few months. On the positive side, durable goods orders increased a stronger than expected 3%, and the Richmond Fed manufacturing survey increased 9 points to 12 with its
Jul 10
Jan 11
Jul 11
Jan 12
* Defined as 0.66 * CFTC net spec longs (in interest rate futures) z-score +.33 * hedge fund return beta to 10-year yields z-score. Hedge fund betas are calculated using daily returns on the IQ Global Macro Beta Index.
key components reaching their highest levels in nine months. Finally, housing data was mixed; pending home sales dipped 3.5% in December, new home sales declined 2.2%, while the FHFA price index increased 1% in November with the trend showing a moderation in home price declines in recent months (see Economics). Looking ahead, we remain biased for moderately higher rates still targeting 10-year yields to reach 2.25% this quarter (Exhibit 1). Even with a more dovish Fed, Treasury rates remain below fair value, and as discussed below, forward OIS rates now appear quite rich relative to the Feds own forecast of policy rates. Technicals are also improved as our index of levered investor bond positions shows levered investors have covered a short duration position from last year (Exhibit 2). While the latest reading does not yet show an extreme long position,
Exhibit 3: Risk-adjusted carry from credit spreads now appears attractive relative to yield curve carry
Return/risk* and the 6-month change in the return/risk for Treasuries and select spread products
Exhibit 4: All but one of the FOMC voting members appear to expect the first tightening in 2014 or 2015
J.P. Morgans estimate of distribution of votes on timing of first rate hike by FOMC member 2012 2013 2014 2015 2016
0.2 0.1 0.0 -0.1 -0.2

MBS 30Y CC 10Y Tsy High Yield HG credit 10Y Agy 2Y Tsy 5Y Tsy 7Y Tsy
Lacker Kocherlakota Raskin George Plosser Pianalto Fisher Bullard Bernanke Lockhart Duke
Yellen Dudley Tarullo Williams 4 4
Evans Rosengren
Current 6m change
EMBIGLOBAL
# participants # voters (est.)
3 1
3 0
5 5
2 0
Voting members are bolded.
Exhibit 5: Fed funds forecasts of FOMC voting members (ex Lacker) suggests that the center of the FOMC expects a 47 bp funds rate by year-end 2014
Number of voting members (excluding Lacker) versus their forecast for the Fed funds target rate at the end of 2014
*This is calculated as loss-adjusted spread divided by (duration * risk * 2). Risk is 5-year standard deviation of 6-month changed. Calculation for Agencies and Treasuries based on yields, and for other spread products based on spreads versus Treasuries.
4 3 2 1 0 12.5 50 75 100 Target funds rate by year-end 2014; bp

Source: J.P. Morgan
duration longs likely increased significantly after the FOMC meeting. Along with continued improvement in Europe, these factors are supportive of higher yields. While flows into intermediate Treasuries were strong this week, the decline in yield curve carry should ultimately cause investors to reallocate away from duration risk into credit risk as the risk-on trade continues. As Exhibit 3 illustrates, yield curve carry now appears unattractive on a risk-adjusted basis relative to credit risk. This is a significant shift from several months ago where a steep intermediate Treasury yield curve, combined with high volatility of credit spreads was supportive of investors earning carry on the Treasury yield curve. This weeks FOMC meeting concluded with a bang as the Feds somewhat dovish message produced a strong market reaction. In their statement, the FOMC lowered their assessment of inflation risks, pushed back their guidance on how long they would leave the funds rate exceptionally low, and hinted that the bar for additional QE may not be especially high. For the first time, the Fed also provided some clarity on the definition of exceptionally low when Chairman Bernanke linked it to the sub 1% funds rate forecast by most members at yearend 2014. The overall message highlighted the Fed will remain supportive of growth and provided a green light for investors to extend out the curve.
Mean=47 bp
At the same time, we view the magnitude of the ensuing rally as surprisingly large with forward OIS rates now extremely rich relative to the forecasts of the FOMC voting members. While the Fed doesnt provide the specific names behind each of the forecasts, Exhibit 4 provides our best guess of these names by aligning the published forecasts with our Hawk-Dove chart of the FOMC. This alignment suggests that the center of the FOMC (including 9 of the 10 voting members) is nearly evenly split in projecting 2014 and 2015 as the year of the next rate hike. Averaging the forecasts of these 9 members (i.e. all voting members except Lacker) suggests that the center of the FOMC expects a 47 bp funds rate by year end 2014 or roughly 37 bp higher than the current effective funds rate (Exhibit 5).
Exhibit 6: Net of term premium, the market is priced to only a 23 bp Fed funds rate by year-end 2014
Forward OIS rates for a 1-month term at various horizons including and excluding estimated term premium; %
Exhibit 7: The Fed rate guidance was in line with expectations prior to the FOMC
Fed funds target rate priced into the market before and after the FOMC meeting versus the mean Fed funds target rate forecast of FOMC voting members (excluding Lacker); %
1.5
50 45 Forward OIS rates 40 35 30 Forward OIS rates term premium 0.0 spot 4Q12 4Q13 4Q14 4Q15 25 20 Market pre FOMC Market post FOMC FOMC forecast
1.0
0.5
By contrast, the forward OIS curve appears quite rich relative to the FOMC forecast. The implied forward OIS rate for December 2014 is currently 58 bp. Subtracting our estimate of 35 bp of term premium in the curve out to that date (see U.S. Fixed Income Weekly, 1/20/12) implies an expected funds rate of only 23 bp, or 25 bp below the forecast of the FOMC leadership (Exhibit 6). While there is no reason why forwards need to equal the Fed forecast, the Fed rate guidance was in line with expectations prior to the FOMC (Exhibit 7). As a result, we view the sharp rally that followed the guidance as more technical and expect forward OIS rates to gradually cheapen over time. Cheapening of forward OIS rates should cause the 2s/3s curve to steepen. The 2s/3s curve appears too flat relative to the level of rates (Exhibit 8). The positive convexity reflects the impact of the zero rate boundary with 3s becoming more volatile than 2s in a sell-off but moving parallel with 2s in a rally as the 2s/3s curve flattens towards zero. We also expect the 3s/7s curve to flatten considering the richness of forward OIS as well as strong cyclical patterns around FOMC meetings. The weighted 3s/7s curve is at its steepest level of the last 4 months as the front end has outperformed into the FOMC meeting. Following each of the last four FOMC meetings, however, this steepening has reversed with the weighted curve flattening an average of 6 bp (Exhibit 9). The back end of the yield curve steepened significantly this week with the 10s/30s yield curve back to its steepest
Exhibit 8: The 2s/3s curve appears too flat relative to the level of rates
0.7 * 3-year - 2-year par Treasury rate (%) versus par 2-year Treasury rates (%)
0.07 0.06 0.05 0.04 0.03 0.02 0.01 -0.00 -0.01 0.15 0.20 0.25 0.30 0.35 2-year Treasury rates; % 0.40 0.45 Y = -1.00 X1 + 1.73 X1^2 + 0.1 R = 20% standard error = 0.01 period = Jul 27,11 - Jan 27,12
Exhibit 9: The weighted 3s/ 7s curve has flattened after each of the last 4 FOMC meetings by an average of 6 bp
0.4 * 7-year - 3-year par Treasury rate (%)
0.23 0.22 0.21 0.20 0.19 0.18 0.17 0.16 0.15 0.14 -20 -15 -10 -5 0 5 10 Business days around FOMC meetings 15 20 Current Average
0.22 0.20 0.18 0.16 0.14 0.12 0.10
10
point since the Fed began Operation Twist. While some portion of the steepening was technical and reflects investor rebalancing flows after the FOMC meeting, most of it was fundamental with virtually every factor in our 10s/30s fair value model pointing to a steeper curve. This includes lower front-end rates, higher forward inflation expectations, and reduced variable annuity hedging needs as equities have rallied this month. Since the start of the year, we estimate these factors have increased the fair value of the 10s/30s curve by 16 bp; this compares to a 14 bp steeping in the 10s/30s curve (Exhibit 10).
Exhibit 10: Despite recent steepening, the 10s/30s curve appears to be close to fair value
Actual versus model* 10s/30s Treasury yield curve; %
1.5 1.4 1.3 1.2 1.1 1.0 0.9 Apr 11 Jul 11 Oct 11 Jan 12 Actual Model
Treasury Refunding and Bills supply

Treasury is scheduled to announce details of the February quarterly refunding on Wednesday next week. In its previous refunding announcement in November, Treasury said that it is prudent to hold offering sizes for notes and bonds stable over the near term given uncertainty on fiscal policy outcomes, but that it expects to continue to gradually increase gross issuance of TIPS in 2012. The introduction of floaters was discussed as well, but the discussion was categorized as exploratory and preliminary. Finally, Treasury had signaled that reissuance of SFP bills was unlikely to occur: given the path and timing of future debt limit increasesthe reintroduction of the SFP was not possible for the foreseeable future. Looking ahead, we expect few changes in the upcoming meeting. We look for coupon sizes to stay unchanged. Even though payroll tax cuts and unemployment benefits have been extended only for two months thus far, we think that they will be extended for the rest of the year, leaving the FY 2012 and 2013 budget deficit at $1150bn and $900bn, respectively. Given their funding needs, current coupon sizes appear appropriate. It would allow Treasury to stabilize the size of the T-bill market at 15% of the overall Treasury market, while modestly lengthening the weighted average maturity of outstanding debt (Exhibit 11). We also expect Treasury to not resume issuance of SFP bills even though the debt ceiling was raised another $1.2 tn this week. Finally, we expect that Treasury will continue to reiterate its commitment to increase issuance in the TIPS program gradually. Earlier this week, Treasury announced a $2bn size increase for 1- and 3-month bills each. The increase in the bills sizes, while modest, is somewhat surprising and earlier than expected given that Treasurys operating balance is modestly higher than typically observed at this
* 10s/30s curve modeled as 3.937-0.594*5-year Treasury rates+0.093669* 5yx5y inflation swap rates -0.009877* Variable hedging needs ($bn of 20-year equivalents) 0.000259*Treasuries outstanding with maturities greater than 17-years ($bn)
Exhibit 11: Given our budget deficit forecasts, we expect the share of T-bills in the Treasury market to stay stable even if coupon sizes are unchanged
Share of T-bills in the Treasury market (%) versus projected weighted average maturity of Treasuries outstanding (# months); projections are shown in dotted lines # of months %
75 70 65 60 55 50 45 Jan 00 Weighted average maturity (months) Share of T-bills (%ge)
35% 30% 25% 20% 15% 10% Dec 12
Aug 02
Mar 05
Oct 07
May 10
time of the year ($112bn currently versus prior 3-year average of $92bn). Looking ahead, we expect net issuance of T-bills to stay relatively modest (albeit positive) until mid-February. For the next few weeks, Treasurys operating balance should stay comfortably above its typical level at this time of the year even with unchanged bill sizes (Exhibit 12). After mid-February, however, net issuance of T-bills will likely accelerate and remain heavy into early April. Based
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on our estimates of Treasurys future funding needs, we expect net issuance of bills to total $110bn in the eight week period beginning February 23.
Exhibit 12: Look for net issuance of bills to be modestly positive until mid-February, but to accelerate thereafter
Projected net issuance of bills and Treasurys operating cash balance $bn $bn 160 30 Proj. cash Projected bill balance net issuance 140 25 21 20 19 120 20
TIPS
Over the past week, breakevens widened substantially thanks to a dovish statement from the Fed. The Fed indicated that it expected to remain on hold until late 2014 and expressed little concern about inflation. In the December 2011 statement, the Fed noted that the Committee will continue to pay close attention to the evolution of inflation and inflation expectations, but this language was removed from this weeks statement. Instead, the Fed merely stated that the Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committees dual mandate. The dovish bias combined with better prospects for QE3 and seemingly less vigilance around inflation caused TIPS to sharply outperform nominals, led by the front end. Over the week, 5-, 10-, 20-, and 30-year breakevens widened 21bp, 18bp, 12bp, and 11bp, respectively. Given our near-term positive view on risky assets and our bias toward higher nominal rates, breakevens could continue to widen further. However, such widening is likely to be modest given that breakevens are already wider than our near-term targets (Exhibit 13). In addition, the upcoming 30-year auction on February 16 is likely to be a headwind to further widening. As Exhibit 14 shows, any widening in breakevens will likely take place after the auction. Therefore, we stay tactically neutral on breakevens in the near term but look to initiate wideners if upcoming supply creates better entry levels.
15 10 5 0
02 Feb 09 Feb 16 Feb 23 Feb
14 7 3 7 4 9 9 4
14
100 80 60 40 20
01 Mar
08 Mar
15 Mar
22 Mar
29 Mar
05 Apr
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Exhibit 13: Breakevens currently look wide relative to fair value

Projected level of breakevens based on our long-term model for breakevens*; bp
Breakeven Targets 3Mx5Y breakevens, bp 3Mx10Y breakevens, bp 3Mx30Y breakevens, bp
26 Jan
Current 186.3 212.7 229.7
1Q12 175 205 225
* See TIPS, US Fixed Income 2012 Outlook, 11/25/11.
Exhibit 14: Breakevens have tended to widen sharply after 30-year TIPS auctions
Weighted 30-year TIPS breakevens (0.60*Feb-40 nominal yield Feb-40 TIPS) averaged around 30-year auctions in 2011; bp
100 95 90 85 80 75 70 -15 -10 -5 0 5 10 20 Business days around 30Y TIPS auction
12 Apr
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US Fixed Income Strategy US Fixed Income Weekly February 1, 2012 Praveen KorapatyAC Renee Park J.P. Morgan Securities LLC
Agencies
We stay overweight intermediate Agencies versus Treasuries but turn underweight 2-year Agencies versus Treasuries as the sector is near the lower end of its recent range and appears too rich We expect FNMA and FHLMC will report their earnings in the next month and expect that they will have moderate MTM losses on derivatives
Exhibit 1: Ahead of the fails charge implementation, Agency debt fails have fallen by more than $40bn since the start of January to the lowest level in a year
Agency debt fails to deliver and receive ($bn)
200 180 160 140 120 100 80 60 40 20 0 2008

Source: Federal Reserve Bank of New York
Market views
Over the past week, Agencies were flat-to-richer versus both Treasuries and swaps with Agencies in the front-end of both spread curves leading the outperformance. On the spread curve versus Treasuries, 20-year Agencies were unchanged over the week, while 2- and 5-year Agencies richened by 6bp and 2bp, respectively. Similarly, versus swaps, 2-year Agencies led the outperformance, richening by 3bp on asset swap, while 5- and 20-year Agencies richened by 2bp and 1.5bp, respectively. The outperformance of Agencies versus both Treasuries and swaps occurred despite 5-year bellwether issuance by FHLMC: $6.5bn of a new 5-year Reference Note was issued this week. The new issue brings total bellwether issuance in January to $21.5bn (the highest since October 2010). Additionally this week, ahead of the implementation of the fails charge rule for Agency debt and MBS markets (effective February 1st), the Agency debt market saw the incidence of fails continue to fall. Since the start of this month, Agency debt fails to deliver and receive have fallen by more than $40bn to $21.5bn, the lowest level in a year (Exhibit 1; for more details on the fails charge rule, see Agencies, US Fixed Income Weekly, 7/8/11). Looking ahead, we stay modestly overweight intermediate Agency spreads versus Treasuries, as despite some tightening in spreads over the past week, Agency spreads versus Treasuries continue to look cheap versus our estimates of fair value. Moreover, the factors driving our constructive view on intermediate Agency spreads remain unchanged from our last publication. We continue to believe the exogenous stresses stemming from Europe will remain low in the short-term, anticipate
2010
2012
Exhibit 2: Agency bullets offer more attractive riskadjusted carry than Treasuries across the curve
Risk-adjusted carry of Treasury yields versus Agency yields, across maturities 0.20
Treasury 0.15 Agency
0.10
0.05
0.00 2Y 3Y 5Y Maturity bucket 10Y
* Defined as 6-month carry and roll divided by the 5-year standard deviation of 6-month changes in spot yields.
that recently-improved liquidity conditions will persist, and think that seasonally increased demand for Agency debt will last into next month. In the current low rate environment, Agencies also appear attractive compared to Treasuries from a carry perspective: on a risk-adjusted basis, Agency carry is currently higher than that of Treasuries across the curve (Exhibit 2). Thus, we maintain our overweight on intermediate Agencies versus Treasuries.
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Exhibit 3: Two-year Agency spreads are at the richer end of their recent range
2-year hot run Agency z-spread to Treasuries (bp)
Exhibit 4: and appear rich adjusted for the 2-year Libor-funds basis and 2-year swap spreads
35 30 25 20 15 10 5 0 Jul 10 Jan 11 Jul 11 Jan 12
2-year Agency z-spreads to Treasury (bp) regressed against 2-year Libor-funds basis (bp) and against 2-year swap spreads (bp)
45 40 35 30 25 20 15 10 5 15 20 25 30 35 40 45 50 2-year Libor-funds basis (bp) 55 60 65 Y = 0.4043 X1 - 0.1998 X2 + 5.0778 R = 52.15% standard error = 2.9548 period = Jan 27,11 - Jan 27,12
The front end of the curve, however, appears rich. Twoyear Agencies are 6bp richer than our target for fair value, and now are near the richer end of the recent historic range versus Treasuries (Exhibit 3). The current tight spread between 2-year Agencies and Treasuries provides limited room for further tightening as the current 2-year spread of 7bp is only a few basis points higher than the historic low (of around 4.5bp). Additionally, 2-year Agency spreads versus Treasuries also appear dislocated relative to their recent historical relationship to the 2-year Libor funds basis and 2-year swap spreads (Exhibit 4). Thus, we underweight 2-year Agencies versus Treasuries. We also continue to expect flattening of the 2s/3s Agency spread curve versus Treasuries. Given similar tightening moves in 2- and 3-year Agency spreads versus Treasuries, the 2s/3s spread curve was relatively unchanged from last week. Thus, the spread curve continues to appear too steep relative to our estimates of fair value and we continue to stay with this trade. This past week, as we anticipated, the Fed came out with their Fed funds rate guidance, extending it past its prior guidance of mid-2013 to late-2014 for the first rates hike (Were not Japan, just keep telling yourself that, Michael Feroli, 1/25/12). Also, in line with our expectations (see Agencies, US Fixed Income Weekly, January 6, 2012), callables with 2-3 year locks richened following the announcement relative to lockout-matched
Exhibit 5: European callables with lockouts near the date of the first Fed hike richened versus lockoutmatched bullets on the day of Fed rate hike extension announcements
Percent change in various European Agency callable spreads* versus lockoutmatched bullets on the day of Fed announcements of extensions of the first rate hike (%), on 8/8/11 and 1/25/12 0%
-2% -4% -6% -8% -10% 5nc1 (5nc2) 7nc1 (7nc2) 10nc1 (10nc2) 5nc2 (5nc3) 7nc2 (7nc3) 10nc2 (10nc3) Aug'11 Jan'12
* Note that the spread changes of the first callable structures listed in each column (5nc1, 7nc1, 10nc1, 5nc2, 7nc2, 10nc2) are calculated on 8/8/11. The spread changes of latter structures (in parentheses) are calculated on 1/25/12.
bullets. This richening move mimicked the richening of callables with 1-2 year locks versus lockout-matched bullets on August 8, 2011, when the Fed extended their rates guidance to mid-2013 (Exhibit 5). Although the event of the Feds announcement has passed and these longer-lockout callable structures have richened versus lockout-matched bullets, we continue to favor holding such callables versus lockout-matched bullets. At current spreads versus lockout-matched bullets, we still see
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Exhibit 6: In 2011, through 3Q11, FNMA has drawn $21bn and FHLMC has drawn $8bn in capital from Treasury, significantly less than FHFAs capital draw projections for 2011
Exhibit 7: FNMA and FHLMC single-family delinquency rates have moderated over the past year
FNMA and FHLMC single-family delinquency rates (%)
Actual and projected annual Treasury draws by FNMA and FHLMC ($bn) Q1'11Cumulative 2009 2010 2011 2012 2013 2014 Q3'11 for 2011Act. Act. Est. Est. Est. Est. Act. 2014
4.6% 4.4% 4.2% 4.0% 3.8% 3.6% 3.4% Nov 10
FNMA FHLMC
Scenario 1 FNMA FHLMC Scenario 2 FNMA FHLMC Scenario 3 FNMA FHLMC

Source: FHFA
60 6 60 6 60 6
15 13 15 13 15 13
21 8 21 8 21 8
33 11 35 12 52 19
13 0 17 0 51 7
6 0 7 0 21 2
3 0 1 0 5 0
55 11 60 12 129 28
Jan 11
Mar 11 May 11
Jul 11
Sep 11 Nov 11
Source: FNMA, FHLMC
room for further spread compression as in the current Fed-on-permahold environment, the probability of call for callables with 3-year and shorter locks remains high. As a result, we continue to like longer-lockout callables more than lockout-matched bullets, now up to 3-year locks.
Exhibit 8: Given the change in rates in 4Q11, we expect FHLMC to report $1bn in MTM losses from derivatives
FHLMCs derivative gains/losses by quarter ($mn) regressed against changes in 10-year swap rates over the same quarter (bp), regression since 2007
5000 y = 38.865x - 1249.3 R = 0.7043
Earnings update
In the coming weeks we expect FNMA and FHLMC will release their fourth quarter earnings and annual filings. We expect two key drivers of their earnings will be credit loss provisioning (which we expect could be mixed relative to their levels of provisioning in the third quarter), and the mark-to-market impact from derivatives gains/losses (which we expect to remain at a net loss for both GSEs, based on the change in rates during the quarter). Credit loss provisions: We expect that in the fourth quarter, both FNMA and FHLMC could report mixed levels of credit loss provisioning compared to their levels of provisioning in 3Q11 of $4.1bn and $3.6bn, respectively. Looking at FHFAs annual loss projections and Treasury draw projections, they show that FNMAs and FHLMCs capital draws from Treasury will be around $14bn and $5bn, respectively, versus their 3Q11capital draws of $8bn and $6bn, respectively (based on FHFAs base case loss projections, scenario 2, for 2011 and year-to-date capital draws by the GSEs; see Exhibit 6). However, moderating single-family
-5000
Estimate for Q4'11
-10000
-15000 -200
-150
-100
-50
50
100
Change in 10-year swap rates over the quarter (bp)
delinquency rates in the fourth quarter (flat for FNMA and only a slight uptick higher for FHLMC), lead us to believe that actual credit loss provisioning by FNMA and FHLMC may differ from that implied by FHFAs forecasts (and in particular, may be lower for FNMA). Mark-to-market impact of derivatives: We expect both FNMA and FHLMC to report a negative mark-tomarket impact to their earnings from losses on derivatives for the third and fourth consecutive quarters, respectively, of -$1bn each. These estimates are driven by the historical relationship between the mark-to-market
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impact of derivatives and the change in rates, as discussed in previous publications (Exhibit 8). Due to asymmetric accounting treatment (derivatives are recorded at fair value while a large majority of assets and debt are not), and given that the majority of derivatives held by FNMA and FHLMC are pay-fixed swaps, the GSEs MTM gains/losses are directional with the change in rates over the quarter.
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High Grade Strategy US Fixed Income Weekly February 1, 2012 Eric BeinsteinAC Dominique D. Toublan Miroslav Skovajsa Anna Cherepanova J.P. Morgan Securities LLC
Corporates
The arguments for the current rally are strong: LTRO reducing European risks, growth in the US and Europe slow but not negative, investors and dealers lightly positioned, credit fundamentals fine, and light supply in January We are near our 1Q spread target and we maintain a neutral view, however The risks are that everyone is pointing to the same positives, bond yields are low, growth risks remain in Europe, the potential fallout from Greece likely restructuring/defaulting is largely dismissed, earnings growth are slowing and expected to slow further, and the spread rally has already been meaningful This week we adjust some sectors to reflect a less negative outlook and highlight the relative outperformance of CDX.IG versus bonds
Exhibit 1: Spreads are rallying but remain within the range over the past three months
bp 270 250 230 210 190 170 150 130 Jan 11
Source: J.P. Morgan
JULI Spread Current
High: 262bp Current: 219bp 2012 YE Forecast :
Low : 144bp
175bp
May 11
Sep 11
Jan 12
Exhibit 2: Lower Treasury yields and lower spreads have pushed yields down to the low end of their recent range again
5.1% 4.9% 4.7% 4.5% 4.3% 4.1% Jan 11 Mar 11 May 11 Jul 11 Low : 4.16% Sep 11 Nov 11 Jan 12 Current: 4.25% High : 5.0%
JULI Yield Current
Will the rally continue or pause from here? We take the more cautious view and maintain our neutral call on the market and a 1Q spread target near the current levels: 225bp target versus 219bp today. The shift in sentiment has been so quick that many investors appear particularly uncertain as to the near-term market direction. It is nevertheless tempting to take profits after the strong month-to-date rally (17bp tighter in spread) and reduce risk going into February, which has historically been a weaker month for spread performance. This is balanced by an understanding that Europes LTRO program has lowered its risks, spreads remain wide, economic data in both the US and Europe, albeit not strong, is unlikely to disappoint, and bond market technicals and fundamentals are favorable. The positive view is winning at the moment, as investors fear missing a strong rally this year, which may be frontloaded. January supply has been modest as well: $62bn month-to-date versus $99bn, $79bn and $126bn in the prior three years, respectively, and February is shaping up to be light as well. Those who had hoped to use an active primary market to add to risk are disappointed, which in turn helps the secondary market.
Source: J.P. Morgan
Exhibit 3: The decline in Italian and Spanish yields has been rapid
% 7 6 5 4 3 2 1 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 Italy 2y r Yields Spain 2y r Yields
Source: J.P. Morgan
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We understand the bullish arguments and we removed our underweight view on High Grade last week. This week we adjust our sector views to reflect a more bullish market stance (see below). Still, we moved to neutral rather than overweight and have a 1Q spread forecast near current levels. Maybe we are being stubborn, but we are cautious for several reasons: 1) The success of the LTROs in greatly reducing European bank funding concerns is now at least partly priced in by markets. It is the issue that everyone is focusing on when explaining a turn to a more bullish stance. Sovereign funding costs have reacted strongly with short-end yields down to 3.7% from 7.6% in Italy and to 2.5% from 5.9% to in Spain. The drop in 10-year yields is not as large but still down to 5.9% in Italy from a peak of 7.5% on November 25. Spanish 10-year yields are down 1.7% to 5.4% versus the peak of 7.1% on November 25. This matters, but funding costs are still high and the growth challenges, which have led to market skepticism on debt sustainability, remain. 2) J.P. Morgan recently raised 1Q European growth forecast to flat from -1.5% previously. It is difficult to square the recent better-than-expected growth data in Europe with the fiscal retrenchment. Structural reforms also usually lead to less growth in the early phase. It seems there could be more disappointment to come given the expectation of slower global growth in 2012 plus the European-specific issues weighting on growth. 3) US growth forecasts have been modestly lowered and the risk is that higher oil prices dampen consumer spending, which was already subdued over the holiday period. Strong financial market performance will provide a positive lift to consumer sentiment and behavior to some extent. 4) HG bond yields remain very low. Yields are now at 4.25%, which is just 9bp above the all-time low. 5) Corporate earning trends are weakening and are expected to weaken even further. So far, with 28% of the S&P 500 having reported annual revenue, growth is 6%y/y (from 11% in 3Q11) and EPS growth is 8%. Equity analysts call for further sharp slowing in earnings growth in 1Q. Consensus estimates are now for a quite modest earnings growth of just 4% y/y in 1Q12.
Exhibit 4: and seems well understood by markets now

7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 %
Italy 1 Yields 0yr Spain 1 Yields 0yr
Source: J.P. Morgan
Exhibit 5: Bond market technicals remains strong as evidenced by light dealer positions
250 200 150 100 50 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 $bn Dealer Positions
Source: J.P. Morgan. Federal Reserve Bank of NY, as collected from the 18 primary dealers. Corporate securities include bonds, notes, and debentures. It includes CMOs and REICs (including residuals) issued by entities other than federal agencies and GSEs. (CMO Collateralized Mortgage Obligations. REICs Real estate investment corporation). It includes stripped securities (both IO and PO components) issued by entities other than the federal agencies and GSEs. Last updated as of January 11, 2012
6) The challenges in Greece and the PSI discussions remain. Our base case view is that the EU/IMF will not let Greece default in March, but there are many challenges and uncertainty between now and then. The situation in Greece is more extreme but not dissimilar to the situation in other peripheral Europe countries. It is likely that the challenging nature of Greeces negotiations and the stretched justifications for following along on the path, which has so far failed to produce results in Greece, will impact other peripheral European sovereign borrowers at some point. Our European
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colleagues published a note on Greece and the potential path to a restructuring that would not lead to widespread contagion.
Exhibit 6: Tier 1 Common ratio

11 10 9 8 7 6 5 4 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 % Tier 1 Common ratio 9.5 10.4 10.1
Bank earnings: Quarterly Checkbook 4Q11

We supplement this checkbook with thoughts on the market, valuations, and provide updated views, given the year-to-date movement in spreads. Financial spreads have rallied 40bp year-to-date, and are now about 75bp from the wides and 137bp from the tights; we have essentially captured 20% of widening in a 3-week span. We became incrementally bullish on domestic-focused names earlier in the year (upgrading Regional Banks) due to the improving domestic data, but we clearly did not anticipate the impact that LTRO would have on MoneyCenter and Yankee bank spreads. The correlation between money center banks and Europe remains high, despite manageable exposures. While we understand contagion concerns, valuations had become detached from fundamentals. The direct benefits of LTRO and additional liquidity is clearly visible; however, we remain hesitant in calling the all-clear given last years spread movement. We prefer to buy beaten-up regional banks and subordinated paper in high quality regional banks, while Bank of America remains our top and only pick within the Money-Centers. On January 18, our colleagues in European Credit Research upgraded senior European Bank credit to Overweight. Following his move; we also upgrade Core European and UK banks in the dollar market to neutral. We are not overweight in the dollar market only because of relative value, as European banks trade flat or inside money center banks. Fundamentals for the domestic bank sector continue to improve, as witnessed by the improved loan growth, higher capital levels, and stable to improving credit quality. On the flip side, margins remain under pressure, trading revenue is volatile and depressed, and management teams remained cautious due to Europe. Regulatory uncertainty persists as investors remain focused on the final interpretation of Volker and the LCR. Thus, we expect the capital NPR within
Source: SNL and J.P. Morgan, as of 4Q11
Exhibit 7: CDX has outperformed JULI in the rally

275 250 225 200 175 150 125 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 105 90 75 bp JULI spread, lhs CDX.IG 5y , rhs bp 150 135 120
Source: J.P. Morgan
the first quarter, which should put to bed all the uncertainty about capital rules. USD issuance across our sectors has been $26bn for January. We have seen issuance from all the money centers except MS. The pace of issuance is ahead of our $235bn forecast for 2012. That said, issuance is usually heavier in the first quarter, and given the 2011 experience, we believe banks probably front-loaded issuance given improved market conditions. We note that issuance of preferred stock recently increaseda trend we expect to continue. In the following pages, we go through our views. In a nutshell, we prefer domestic-oriented names that are most leveraged to an improving US economy, especially housing. We remain cautious on the pure broker/dealers, and prefer BAC to GS. Although a
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healthy market would help trading and capital markets revenue rebound, we prefer BAC as it will benefit from both a bounce in trading as well the US economy. In this environment, we have greater conviction around security selection, rather than sector calls.
Exhibit 8: Sector View changes since we moved our market call to Neutral
View Sector Upgrades Regional US Banks UK Banks Core European Banks Life Insurance P&C Insurance REITs Utilities Holding Companies Downgrades Energy Utilities Operating Companies Utilities Power Generation Companies Overweight Overweight* Overweight* Neutral Underweight Neutral Underweight Underweight Underweight Neutral Underweight Neutral Overweight* Neutral Neutral Neutral Overweight Neutral Overweight Overweight Prior Current
High Grade bonds lagging CDX

CDX.IG rallied 7bp in the last week to 101bp and is now at the tightest level since August of last year. It is trading 8bp tighter than its underlying CDS which is close to the maximum divergence from fair value for IG over the past year. CDX.IG also significantly outperformed JULI which has tightened by 5bp on the week. IG is trading 20bp too tight or 1.6 standard deviations away from its 6month regression with JULI. The R-square for 3-month regression is low at 56%, however it is much stronger for 1-year regression at 92%, which also suggest similar outperformance of CDX.IG. Therefore, it appears that HG bonds are significantly lagging CDX in the rally. We believe that this is partially due to the low all-in yields that have prevented bond spreads to rally further. However this does not look sustainable and we expect bonds to outperform CDX. Investors can actually implement this view by using iBoxx USD HG TRS or a HG ETF such as iShares iBoxx Investment Grade Corporate Bonds ETF (LQD).
Tobacco Overweight Neutral Source: J.P. Morgan. Note*: Utilities was rated Overweight and we have now broken it into three smaller sectors.
Core European and UK Banks

We upgrade both Core European and UK Banks to neutral from underweight. We make this move in the wake of the upgrade to overweight of senior bank credit by our European colleagues. In December, the ECB announced the LTRO, which removed the risk of significant funding pressure in the near term and removed catalysts for near-term widening. We originally moved UK and Core European names to underweight in June of last year, when Core European names in the JULI averaged 182bp, and UK names averaged 249bp. With the LTRO in place now, we note that Core European banks trade around 326bp and UK Banks around 359bp. At this point, we think the likelihood of additional widening has been reduced and now take a neutral stance in both sectors. We do not move to an overweight as valuations do not warrant a more bullish view. Core European names trade 10bp inside domestic Money-Centers, while UK names are only 10bp wider. Given our preference for exposure to the US over Europe, we think the European names trade too close to domestic peers.
Sector View Changes

Last week, we moved our market call to neutral and over the week our sector analysts have updated their views in light of the less bearish overall market call.
Regional US Banks
Since our outlook presentation, domestic economic data have come in better than expected, and we are more confident in the domestic picture, thus we are moving our view on Regional Banks to neutral from underweight. We think that any outperformance by the US economy relative to expectations would generate a bid for these names, despite tight valuations.
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Life Insurance
We are raising our view on Life Insurers to overweight from neutral. The major catalysts behind the change are the improvement in markets as well as tangible progress coming out of Europe. The improved market, which includes the S&P 500 rising 11% in 4Q, should help Life companies report strong results over the next three weeks. In addition, equity and credit markets have improved thus far in 2012 and this could signal further improvement if these trends are sustained. While broad market performance will likely be one of the largest factors determining valuations in 2012 (given the effect on reserves, fee-based income and product sales), we believe Life companies have strong balance sheets that are more than adequately prepared for any degree of potential volatility in the markets. As we focus on Life companies during earning season, we expect good 4Q earnings, especially for those companies correlated to equity markets.
Thai flooding and is set to complete its annual comprehensive loss reserve review. Hence, we would advise investors to be somewhat cautious over the next month related to Global Insurers/ Reinsurers, noting that 4Q earnings may not be fully reflective of the underlying environment, which we see as improving for P&C insurers.
REITs
Following our move to a neutral view on high grade bonds we are upgrading our view on REITs to overweight. Our strategy team late last week upgraded their view on high grade credit from underweight to neutral. As we discussed in our Outlook 2012, our REIT view had been neutral with a positive bias. We had already shifted our view to a bias on the wider trading credits in cash and CDS. So this upgrade is really just a formality now that we are no longer calling for wider market spreads. REITs year-to-date have handily outperformed the corporate market (REITs: -43bp; JULI ex. EM: -17bp) and we expect continued strong performance as property level fundamentals at worst remain stable and in many sectors are improving. With the bank term loan market continuing to offer even tighter funding for REITs compared to the bond market, sector issuance should continue to be very manageable and well received. Our top picks remain the wider trading REITs in cash and CDS, most notably PLD in industrial, DDR/EQY/NNN/WDCAU in retail, DRE/KRC/DXSAU in office, and BRE/CPT/PPS/CLP in multifamily.
P&C Insurance
We are raising our view on P&C companies to neutral from underweight. The primary drivers behind the change are an improved pricing environment and our expectation that P&C insurers are finally ready to put their challenging 2011 results behind them (which included over $100bn in catastrophe losses globally). We note that diminishing levels of positive reserve releases as well as our expectation for annual declines in alternative investment performance (both seen in TRVs 4Q report on January 24) remain issues to monitor and keep us away from an overweight view. Looking ahead, we expect 4Q earnings will be a tale of two cities for the subsector. While US-only based companies enjoyed a benign catastrophe quarter and should generally report solid 4Q results (as evidenced by CINFs recent positive commentary), Global Insurers/ Reinsurers are likely to be affected by the October/November 2011 Thailand flooding. Regarding Thai losses, many industry players have preannounced expected losses based on total insured industry losses of $10-15 billion. In addition, many companies have announced planned increases to reserves for re-estimations of losses related to 2011 catastrophes. Finally, we would highlight AIG as a company to watch in the days leading up to its 4Q earnings as it has yet to disclose its loss estimates for
Energy
Following our move to a neutral view on high grade bonds we are modifying our view on Energy to neutral, as we consider current valuations appropriate. With current spreads settling at approximately 24bp tight to the index and an improved view of the high grade market, we do not foresee a catalyst for significant outperformance
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Utilities
Given the change in our broader High Grade credit view from underweight to neutral, we move utilities to neutral from overweight. Although we do not expect significant improvement (the JULI 1Q spread target remains at 225), with recent positive news in Europe and stronger US economic data, we believe investors will gravitate to sectors which offer the opportunity for more incremental yield than Utilities provide. We have broken out our views to reflect the various issues across utilities capital structure:
concerns over the European debt crisis. As such, Yankee performance has actually constrained the outperformance of the domestic utilities index. We do not offer an opinion on Yankees except to note that as part of the holding company segment and the broader Utilities Index, as concerns over Europe either ebb or increase, there will be a look through to these indices.
Tobacco
We lowered our rating to neutral from overweight for the HG Tobacco sector due to strong outperformance through December and spreads that are the tightest to the JULI since June 2009. Regulatory developments have turned out to be more benign than feared, yet secular trends in the US have begun to dampen the outlook for the sector. In March, the Tobacco Products Scientific Advisory Committee (TPSAC) determined that a ban on menthol cigarettes would benefit public health, but stopped short of recommending a ban. The FDA is conducting a peer review of the TPSAC findings and is likely to issue some statements in the near term. In early November, the US District Court of the District of Columbia temporarily blocked new requirements that cigarette makers place graphic anti-smoking images on packaging. Despite these favorable regulatory developments, US cigarette sales are in a long-term decline with estimated volumes down 3.8%y/y in 2011 alone. This is a reflection of the effect of higher prices on a weakened US economy in conjunction with other challenging developments such as fewer young smokers and a consistently growing number of prohibitions in public places.
Utilities Operating Companies

We are underweight utility operating companies based primarily on trading levels. Operating companies are highly regulated and issue either Senior Unsecured or First Mortgage Bonds. While we caution that utility operating companies are not created equally, this segment of the broader sector represent the most defensive part of the capital structure and trades accordingly.
Utilities Generating Companies

While generating company subsidiaries of investment grade utilities are not nearly at the wides (259bp October 5, 2011), we still expect the sector to face some pressure given a sustained low gas and power price environment, particularly as gas prices have continued to move lower. While the generation company subsidiaries represented in the index (FirstEnergy Solutions, Exelon Generation, PPL Energy Supply, PSEG Power) are typically highly hedged for the prompt year, concerns about the long-term effect of low power prices as hedges roll off will be a concern that will be reflected in spread levels as will continued concerns about the effect of plant retirements and environmental Capex.
Utilities Holding Companies

We are overweight utility holding companies. The holding company level is somewhat more difficult to evaluate, given the inclusion of Yankee issuers in this segment. The Holding Company segment of the Index, which includes Yankee issuances, widened due to
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US Fixed Income Strategy US Fixed Income Weekly February 1, 2012 Peter DeGrootAC Josh Rudolph J.P. Morgan Securities LLC
Exhibit 1: Weekly supply is chugging along at $4-5bn
Municipals
Yields remain low against the backdrop of manageable supply, but this may be challenged should we see an uptick in volume Total issuance in January is shaping up to be about $19bn, which implies total annual issuance of $324-355bn Significant mutual fund inflows and reinvestment capital continue to bolster investor cash balances The roughly 400 redevelopment agencies in CA are likely to be dissolved on Wednesday. Many of them have publicly released their respective lists of enforceable obligations, some of which include many non-bond debts. There is some risk that bond coverage could potentially be diluted by claims from other creditors. We provide a basic metric to gauge this risk for any given RDA. Until this issue is cleared up, the near-term uncertainties will continue to out-weigh the longterm positive credit factor of no more issuance
Weekly municipal bond issuance ($bn)

15
Tax-exempt
* *
Taxable
Next week *
10
5 * 0 J J A S 2010
* Holidays Source: Bloomberg CDRA
* * * O N D J * * * * * * * *
** * F M A M J J A S O N D J 2011 2012
Exhibit 2: The level of January issuance implies $324-355bn of annual 2012 issuance
Annual issuance since 1990 ($bn)
500
400 355 324 300 200
1990's 2000's
2012 predictions 2011 Period 10-year 20-year 0 10 Equation 2012 y = 173.3ln(x) - 156.34 324 y = 203.76ln(x) - 276.27 355 30 40
Awaiting supply as cash piles up and yields hover near lows

Supply next week is expected to be approximately $4.5bn after $4.7bn in long-term issuance this week (Exhibit 1). Market performance was mixed relative to Treasuries with tax-exempt ratios cheapening by approximately 2%-pts in 10-years and tightening by 2%-pts in the 30-year spot. While supply next week is low, we expect the tone of the market to be set by Tuesdays $699mn Washington State deal. The refunding bonds will be spread out from 3- to 17year on the curve with the largest terms in 11- to 16-year. The relatively large size of this offering, coupled with the low-yield environment, may weigh on the high-grade scale, particularly in intermediate terms. That said, Februarys large reinvestment (-$11bn), sizable cash accumulation in funds, and the steady diet of inflows into municipal funds should support trading in spread product. January supply is consistent with our 2012 forecast For those looking to draw conclusions on full-year 2012 volume based on full-month January issuance, we have run
100 0
19 20 January issuance
Source: Thomson SDC, J.P. Morgan
regressions comparing each Januarys supply to annual supply totals over the past 10 and 20 years. The models show an R-square of approximately 75%, suggesting that January issuance is a decent indicator of full-year supply. Issuance for January 2012 is expected to be about $19bn, which is 53% above last year but 17% below the 10-year average supply for the month. Based on 10- and 20-year regressions, Januarys volume suggests full-year 2012 issuance of $324bn to $355bn (Exhibit 2). This is relatively in-line with our $350bn full-year 2012 volume estimates and, coupled with continued low yields, is supportive of prolonged manic market conditions. Average trade volume over the past two weeks (1,933 trades over $1mn per week) has dropped by 50%, based on weekly customer buy transactions versus the trailing 3-
23
month average (Exhibit 3). One of the more obvious impediments to more fluid markets is that high-grade yields have been hovering at or near generational lows (Exhibit 4). The market has been able to hold these levels against a backdrop of manageable supply, but may be challenged to do so should we see an uptick in volume. In our view, investors are better served supplementing low high-grade yields by allocating capital to intermediate-term lower investment grade bonds versus extending into longer-dated callable high-grades. A-rated spreads to the AAA scale are at their widest levels of 93bp in the 11-to-20-year points on the curve. Municipal funds see $513mn in inflows for the week For the period ending January 25, 2012, municipal bond funds registered inflows of +$513mn following last weeks +$1.0bn. For the year, net cash flow rose to $5.6bn. Investors continued to favor longer-dated funds this week, with $150mn in net new cash flow. Intermediate funds ($86mn) and high-yield funds ($91mn) also enjoyed positive capital flows (Exhibit 5).
Exhibit 3: Weekly trading volume has declined

Average weekly number of fixed-rate tax-exempt trades over $1mn
6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 Oct
Source: MSRB, J.P. Morgan
Nov
Dec
Jan
Exhibit 4: Tax-exempt yields are back down to their historic lows

5 4 3 2 1 0 5 10 15 20 25 30
Source: J.P. Morgan, Thomson MMD
Latest on CA redevelopment agencies

In December, the CA Supreme Court upheld legislation ordering the dissolution of the states roughly 400 redevelopment agencies (RDAs) on February 1, 2012, which is next Wednesday. Closure was recommended by Governor Brown a year ago in order to release excess capital to provide budgetary relief for state and local governments. The upheld legislation sets forth the procedures for the establishment of new successor agencies that cannot issue new bonds but will be charged merely with paying back existing creditors as scheduled. Three weeks ago, we published a research note detailing the actions taken by this legislation and the implications on existing bondholders. We cautioned that the new longterm positive credit factor (no more issuance) is outweighed by the new short-term credit risks (limited access to unpledged revenues and uncertainties around pledged priorities and mechanical implementation). See US Fixed Income Weekly, January 6, 2012. Since then, all three rating agencies have either downgraded the sector or placed it on review for potential downgrade. The fundamental problem is that it remains to be proven that compliance with bond indentures will be smoothly implemented and will take precedence over compliance with the new legislation.
Average since 2000 Today Low since 2002
Exhibit 5: This week saw $513mn of broad-based inflows

Flows in to (out of) municipal bond mutual funds ($mn)
Fund flows Fund Assets Type of funds Actual 4-wk. avg. Actual 4-wk. avg. All term muni funds 513 1,394 517,055 514,158 New York -39 16 33,296 33,150 California 25 67 48,151 47,895 National funds 425 1,201 353,895 351,857 High Yield 91 203 49,092 48,737 Intermediate 86 384 120,854 120,630 Long Term 150 576 298,529 296,590 Tax-exempt money market -2,756 576 291,483 292,835 Taxable money market -14,677 -5,505 2,355,752 2,371,174 Taxable Fixed Income 6,211 5,569 3,045,762 3,034,763 Equity 7,798 -1,829 5,517,506 5,461,460
Source: Lipper FMI
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As we previously indicated, it is certainly helpful that the new legislation explicitly states its intention that nothing in the bill should absolve the RDAs of their obligation to service existing debts. However, that might not be the same thing as declaring that the legislation is subordinate to any potentially conflicting requirement in any bond document. Moreover, it remains to be seen whether the successor agencies will effectively segregate and report pledged revenues by project area, without which it is hard to imagine how priorities and pledges could be enforced. The upheld legislation does not explicitly require the successor agencies to report any such segregation, but S&P believes that the association of county-auditor controllers is working on guidelines that would help the successor agencies prioritize debt service payments. However, until those guidelines are released and successfully implemented, these bonds have an elevated level of near-term mechanical risk. This risk could be captured by a new metric that shows the extent to which an RDAs outstanding municipal bonds might be diluted by other enforceable obligations. As part of the dissolution of the RDAs, the upheld legislation requires them to report an enforceable obligation payment schedule (EOPS) to show their successor agencies what debts are outstanding and must be repaid. In recent weeks, many of the RDAs have publicly released their EOPS, some of which include hundreds of millions of dollars worth of non-bond obligations. The upheld legislation (part 1.85, Chapter 1, section 34171d) stipulates that enforceable obligations should include: A. Bonds B. Loans borrowed by the RDA, to the extent legally required to be repaid, pursuant to loan terms C. Payments to the federal government D. Judgments or settlements E. Any legally binding and enforceable agreement or contract that is not a violation of a public debt limit F. Contracts or agreements necessary to administer the successor agency G. Amounts borrowed from the Low and Moderate Income Housing Fund The legislation goes on to say that enforceable obligations do not include any agreements, contracts, or
Exhibit 6: The majority of Anaheim RDAs enforceable obligations are for development and housing projects
Breakdown of Anaheim RDAs enforceable obligations ($mn)
Muni bonds 355 330 1,292 187 64 Statutory payments Development, housing, other Administrative costs Pass-through payments
Source: http://www.anaheim.net/images/articles/2088/AB26EnforceableObligationSchedule.pdf
arrangements between the RDA and the city or county that created the RDA. It seems as though much of the non-bond indebtedness to various cities, counties, utilities, developers, and school districts is qualifying as enforceable under item E in the legislation. For example, the Anaheim RDA lists 113 obligations totaling $1.5bn, but only one of those debts is for municipal bonds (worth $355mn or 23% of the total). Many of the other 112 obligations are owed to developers and local governments, such as cooperative agreements and leases agreements for rehabilitation projects. The Anaheim RDA also lists $60mn for the professional services of various consultants and $119mn of down-payment assistance for first-time homebuyers, among other items (Exhibit 6). It appears as if the vast majority of these obligations will be paid for from the same funds that are securing bondholders. It should be noted that freeing up excess capital to be spent by local governments rather than by RDAs is precisely the goal of shutting down the agencies. However, it was also the intent of the legislation that bondholder pledges not be impacted and thus a bond with more than 1x coverage retains its priority over other junior payments. It remains to be seen whether and how the successor agencies will ensure the retention of that seniority. If they do not and if all of these enforceable obligations are simply paid for out of the same pool of money, longerterm debts could become structurally subordinated versus short-term payments. If passengers boarding an airplane do not have specifically assigned seats, finding a seat suddenly becomes a first-come-first-serve game of musical chairs. It is not until the last passenger is seated that anyone knows whether there are enough seats.
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Exhibit 7: Until the legislation is implemented as intended, RDA bonds might start to develop a new shadow credit metric
Selected statistics for a sampling of liquid intermediate and longer-dated CA RDA fixed-rate bonds larger than $40mn, ranked by credit rating Basic info Traditional credit metrics Dissolution metrics Spread Price Example Underlying Debt service Muni bonds Enforcable Muni's / Issuer Project (bp) (per $1) CUSIP credit rating coverage outstanding obligations all obligations Los Angeles RDA Bunker Hill 54 108 54438EGZ5 Aa3neg /AA-sta 1.65 1,118 1,827 61% Anaheim RDA Merged Area 153 104 032565DW0 Aa3neg /Asta 3.50 355 Exhibit 6 1,543 23% Rancho Cucamonga RDA Housing set-aside 269 97 752123JF7 Baa2neg /A+sta 1.62 566 1,476 38% San Jose RDA Merged Area 295 100 798147K78 Baa2neg /BBBneg /BBB-neg 1.09 3,809 4,143 92% Pittsburg RDA Los Medanos 274 104 724568ME7 BBBsta /BB+neg 1.34 22 35 62% Hesperia PF. Auth. RDA/housing proj. 375 76 42805GAX1 Ba1neg 2.66 209 1,011 21%
Exhibit 9 Exhibit 8 Note: Outstanding debts are in $mn. Pittsburg does not appear to post their EOPS or draft ROPS on their website. The "dissolution metrics" above are 7/1-12/31 payments, rather than outstandings. Source: Ratings from Bloomberg. Pricing from S&P. Other metrics from RDA filings and RDA websites: http://www.crala.org/internet-site/Documents/upload/EOPS_01_24_12_Amended.pdf; http://www.anaheim.net/images/articles/2088/AB26EnforceableObligationSchedule.pdf; http://www.rcrda.us/DocumentView.aspx?DID=1460; http://www.sjredevelopment.org/Finance/ROPS/DraftROPS9.30.11.pdf; http://apps.ci.pittsburg.ca.us/sirepub/cache/2/lipmfr55yrxd5w45oh4x0z55/275222901262012123114800.PDF; http://www.cityofhesperia.us/DocumentView.aspx?DID=1799
The risk is that bondholders might find themselves in a first-come-first-serve competition against other creditors who might have more flexibility to accelerate their own payments. Given that the semiannual required obligation payment schedules to be reported by the successor agencies will only list the obligations coming due over the following six months, investors looking to gauge this risk for a particular RDA will simply have to look at how much outstanding nonbond enforceable obligations they are competing against. The right-most column of Exhibit 7 shows that this metric varies broadly. Non-bond obligations are much more prevalent in credits with higher debt service coverage, such as Anaheim and Hesperia, than lower coverage credits, such as San Jose (Exhibit 8). The bonds of these RDA credits are still trading largely in-line with their credit ratings (Exhibit 9), which are not yet differentiated to reflect this risk. We think that the market could increasingly price in the possibility of coverage dilution from non-bond enforceable obligations, as more time passes by without the following questions being answered: Will the successor agencies segregate and report the different revenue sources and priorities of payment for each enforceable obligation? Will the county auditors overrule the large magnitude of non-bond obligations? Will the state legislature pass a clean-up bill to clarify that compliance with bond documents takes precedence over any conflicting aspects of the recently upheld Assembly Bill X1 26?
Exhibit 8: Redevelopment agencies with higher coverage are recognizing more non-bond enforceable obligations
Muni bonds outstanding, as % of enforceable obligations
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0.5
San Jose
Pittsburg
Los Angeles
Rancho Cucamonga Hesperia 1.0 1.5 2.0 2.5 3.0 Debt service coverage
Anaheim
3.5
4.0
Exhibit 9: RDAs are priced primarily to their credit ratings

Spread in basis points (left axis, inverted), dollar price per $100 of par (right axis)
Spread (lhs, inverted) Price (rhs)
110
100
100
200
90
300
80
400 Los Angls. Anaheim Rancho C. San Jose Pittsburg Hesperia Aa3/AA- Aa3/A Baa2/A+ Baa2/BBB BBB/BB+ Ba1
Source: S&P
70
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The legislature is currently considering two clean-up bills that would have to be passed by Tuesday January 31, 2012, because that is the deadline for considering legislation written last year and because the RDAs will be officially dissolved on Wednesday. Unfortunately for bondholders, neither of those two bills clarifies any of the questions above. One of them (#659) would extend the dissolution date from February 1 to March 15, 2012. According to Dan Walters of the Sac Bee, this bill is supported by a hastily formed coalition of labor, business and local government groups in order to buy time to build political impetus for resuscitating redevelopment. However, it does not seem as if this last ditch effort has sufficient support in either the Senate or the Assembly. Moreover, the Governor does not support it, recently quipping, I dont think we can delay this funeral. The other bill (#654) is intended to divert billions of dollars worth of funds on hand at the RDAs to local governments. It accomplishes this by remitting dedicated housing funds (about $2bn) to the sponsoring city or county, and by expanding the definition of enforceable obligations to include loans made over the years to local governments (unknown amount). It is unclear how the passage of this new bill would impact the ability of the county auditors to challenge the magnitude of loans to local governments currently appearing on the EOPSs. Until these questions are answered, the near-term uncertainties will continue to out-weigh the long-term positive credit factor of no more RDA issuance.
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Supply forecast
Monthly tax-exempt bond issuance ($bn) Monthly tax-exempt net supply/(redemptions) ($bn)
50 40 30 20 10 0
Annual total: 5yr avg. $410 2011 $297 2012 $350
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source: Bond Buyer, J.P. Morgan
25 20 15 10 5 0 -5 -10 -15 -20 -25

Source: Bond Buyer, IDC, J.P. Morgan
Annual total: 5yr avg. +$87 -$73 2011 +$4 2012
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Interest rate forecast

Yield (%)
Treasury 2yr 5yr 10yr 30yr
1Q12 2Q12 3Q12 4Q12 Current Forecast Forecast Forecast Forecast 0.21 0.27 0.30 0.30 0.30 0.75 1.89 3.06 1.10 2.25 3.30 1.25 2.50 3.60 1.25 2.50 3.60 1.25 2.50 3.60
AAA tax-exempt yield / Treasury yield (% ) Min Max Mean St. Dev. 2yr 164.5 123.4 187.3 157.6 14.2 5yr 98.3 91.1 136.8 111.9 14.1 10yr 92.6 88.1 117.7 102.4 8.9 30yr 105.4 104.8 132.8 119.3 7.2 AA corporate yield - AA tax-exempt yield (bp) Min Max Mean St. Dev. 3-5yr 77.6 72.3 102.7 91.3 7.8 5-7yr 111.5 104.2 161.1 135.6 15.0 7-10yr 150.3 110.0 174.4 150.2 19.0 25yr 111.8 61.5 121.6 84.4 15.9
Source: J.P. Morgan
Z-score 3mo 12mo 0.5 1.2 -1.0 0.3 -1.1 -0.4 -1.9 -0.5 Z-score 3mo 12mo -1.8 -2.1 -1.6 -2.4 0.0 0.9 1.7 1.7
AAA tax-exempt 2yr 0.35 5yr 0.74 10yr 1.77 30yr 3.23
Source: J.P. Morgan
0.72 1.10 2.22 3.65
0.49 1.21 2.44 3.91
0.49 1.21 2.44 3.91
0.49 1.21 2.44 3.91
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European Credit Research US Fixed Income Weekly February 1, 2012 Saul DoctorAC J.P. Morgan Securities Ltd
Special Topic:
Limiting Contagion in a Greek Restructuring; Picking a winner in the
ugly contest and the impact on CDS
In this note, we present our view on how to restructure Greek government debt and prevent contagion to other markets. The situation is delicate but manageable, and great care is needed to limit further market contagion We believe there are currently no good choices left and that what we are left with is an ugly contest where the aim is to find the least bad solution. Every scenario we can think of has its positives and negatives, so we should aim now to limit the contagion to the broader market The current best solution should meet as many of the eight points we list below as possible. They are: 1. Greek debt must be reduced to a sustainable level 2. Private creditors must accept a loss that is fair 3. The ECB cannot be seen as a senior creditor 4. The Euro system (ECB and NCBs) needs to show that it is well capitalized 5. Holdout creditors should not receive a free ride 6. Legal precedent should not be overridden 7. CDS must be shown to be a legitimate hedging product 8. Avoid the unexpected The optimum route is the one that offers the greatest chance of limiting market contagion. Building on the scenarios highlighted by our Rates colleagues in Global Fixed Income Markets Weekly (January 21), we believe the current best route is to have a Greek exchange offer where collective action clauses are used to ensure that minority holdouts are included in the exchange. We believe that CDS should trigger with bonds
available for recovery and that the ECB should share the burden so as not to impose itself as a senior creditor We continue to believe that CDS will likely trigger in order to find a comprehensive solution. We clear up some common misconceptions, including the size and impact of a CDS trigger, the timeline and likely pool of deliverable bonds
Check list for success

1) Greek debt must be reduced to a sustainable level It may seem obvious, but the first aim of any restructuring should be to get Greece back onto the path of fiscal sustainability. Anything less than this will simply mean kicking the can down the road in the hope of dealing with it at some future date. While can-kicking has been the preferred strategy over the past year, we believe that time is running out and the EUs and ECBs ability to continue to do this is limited. The current restructuring of Greek debt is looking like Europes last chance to deal with Greece and limit contagion to the broader market. Only by fixing the Greece situation do politicians have a chance of showing that they are taking decisive action to solve the European debt crisis. Greece currently has a debt-to-GDP level of 162%, which the IMF expects to fall to 120% by 2020 assuming everything goes to plan. Our economists believe that this projection is optimistic and their own base case sees debt at 170% in 2020. These assumptions incorporate 100% take-up of the PSI plan for a 50% reduction in privately owned debt. While the current restructuring cannot guarantee that Greece will be able to continue to maintain sustainable levels of debt, it should at least show that debt sustainability is feasible without further losses to bondholders. Our economists believe that even 100% acceptance of the PSI will only reduce debt/GDP by 20%, making future losses likely. If bondholders feel that they will have to shoulder further losses in the future, they will continue to be unwilling to invest now. PSI must include Public Sector Involvement to reduce debtto-GDP to sustainable levels.
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2) Private creditors must accept a loss that is fair While no-one likes to accept a loss on a trade, particularly on investments thought to be risk-free, sometimes the unexpected happens. Most investors accept this outcome even though they may dislike it. In the case where these losses are imposed on investors however, they need to be shown that the losses they are taking are fair. Investors who feel they are being unfairly treated will be unlikely to make the same investments in the future, or they will demand a significantly higher premium for doing so. In the case of Greece, market participants, both those that invested in Greece and also those that did not, need to accept that the outcome of the Greek restructuring is fair. An unfair outcome will have a detrimental impact on markets as it will discourage investors from lending to sovereigns in the future if they believe that in doing so they are opening themselves up to losses which they could not predict and did not accept when they entered their investment. We believe that private creditors have already accepted that they will need to bear significant losses but will be unhappy with an unfair outcome. Fairness is not an absolute outcome, but a relative one. All investors need to be treated equally and accept their proportionate loss. 3) The ECB cannot be seen as a senior creditor While the ECB has so far been unwilling to accept any loss on its bond purchasing program, insisting that PSI means Private Sector Involvement, we believe that this stance has the potential to cause large market disruption. If the ECB is seen as a preferred creditor, it means that every time the ECB intervenes and either provides a loan or buys bonds from a sovereign, private investors are being subordinated and may be forced to accept greater losses. This is not the message the ECB wants to portray from its programs, which should focus on providing stability and liquidity to sovereigns and the market. The history of IMF involvement in sovereign restructuring has shown this on numerous occasions. IMF involvement rarely signals the end of a crisis and is usually the precursor of further market losses. The more the IMF lends to a troubled sovereign, the more losses private investors will need to accept. Accepting a loss on its bond holding could impair the ECBs ability to continue its sovereign bond purchase
Exhibit 1: Greek debt dynamics after a 50% haircut on privately held debt
% GDP (assumes debt relief worth around 85bn from the debt exchange)
180 170 160 150 140 130 120 09 11 13 15 17
J.P. Morgan
IMF with slippage
IMF
19
21
Exhibit 2: Greek general government gross debt

(bn) and % GDP (at the end of 2011)
bn Breakdown of Greek debt at the end of 2011 Outstanding debt Official loans (EU and IMF) Other loans T-bills Bonds Breakdown of 260bn of bonds ECB Bank of Greece Greek social security funds Greek banks Other European banks Insurance companies Rest (asset managers, SWFs, foreign central banks, etc.)
We employed assumptions where information was incomplete.
% GDP 162.2 33.6 3.7 7.4 117.5 22.1 3.2 13.8 20.7 18.4 6.9 32.3
352 73 8 16 255 48 7 30 45 40 15 70
program, as there may be political pressure from core EU countries to no longer support the periphery through fiscal transfers. Ultimately, since the member states would bear the loss on the Euro systems holdings, a better solution may be for the EFSF to assume the Greek bonds from the ECB in exchange for a loan. If the ECB and the EU want to be senior creditors, we believe they should make it clear. While markets will reprice sovereign debt accordingly, once this is done, the rules of the game are clear and there will be fewer surprises going forward.
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4) The Euro system (ECB and NCBs) needs to show that it is well capitalized In order to limit contagion further, the ECB needs to show that it is well capitalized and can withstand a default of Greece. We believe that this is the case for a number of reasons: a) We estimate that the Euro system has bought bonds at a market average price of around 80. Assuming a write-down in line with other investors, this would lead to a loss of 25bn (50pts on their holding of 50bn). Given that the Euro system has 83bn in capital and reserves, we believe this is manageable. Although clearly the Euro system will be unwilling to see its capital and reserves drop by 30%.
Having an effective way to deal with the holdouts is in our view imperative to ensure that acceptance is high. In order to do so, we believe there needs to be a stick to encourage the reticent investors. We believe the best stick available is the use of CACs (collective action clauses). We have written extensively about CACs, but essentially they allow debtors to restructure bonds so long as a threshold majority of investors agree to the restructuring. CACs ensure that minority bondholders are not able to hold up a restructuring when a majority of bondholders agree to it. Currently, Greek bonds issued under domestic law do not contain CACs, while the international law bonds do. Recent press reports have suggested that Greece is looking to insert CACs into domestic bonds retroactively such that all government bonds issued under Greek law will have collective action clauses in them. We believe that this could be done and that the legal challenges will be limited. It is not immediately clear whether these bonds are more or less valuable with the CACs in them. On the one hand, they can be more easily restructured; while on the other hand, their existence makes a messy outcome less likely. Majority bondholders might see them as a benefit while minority holders as a cost. Recent discussions over CACs have also proposed the use of a new aggregate CAC. While they usually require a majority of each issue to be restructured, the new proposals may allow a majority of bondholders of a particular class of bonds to impose a restructuring. We believe this would be an effective way to deal with minority holdout bondholders. Since the majority of bondholders accept that the deal is a fair one, it will lend weight to the argument that it is fair for everyone. This is not to say that the use of the CACs will not be challenged, but rather that we believe that it will be seen as a fair way of dealing with holdouts. 6) Legal precedent should not be overridden The alternative to using CACs is to change the domestically issued bonds directly through a change to Greek law, for example by imposing a loss through legislation. We believe this is a rather nuclear option that will have a detrimental impact not only on Greek bonds, but on all EU domestically issued bonds. If Greece implements a law to change the terms of its bonds, it is likely that investors would be unwilling to buy bonds from any EU sovereign unless they were issued under a
b) The Euro system is sitting on unrealized revaluation reserves of almost 400bn from its holding of Gold and other currencies, which are still marked at their purchase price. While these reserves are typically used for exchange rate stability, they could be recognized and used as a buffer against losses. That said, in order to do so, the ECB may need to sell these assets, which they may be unwilling to do. c) The Euro system can print money. The ECB ultimately has an almost unlimited supply of cash since it can print money in order to cushion against losses. While there are restrictions on how it can do this, we believe that these can be overcome in these unprecedented times.
Ultimately, losses need to be socialized across the EU, with the stronger countries supporting the weaker ones. We recognize of course that the ECBs losses from a Greece default may be larger than detailed above if counterparties also default, leading to losses on repo and ELA transactions. While repo collateral is likely marked close to the market price, ELA transactions could see larger losses. 5) Holdout creditors should not receive a free ride Dealing with holdouts is a tricky point in all restructuring situations. Firstly, if the holdouts are large enough, they could limit the effectiveness of any restructuring proposal such that fiscal sustainability is not reached. Secondly, the existence of holdouts makes other investors unwilling to accept an exchange where those who signed up will receive materially worse terms than those who do not.
31
law outside of that control of the sovereign. We do not believe that core EU countries would allow this situation to take place. Investors should feel that laws are being upheld and not just changed at the whim of sovereigns, setting a very dangerous precedent. 7) CDS must be shown to be a legitimate hedging product We believe that CDS will be triggered in a restructuring credit event unless the exchange remains voluntary. Sovereign CDS are primarily used by market participants hedging their sovereign and sub-sovereign exposures. Rather than selling particular bonds, investors often hedge their default exposure using CDS. Plus, loans and derivative transactions with sub-sovereign entities (such as national railways and social security agencies) are often hedged using sovereign CDS as it is liquid. If investors no longer believe that CDS offers an effective hedging tool, they will no longer use it. This forces investors to sell bonds rather than hedging with CDS, leading to widening bond yields as investors demand additional premium for the illiquidity risk they take. Additionally, banks will be less willing to engage in transactions with sub-sovereign entities as they would be unable to hedge these exposures unless they were compensated by higher borrowing costs. Only if CDS is shown to be an effective hedge will investors continue to use it as such. CDS are only a small part of the total bond market, yet they are the liquid part. As we have highlighted many times, there is only $3.2bn of net CDS outstanding on Greece. While some market commentators insist on focusing on the gross figure of $70bn, this shows a misunderstanding of how CDS contracts are traded and settled, where the absence of a central clearer and exchange means that offsetting trades are very common. The recent data from the December EBA stress tests showed that EU banks were only exposed to 500mn of net CDS on Greece (on 20bn gross CDS), a drop in the ocean compared to the 80bn of bond exposure. See below where we clear up some common CDS misconceptions.
One situation which we believe should be avoided at all costs is a hard default, by which we mean a moratorium on payments until an agreement is reached and/or a payment failure. We believe this is not in the interest of bondholders, Greece or the wider markets. The problem with a payment failure is that it opens up a Pandoras box of claims, with everyone rushing for the exit at the same time. Such a disorganized default would increase the chance of different recovery outcomes for different jurisdictions, different governing laws and different contractual terms on instruments that essentially bear the same risk. This could lead to years of legal wrangling in courts.
Clearing up some common CDS misconceptions

1) Gross versus net CDS notional While the CDS market is moving towards central clearing counterparties, the current market structure involves market participants engaging in bilateral trades with each other. The gross CDS notional reflects the sum of all the long risk trades in the market (this is also equal to the number of short risk trades as every long trade is also a short trade). When two CDS counterparties close out a trade, it is common for them to enter an offsetting trade rather than tear up the original contract. While the net notional at risk in an offset is zero, the gross number is twice the original trade. This is also common when an investor opens and closes a trade with two different counterparties and a trade is assigned from one counterparty to another. This can quickly inflate the gross notional away from the net notional numbers. For this reason we believe that net notional reflects an institutions true exposure to a credit event. 2) CDS trades are unreported and are potentially enormous The latest EBA stress tests asked for explicit positions on sovereign CDS from the reporting banks. The largest CDS net exposure is to Italy with 5bn of long risk across the banks, for Greece, the number was 545mn (Exhibit 3). These numbers are miniscule in comparison to 2tn of Italian debt and 350bn of Greek debt. Unless banks misreported or misrepresented their holdings to the EBA, a very serious charge, CDS notional exposure is
8) Avoid the unexpected
32
rather limited. On average, EU banks account for 10-20% of the total CDS net notional exposure. 3) Net notional does not account for counterparty risk While an institution can reduce its net notional by engaging in offsetting trades with two different institutions, it is still at risk that one counterparty defaults and it is therefore not entirely hedged. While this could be the case, note that almost all CDS come under standard ISDA and CSA agreements, such that collateral is posted daily to reflect the mark-to-market of a CDS trade. While this does not guard against a jump to default (most institutions demand additional collateral for this), in the case of Greece, which is already trading at 60% upfront, the potential jump to default loss is rather small. 4) From credit event to auction Assuming the Greece PSI remains a voluntary exchange, there will be no CDS credit event. The use of a CAC however will likely cause a CDS trigger. The way we see this working is similar to how the Irish banks were restructured. An exchange offer was made and there was a period of about two weeks to sign up to the exchange. Investors agreeing to the exchange also agreed to use Exit Consents to insert a call in the old bonds at 1c. Once the exchange window closed and the required number of votes exceeded the threshold, a CAC in the bond was used to insert the call and call the bonds. At this point, the ISDA Determination Committee (DC) decided that a credit event had occurred. We see a similar timeline for Greece. Once the bond was exchanged, however, the investor could no longer deliver the old bond into the CDS auction as they no longer owned it; it was uneconomic to deliver the new bond as it was trading with a higher price as a percent of its new notional. In order to ensure that there were still deliverable bonds into the CDS auction, which generally happens within two to four weeks after the DC deciding that a credit event has occurred, the call process was staggered, with two bonds remaining outstanding for a period after the first bond was called. These bonds were used in the auction settlement. 5) Deliverability of Strips, Zeros and Linkers Following the DC making a determination that a credit event has occurred, they will publish a list of deliverable obligations for the auction. Market participants can
Exhibit 3: European Bank Exposure to Sovereign CDS

Net Long Risk (mn)
France
Source: J.P. Morgan, EBA
Exhibit 4: EBA exposure as % of Total Market Net

EBA Exposure / DTCC Exposure
France
Source: J.P. Morgan., EBA, DTCC
suggest additional bonds, which, assuming they meet the deliverability criteria, can be added to the list. Any bond from this list is deliverable into the auction, which will likely settle at the price of the cheapest to deliver bond. When looking at whether Strips, Zeros and Linkers are deliverable, it is important to keep in mind that the CDS settlement price is always done against the principal claim at the time of the auction. If a bonds notional claim is reduced in half, an investor would need to deliver twice as much to affect physical settlement. For Linkers, these typically have an initial par claim which accretes higher with inflation. If the notional claim can also decline, then an investor would likely only be able to deliver the initial par claim or floor. For example, a par claim of 100mn which accreted to 150mn would likely remain a claim of 100mn. For a Zero, a similar concept holds; as the par claim increases, an investor can
33
United Kingdom
Austria
40% 35% 30% 25% 20% 15% 10% 5% 0% -5% -10%

Italy
Netherlands
Sweden
Denmark
Belgium
Portugal
Norway
Germany
Finland
Greece
Iceland
Spain
Ireland
United Kingdom
Austria
6000 5000 4000 3000 2000 1000 0 -1000

Italy
Netherlands
Sweden
Denmark
Belgium
Portugal
Norway
Germany
Finland
Greece
Iceland
Spain
Ireland
only deliver against the actual claim they have at the time of the credit event. For example, if the bond was a claim of 70 at the time of the credit event, it would remain at this level and would not be considered a claim of 100. For Strips the situation is more difficult; it is likely that the principal component strip would need to be delivered along with all the interest component strips as only the full package would be considered a debt security. 6) CDS does not hedge economic losses One of the main risks we highlighted above is that CDS should be shown to work and should provide a hedge against bond losses. One of the biggest risks in CDS is deliverability riskthe risk that following a credit event, CDS contracts trigger but there are few if any deliverable bonds. This could either lead to a squeeze in prices resulting in a high recovery or at worst a recovery of 100%. a) Risk of Squeeze The CDS auction settlement process is designed to limit this squeeze. The auction works by matching buyers and sellers of physical bonds to determine a final settlement price for the cheapest-to-deliver bond which is then used as the settlement price for CDS. All standard CDS settle in this way. In the case of Greece, there is 3.2bn of net exposure; the settlement rules stipulate that no firm can ask for physical settlement greater than its net position. Since many investors prefer cash to physical settlement, not all $3.2bn will be looking to buy bonds in the auction. Suppose 70% want physical settlement, a high number given that typically less than 40% opt for this. This would see $2.24bn of CDS holders looking to physically buy or sell bonds. Following the auction, investors have a period of a few weeks to affect physical settlement, so investors do not actually have to own the bonds they sell on the auction date. This allows bonds to be recycled and further reduces the amount needed for physical settlement. Suppose 50% of bonds are recycled, this leaves only $1.12bn of bonds needed for physical settlement. Compared to 237bn of domestic GGBs and 19bn of international GREECE bonds, this would seem manageable.
b) No Deliverables CDS settlement in an auction is based on the price of the cheapest to deliver bond. In the case of Greece, we could see a situation where the pool of deliverable bonds is limited. Currently all regular domestic and international law bonds are deliverable. However, if Greece enters into an exchange with its creditors that triggers CDS, there is a risk that the pool of deliverable bonds will be reduced if the new bonds from the exchange are no longer deliverable. We see four scenarios: 1) New restructured bonds are not deliverable and some of the international bonds due to holdouts are. This could happen in the case where the new exchanged bonds do not represent a claim on Greece but a future claim on the EFSF and are therefore not deliverable, but some of the international law bonds remain outstanding in their previous form. In this case the CDS would settle on the cheapest to deliver international law bond, which are currently trading inline with the domestic issues at around 20-25c. Some old domestic bonds still exist. Suppose some bonds are left out of the exchange either because they do not have the threshold votes from a CAC or they are not included in the exchange offer, e.g. long-dated bonds, these would still be deliverable and likely the cheapest-to-deliver trading at 20-25c. The new restructured bonds are deliverable. The current PSI discussion will reportedly have a 50% haircut on the original notional, a 15% cash or EFSF loan, and the remaining 35% notional as a 3.5% 30-year Greek bond. Assuming Greece trades with a 13% yield following the exchange, this bond would be valued at 25-30c assuming that the claim on Greece and the claim on the EFSF are separate instruments. In the case where they trade as a single instrument, the price would be higher. All bonds, domestic and international, are swept up in the exchange and none are deliverable.
2)
3)
4)
Only in the last case, which we do not assign a high probability to since some bonds will undoubtedly be blocked by holdouts, do we see a real problem with deliverability in CDS.
34
The way forward

Greece and the EU now stand at a crossroad with many routes before them: a) Continue to pay bondholders and hope that the situation improves
b) Enter a voluntary restructuring agreement with a majority of bondholders but not enough to ensure that Greece has a fighting chance. c) Enter a restructuring agreement with the use of CACs to sweep up minority holdouts
d) Declare a moratorium and restructure bonds through Greek law. Based on our eight points, we believe that the best way to move forward is for Greece to offer an exchange to bondholders with the stick of a collective action clause. This should encourage investors to sign up and will effectively deal with the holdouts, at least on the domestic bonds. We believe that such an exchange could be done in a similar fashion to the exchanges offered in the case of Irish bank subordinated debt. Here, investors were invited to tender bonds and in doing so they agreed to an exit consent that called the remaining outstanding bonds at 1c. This triggered CDS and ensured that bondholders who had hedged themselves with CDS received the payout they expected. In the case of Greece, calling the bond at 1c might seem aggressive due to the imposition of retroactive CACs, and holdouts will likely receive the new exchange bonds. The use of CACs would have the effect that the ECB would also be dragged along into the process. We believe that while there are many risks to this position it is preferable to asserting themselves as senior creditors thereby subordinating all other investors and causing much wider consternation. We believe that there is an increasing acknowledgement among politicians that losses will have to be socialized and that resistance to this route is diminishing. We are not suggesting that our solution is the most likely outcome, given historical precedence, muddling on through with a voluntary exchange offer is still highly likely. Nor do we believe that the solution is riskless or obvious, but rather that in our view it is currently the best option for limiting greater marker contagion.
35
US Fixed Income Strategy US Fixed Income Weekly February 1, 2012 Srini RamaswamyAC J.P. Morgan Securities LLC
Forecasts & Analytics

Interest Rate Forecast
Jan 27, 2011 Rates Effective funds rate 3-month Libor 3-month T-bill (bey) 2-year T-note 5-year T-note 10-year T-note 30-year T-bond Curves 3m T-bill/3m Libor 2s/5s 2s/10s 2s/30s 5s/10s 5s/30s 10s/30s 16 139 279 397 140 258 117 43 83 198 303 115 220 105 38 95 220 330 125 235 110 33 95 220 330 125 235 110 33 95 220 330 125 235 110 0.08 0.30 0.15 0.59 1.98 3.38 4.56 Mar 31, 2012 1Q12 Forecast 0.06 0.45 0.02 0.27 1.10 2.25 3.30 Jun 30, 2012 2Q12 Forecast 0.06 0.40 0.02 0.30 1.25 2.50 3.60 Sep 30, 2012 3Q12 Forecast 0.06 0.35 0.02 0.30 1.25 2.50 3.60 Dec 31, 2012 4Q12 Forecast 0.06 0.35 0.02 0.30 1.25 2.50 3.60
* Fed funds assumed to be 0.125% for Fed funds/3m Libor calculation.
Swap spread forecast*

Jan 27, 2011 Feb 26, 2011 1M Forecast 2-year sw ap spread 5-year sw ap spread 10-year sw ap spread 30-year sw ap spread *Forecast uses matched maturity spreads 20 21 6 -27 34 30 11 -31 Apr 27, 2011 3M Forecast 33 31 11 -25 Jul 26, 2011 6M Forecast 32 33 12 -24
36
Economic forecast
%ch q/q, saar, unless otherw ise noted 11Q2 Gross Domestic Product Real GDP Final Sales Domestic Final Sales Business Inv estment Net Trade (% contribution to GDP) Inv entories (% contribution to GDP) Prices and Labor Cost Consumer Price Index Core Producer Price Index Core Employ ment Cost Index Unemploy ment Rate (%, sa) * Q4/Q4 change 1.3 1.6 1.3 10.3 0.2 -0.3 4.1 2.5 7.1 3.2 2.8 9.0 11Q3 1.8 3.2 2.7 15.7 0.4 -1.4 3.1 2.7 1.9 3.8 1.0 9.1 11Q4 2.8 0.8 0.9 1.7 -0.1 1.9 0.9 1.7 1.5 1.0 2.0 8.7 12Q1 2.0 2.3 2.3 7.4 -0.1 -0.3 1.8 1.4 2.5 2.0 2.0 8.4 12Q2 2.5 2.6 2.8 8.1 -0.1 -0.1 1.4 1.2 1.5 1.2 2.0 8.3 12Q3 3.0 2.9 2.8 8.1 0.1 0.1 1.3 1.2 1.5 1.2 2.0 8.2 12Q4 2.0 2.1 2.2 6.5 -0.1 -0.1 1.3 1.2 1.5 1.2 2.0 8.1 13Q1 1.5 1.5 1.3 4.5 0.2 0.0 1.5 1.3 1.5 1.3 2.0 8.1 2010* 3.1 2.4 2.9 11.1 -0.5 0.7 1.2 0.6 3.8 1.4 2.0 2011* 1.6 1.4 1.3 7.3 0.1 0.1 3.3 2.2 5.6 2.9 2.1 2012* 2.4 2.5 2.5 7.5 -0.1 -0.1 1.4 1.2 1.7 1.4 2.0 -
Financial markets forecast

Financial markets forecast
Credit Spread 10Y sw ap spread* 30Y current coupon MBS L-OAS** 10Y AAA 30% CMBS (2007 vintage)** 3Y AAA Credit Cards fixed** JULI portfolio spread* High Yield Index* Em erging Market Index* Corporate Em erging Market Index (Broad)* Current 6 19 215 25 155 549 289 271 Mid-year 2012 12 35 250 11 225 700 375 425 Current S&P* ($) Brent** ($/bbl) Gold** ($/oz) EUR/USD USD/JPY
** 2Q1 quarterly average fo recast 2
Mid-year 2012 1430 110.0 1875 1.34 76
1313 113.1 1730 1.31 76
* S&P 500 fo recast is a year-end 201 fo recast 2
* spread to Treasuries. No te: The JULI mid-year spread target is interpo lated fro m year-end targets. ** spread to swaps
Gross fixed-rate product supply*

350 300 250 200 150 100 50 0 Jan 09 Apr 09 Jul 09 Oct 09 Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12
Agency Corporate MBS CMBS ABS
* amount in $ billions
37
Client surveys
Duration Jan 23, 2012 Jan 17, 2012 3-month average Long 21 19 18 Neutral 64 68 69 Short Changes 15 21 13 9 13 14
Treasury Client Survey

30 Longs minus shorts 20 10 0 -10
Credit Corporate Bond Weighting Jan 12, 2012 1.52 Dec 7, 2011 1.28 3-month average 1.35 Cash Position 0.85 1.03 0.98 Spread Outlook 1.71 2.00 1.50
-20 -30 Dec 10
Feb 11
May 11
Aug 11
Oct 11
Jan 12
Credit Client Survey

1.8 1.6 1.4 Corporate Bond Weighting
*Corporate bond w eighting index is the ratio of the sum of ov erw eights and neutral positions to the sum of underw eights and neutral positions; the cash position index is the ratio of the sum of high and medium cash positions to the sum of low and medium positions; the spread outlook index is the ratio of the sum of positiv e and neutral outlooks to the sum of negativ e and neutral outlooks. 6 3 7 4 8 5
1.2 1.0 0.8 Sep 08
MBS January 2012 December 2011 3-survey average Overweight 64% 64% 58% Flat Underweight 23% 13% 32% 4% 34% 8%
May 09
Jan 10
Sep 10
May 11
Jan 12
MBS Investor Survey

60% 40% 20% 0% -20% -40% -60% Sep 09 Feb 10 Jun 10 Nov 10 Mar 11 Overweight - Underweight
Jul 11
Nov 11
38
US Fixed Income Strategy US Fixed Income Weekly New York, February 1, 2012
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39
US Fixed Income Strategy US Fixed Income Weekly New York, February 1, 2012
Market Movers
Monday Tuesday Wednesday Thursday Friday
23 Jan
24 Jan
Richmond Fed survey (10:00am) Jan FOMC meeting
Auction 2-year note $35 bn
25 Jan
Pending home sales (10:00am) Dec -2.0% FHFA HPI (10:00am) Nov -0.3% (-3.6%oya) FOMC statement (12:30pm) and press conference (2:15pm)
26 Jan
Initial claims (8:30am) w/e prior Sat 380,000 Durable goods (8:30am) Dec 1.4% Ex transportation 0.7% New home sales (10:00am) Dec 320,000 Leading indicators (10:00am) Dec KC Fed survey (11:00am) Jan
27 Jan
Real GDP (8:30am) 4Q advance 3.0% Consumer sentiment (9:55am) Jan final 74.5
30 Jan
Personal income (8:30am) Dec Dallas Fed survey (10:30am) Jan Senior loan officer survey (2:00pm) 1Q
31 Jan
Employment cost index (8:30am) 4Q S&P/Case-Shiller HPI (9:00am) Nov Chicago PMI (9:45am) Jan Consumer confidence (10:00am) Jan Housing vacancies (10:00am) 4Q
1 Feb
ADP employment (8:15am) Jan ISM manufacturing (10:00am) Jan Construction spending (10:00am) Dec Light vehicle sales Jan
Announce 3-year note $32 bn Announce 10-year note $24 bn Announce 30-year bond $16 bn Philadelphia Fed President Plosser speaks on economy in Gladwyne, PA (8:30am)
2 Feb
Initial claims (8:30am) w/e prior Sat Productivity and costs (8:30am) 4Q preliminary Chain store sales Jan
3 Feb
Employment (8:30am) Jan ISM nonmanufacturing (10:00am) Jan Factory orders (10:00am) Dec
6 Feb
7 Feb
JOLTS (10:00am) Dec Consumer credit (3:00pm) Dec
8 Feb
Auction 10-year note $24 bn San Francisco Fed President Williams speaks on economy in San Ramon, CA (10:30am)
9 Feb
Initial claims (8:30am) w/e prior Sat Wholesale trade (10:00am) Dec
Auction 30-year bond $16 bn Announce 30-year TIPS $10 bn
10 Feb
International trade (8:30am) Dec Consumer sentiment (9:55am) Feb preliminary Federal budget (2:00pm) Jan
Unless otherwise expressly noted, all data and information for charts, tables and exhibits contained in this publication have been sourced via J.P. Morgan information sources. __________________________________________________________________________________________________________________________ Analyst Certification: The strategist(s) denoted by (AC) certify that: (1) all of the views expressed herein accurately reflect his or her personal views about any and all of the subject instruments or issuers; and (2) no part of his or her compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by him or her in this material, except that his or her compensation may be based on the performance of the views expressed.

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US Fixed Income Strategy 1 February 2012

US Fixed Income Weekly

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

Investment-Grade Corporates Eric Beinstein

Municipals Peter DeGroot, Josh Rudolph

Special Topic: Limiting Greek Contagion Saul Doctor

Terry Belton Srini Ramaswamy Alex RoeverAC

Cross Sector Overview

Target funds rate by year-end 2014; bp

Source: EPFR Global

0.2 0.1 0.0 -0.1 -0.2

Exhibit 1: Real GDP and real final sales

Real GDP Real final sales

Exhibit 2: Real private inventories and major components

Total Nonfarm Manufacturing Wholesale Retail

4Q10 38.3 44.7 39.7 16.5 -13.7

1Q11 49.1 59.7 33.3 22.3 -0.7

2Q11 39.1 51.0 24.2 39.0 -20.5

3Q11 -2.0 5.5 11.3 6.4 -12.7

4Q11 56.0 63.6 34.1 24.8 -9.5 -16.6 7.1

Exhibit 3: Real business fixed investment, equipment and structures

Equipment and software

20 10 0 -10 -20 -30 2010 2011 Structures

Exhibit 4: Regional Fed surveys, capital spending plans

Business spending comes off the boil

30 25 20 15 10 5 2010 2011 2012

Exhibit 5: Durable goods orders

Core capital goods Total ex transportation

Mixed messages on orders for durables

Exhibit 1: J.P. Morgan interest rate forecast

1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5

0.2 0.1 0.0 -0.1 -0.2

Yellen Dudley Tarullo Williams 4 4

# participants # voters (est.)

Voting members are bolded.

4 3 2 1 0 12.5 50 75 100 Target funds rate by year-end 2014; bp

0.22 0.20 0.18 0.16 0.14 0.12 0.10

Treasury Refunding and Bills supply

75 70 65 60 55 50 45 Jan 00 Weighted average maturity (months) Share of T-bills (%ge)

35% 30% 25% 20% 15% 10% Dec 12

Exhibit 13: Breakevens currently look wide relative to fair value

Breakeven Targets 3Mx5Y breakevens, bp 3Mx10Y breakevens, bp 3Mx30Y breakevens, bp

Current 186.3 212.7 229.7

1Q12 175 205 225

* See TIPS, US Fixed Income 2012 Outlook, 11/25/11.

100 95 90 85 80 75 70 -15 -10 -5 0 5 10 20 Business days around 30Y TIPS auction

200 180 160 140 120 100 80 60 40 20 0 2008

Treasury 0.15 Agency

0.00 2Y 3Y 5Y Maturity bucket 10Y

35 30 25 20 15 10 5 0 Jul 10 Jan 11 Jul 11 Jan 12

4.6% 4.4% 4.2% 4.0% 3.8% 3.6% 3.4% Nov 10

Scenario 1 FNMA FHLMC Scenario 2 FNMA FHLMC Scenario 3 FNMA FHLMC

Source: FNMA, FHLMC

5000 y = 38.865x - 1249.3 R = 0.7043

Estimate for Q4'11

Change in 10-year swap rates over the quarter (bp)

High: 262bp Current: 219bp 2012 YE Forecast :

Source: J.P. Morgan

Source: J.P. Morgan

Exhibit 4: and seems well understood by markets now

Source: J.P. Morgan

Exhibit 6: Tier 1 Common ratio