All aboard QE2

- Cross Sector "The Fed’s decision to reinvest Agency paydowns into Treasuries is a shift toward a more accommodative monetary policy that defers its eventual exit strategy further. We now expect the Fed to stay on hold until 2Q12. The search for carry will likely stay the dominant theme. Look for further declines in intermediate yields. Stay overweight credit. Turn overweight MBS."
- Governments "The quest for carry continues, and is likely to progress further out the curve—look for the 2s/10s curve to flatten further in coming months, and continue to anchor belly-richening trades in the 10-year sector. Buy 3% Feb 17s versus TYZ, as Feb 17s are cheap and the Fed holds almost none. Buy 3.375% Nov 19s versus selling 2.625% Aug 20s and 4.75% Aug 17s. Overweight MBS versus Agency debt."
- Interest Rate Derivatives "We remain tactically neutral on spreads. Look for bull flattening to be increasingly concentrated outside the 5-year point of the curve; pay in 1Yx5Y versus a weighted barbell. Stay short volatility with a bias to longer expiries."
- MBS and CMBS "Move to an overweight on the mortgage basis, based on more attractive
fundamentals. Begin to add premium and IO exposure. Low nominal yields will motivate CMBS investors to reach for spread and duration in search of higher returns; look for AM prices to gravitate toward par."
- ABS and CDOs "Stay overweight subordinate Bankcard, Prime Auto Loan, and FFELP. Our top picks in AAA ABS are AMOT, WFNMT, and COMNI."
- Investment-Grade Corporates "An extremely strong technical backdrop and solid credit fundamentals will limit the magnitude of any spread widening. Thirty-year bonds are attractive vs. 10s."
- High Yield "The strong rotation of retail money into the high yield asset class remains intact; this week’s inflow was the fifth consecutive for a total of $4.9bn."
- Short-Term Fixed Income "Funding markets have improved so fast that LIBOR levels for the BBA panel banks are now lower than they were in March. However, funding pressures may re-emerge as over $150bn of EU bank debt still needs to be refinanced."
- Municipals "QE is supportive of further inflows into longer-term mutual funds at the expense of money funds. But, look for ratios versus Treasuries to move higher."
- Emerging Markets "Robust inflows to EM should continue to benefit assets, and we keep a year-end 250bp spread forecast."
- Special Topic: The JPM Agency Prepayment Model "Our agency involuntary prepayment models have been updated to take into account new efficiencies in GSE delinquent loan buyouts, a new primary/secondary spread mortgage model, and other factors. The model generates wider OAS and longer durations."

JPMorgan US Fixed Income Markets Weekly 20100813

US deflation would likely imply higher USD

- Deflation is a potential scenario for currency markets "We take a very preliminary stab at considering the possible FX implications of such a scenario for G10 currencies. Risks on the deflation side have clearly been growing and our US economics team would characterize the odds of a return to QE in the next year as 35%, which is a substantial risk of such a bad outcome."
- We consider two different deflation scenarios "We consider two possible scenarios for the US in such a deflation environment: the “recoupling” scenario where deflation becomes widespread outside of the US, and the “decoupling” one where deflation starts and stays in the US. But our base case is that if deflation starts in the US, it will not stay limited to the US."
- Our base case deflation scenario: recoupling "Unlike Japan, which has been in deflation on its own, the US would wind up pulling the developed world into similar deflationary straits. Intuitively, this scenario feels like the most likely deflationary scenario for the US, in our opinion, given the central importance of the American economy to both the global growth picture and global financial markets."
- US-specific deflation could be quite USD-negative "The Fed would be implementing another massive round of quantitative easing as other banks either stand pat or normalize their own rates. Interest rate differentials would wind up tilted against the USD. In this state, the dollar would be viewed as the chief funding currency, replaying the great yen carry trade of 2005-2007."
- One commonality in both of our scenarios: more QE "In either case, there would likely be additional action out of the Federal Reserve for additional quantitative easing. Short term reaction depends crucially on policy: re-emergence of QE could mean a frenetic but short term USD sell-off, similar to what to December 2008. It is hard to overlook such an event given how frantic and powerful such moves can be; the move from 1.24 to 1.44 in that December 2008 episode was both stunning and deeply concerning. However, the persistence of such a move depends on the scenario."
- Limited currency lessons from Japan "While Japan has been in deflation, essentially by themselves, nominal JPY has bounced around a fair amount. But since the rest of the world joined Japan in financial, macro and banking dysfunction, deflation has become more entrenched and the risk properties more enhanced. There has also been a stronger JPY in both nominal and real terms."

Merrill Lynch FX Spotlight 20100813

The Fed Re-enters Treasuries

- Flying too High: "We recommend selling 5yr Treasuries versus 2yr and 10yr Treasuries. Recent strong performance is beyond what is justified by Fed actions."
- Fed Treasury purchases will have an average duration of 6 years: "The Fed is likely to distribute Treasury purchases across maturities similar to what it did in 2009 with a slightly longer duration. The SOMA 35% limits should not be a binding constraint."
- Buy Vol: "Buy 5y10y swaption straddles to express the view that vol is cheap."
- Treasury Auctions were Strong: "All three auctions this week had a Citi Strength Indicator of greater than 50%."
- Flow: "Strong demand for the US fixed income in the week before the FOMC statement. Duration is still being extended."
- Unbalanced market re-pricing of MBS refi spike risk: "although a low probability in our view, a government engineered refi spike should bring with it a surge of production in MBS; in this scenario production coupon MBS spreads should widen."
- Agency Debt: "GSE reform hearings commence on August 17th and despite an additional two sessions after that we expect only modest spread volatility. The continued decline in agency debt supply should help to offset spread widening."
- US Rate Strategy Model Portfolio: "The portfolio is up 0.1% month-to-date."

Citigroup US Rate MBS Strategy 20100813

China Social Housing: Lackluster Growth or Quantum Jump?

- What's the Issue: "The social housing program has attracted a lot of attention from market observers of late. Many market observers had doubts about the progress being made so far and the prospect of fulfilling the social housing construction plan by the end of this year. At the same time, a dearth of timely and reliable data on this front makes it very difficult to evaluate and track the progress along the way."
- Our view: "We revisit and reaffirm our calls that: 1) the austere measures regarding property speculation will not cause a hard landing in fixed-asset investment growth in general and real estate investment growth in particular; and 2) the social housing program is on track and will constitute an important cushion for any potential slowdown in private market-based residential property construction and thus help ensure a soft landing in fixedasset investment growth. Moreover, we highlight a scenario featuring a potential “quantum jump” in construction of social housing in the latter part of the year that could tilt the balance of risks to the upside for fixed-asset investment growth. In this context, a potentially strong performance from a social housing program in 2010 would make the authorities’ pledge to “solve the housing problem for 15.4 million of low-income households by end of 2012” a lot more credible."
- Where we differ: "We take a hard look at the structure of real estate construction activity in China. By presenting our analysis in a flow chart format, we help clarify the relative importance of market-based private residential property construction vs. non-market-based residential property construction and, in that context, highlight the critical role of the social housing program in shaping the potential outlook for investment growth. We also compile a comprehensive set of data to help bridge an important information gap for monitoring the progress of the social housing program."

Morgan Stanley China Economics 20100813

Evaluating FX vol relative to interest rate volatility

- "We evaluate FX volatility using interest rate volatility. The relationship with the vol of associated interest rate spreads is persistent and has been especially strong in the past few years. Current valuations point to G10 FX vol being rich vs interest rates and EM FX vol appearing cheap by the same metric. With developed-economy policymakers increasingly expected to leave interest rate policy unchanged for a substantial period and growth prospects in G10 expected to be on average sluggish, we recommend selling G10 FX vol. Against this, to make the trade more relative-value in nature, we recommend buying EM FX vol – specifically a basket of TRY, ZAR and BRL vs USD."

Nomura Macro Insights 20100812

First signs of progress towards “Japanese corporate revival”

- "We expect Japan's economic growth to ease slightly through 2011 H1 as export growth slows and the impact of government measures wears off. It is difficult to be optimistic regarding the operating environment facing Japanese companies over this period. However, Japanese companies have already gone a long way towards eliminating the negative after-effects of Japan's bubble period, such as excessive debt, and have been steadily improving productivity and efficiency. We think it will become increasingly clear that the Japanese economy is likely to avoid a double-dip and that growth will probably start to pick up again from mid-2011. If Japanese companies step up their efforts to tap into demand in Asia and their medium-term growth expectations improve, that could lead to greater dynamism for Japanese companies and the Japanese economy through growth in capital investment and employment."

Nomura Japan Economic Overview 20100812

Why does a crisis last for a long time?

- "We seek to ascertain what explains the difference between a short recession, followed fairly quickly by a recovery, and an enduring crisis, in which the recession is followed by a long period of low growth."-
- "We believe that the explanation lies in the need to correct households' balance-sheet structure. Companies can fairly easily improve their balancesheet situation, especially in the United States, by distorting income sharing in their favour and by sharply scaling back their investments (as in the early 2000s), something that households cannot do."
- "Households must very gradually reduce their indebtedness and restore their wealth by saving more and reducing their housing investment; this process is all the more difficult in that, because household spending is sluggish, growth (in GDP and household income) is slower. This is what occurred in Japan and it is what will probably occur now in the United States and Europe."

Natixis Flash Economics 392 20100806

Sovereign CDS and fiscal solvency

- "The hierarchy of sovereign CDS displays several apparent anomalies:
• between OECD countries (for example, is the risk on the United States, Japan and the United Kingdom so low?)
• between OECD countries and emerging countries, in one direction (very low perceived risk for some emerging countries: for instance Slovakia, Slovenia and the Czech Republic) or in the other direction (well-managed emerging countries still perceived as risky: for instance South Korea, Poland and Brazil)."
- "We seek to ascertain whether these apparent anomalies can be explained by looking at the situation of these countries’ public indebtedness and fiscal solvency, or whether they are real anomalies that can be expected to correct."
- "We show that:
• the countries where the return to fiscal solvency will require the greatest reduction in the fiscal deficit are the United Kingdom, France, Spain and the United States,
• the hierarchy of the CDS of OECD countries seems irrational, since it does not take into account the public debt ratio or the differential between the fiscal deficit and the deficit that would ensure fiscal solvency,
• the CDS of emerging countries can be partly explained by the public debt ratio."

Natixis Flash Economics 391 20100805

Could Germany's exports to emerging countries save the euro zone?

- "Domestic demand in euro-zone countries will very likely remain weak, due to the slowdown in wage growth, sluggish investment, the increase in household savings and fiscal consolidation."
- "But there is at present a sharp increase in exports, especially in Germany's exports, due to the rapid pickup in demand in emerging countries (and also the United States). Could the euro zone enjoy growth driven by exports (from Germany)?"
- "For this to happen:
• demand from emerging countries must not weaken too much;
• the euro zone's exports to emerging countries must be sufficiently large to drive the euro-zone economy (directly, or through the knock-on effects on the other euro-zone countries of a recovery in Germany due to its exports), and the import content of these exports must not be too high."
- "Emerging countries' imports (and activity) are clearly slowing down significantly by comparison with the start of 2010, but emerging-country growth is likely to remain fairly robust. Most strikingly, the import content of the euro zone's exports to the emerging and oil-exporting countries seems extremely high. All in all, it is therefore likely that exports to emerging countries will have only a modest effect on euro-zone value added."

Natixis Flash Economics 390 20100804

JPY positioning indicates little belief in BoJ intervention

- "The latest IMM data covers the week from 3 August to 10 August."
- "The collapse in US interest rates has driven USD/JPY to a new cyclical low of 84.73 and brought renewed speculation about the potential for intervention by the Bank of Japan (BoJ). However, non-commercial positioning does not indicate that the market is placing that much confidence in the probability of a scenario of imminent and successful intervention. Rather net long JPY positions were built further to reach 38% of open interest – the highest level since December last year when net longs peaked at 39%."
- "Despite the dollar beginning to recover by 10 August, non-commercial investors added further to net short US dollar positions – which reached USD18.7bn. Recent strong dollar performance is likely to have seen part of the dollar shorts being unwound, although we continue to view risks as skewed to the upside for the dollar should further position squaring be triggered."
- "Speculative positions remain neutral in EUR/USD leaving limited positioning risk on the air at present."
- "Recent underperformance by the NZD, seeing AUD/NZD trade back above 1.26, has coincided with speculative investors trimming long NZD positions. Even so, positioning remains stretched in the commodity currencies AUD, CAD and NZ."

DenDanske IMM Positioning 20100816

Fear of a double dip keeps yields low

- "The ECB unlikely to be in a hurry to tighten monetary conditions. The first rate hike is seen in late H2 2011."
- "Danish short bond yields – such as F1 floating-rate bonds – should remain low for a long time, but the risk of an independent hike of CD rates has increased."
- "Our forecast for German bond yields has been revised slightly lower for the coming three months. However, we still expect yields in Germany to move up slowly from current low levels in the medium term."
- "Weaker data and a dovish Fed cause us to postpone the first rate hike from the Fed until Q4 2011."
- "Long US bond yields should decline further in the next few months. In the medium term we expect the US yield curve to move higher."
- "The US and German yield curves are expected to continue to flatten in the coming months."

DenDanske New Yield Forecast 20100813