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					                                                                                Global Asset Allocation
                                                                                J.P. Morgan Securities Ltd.
                                                                                Mar 16, 2012

Flows & Liquidity

VIX hungry                                                                      Nikolaos PanigirtzoglouAC
                                                                                (44-20) 7777-0386
• Flows into VIX ETFs continue to rise steeply to a record $1.5bn over
  the past four weeks.
                                                                                Seamus Mac Gorain
• The combination of low volumes, overweight positions in equities, and         (44-20) 7777-2906
  strong demand for hedges, such as long VI X exposures, are reflective
  of still widespread fear and a general lack of conviction.
                                                                                Matthew Lehmann
• A restructuring of Irish promissory notes seems inevitable given the          (44-20) 7777-1830
  very serious situation the country is in terms of deficit/debt dynamics.
  Ireland’s debt could easily exceed 150% of GNP by 2016.
                                                                                Leo Evans
• The impending wave of rating downgrades of European banks by                  (44-20) 7742-2537
  Moody’s should have limited impact on haircuts for bank bonds posted
  as collateral with the ECB.                                                   Chart 1: Flows into VIX ETFs
                                                                                Includes 16 ETFNs and ETFs that track the VIX. Flows
• Selling by Japanese banks is a risk to bonds.                                 into ETFs/ETNs tracking the inverse of the VIX are
• EUR spec shorts remain stubbornly high.                                       subtracted. The slope of the VIX futures curve is
                                                                                measured as the 6th month minus the first.
                                                                                  $mn, 4wk total
• This year global equities have rallied some 12% with other risky assets         2000            Slope of VIX futures curve       15
  also performing very well. However, this rally has been somewhat                1500
  unusual by historical standards for a number of reasons. Trading                1000
  volumes are much lower than is historically normal and hedge funds                                                                 5
  have hardly participated, only turning long equities in the past few
  weeks (see F&L, Jan 27). The other unusual aspect of this year’s rally is            0                                             0
  that at the same time as investors increased their equity exposure, they        -500
  also bought hedges via VIX ETFs. Historically, large inflows into these                                                            -5
                                                                                 -1000            Flow into VIX ETFs
  ETFs have not coincided with equity rallies.
                                                                                 -1500                                               -10
• Not only is the correlation between inflows into VIX ETFs and equities               Apr-09      Jan-10       Oct-10   Jul-11
  unusual, but so is the magnitude of the flows. Chart 1 shows the four         Source: Bloomberg, J.P.Morgan

  week total flow reached $1.5bn this week, a new all time high. Assets         Chart 2: Macro hedge fund betas to equities
                                                                                Rolling 21-day beta of macro hedge fund returns to
  in one large VIX ETN rose so rapidly that the provider was forced to          returns on the S&P500. The beta represents the
  suspend further issuance of shares in order not to adversely impact the       average exposure of hedge funds to equities over
  secondary market.                                                             the previous 21-days.
• This large demand for exposure to the VIX reflects the fact that the
  level of the VIX index is historically very low while it was only a few
  months ago that we were in an environment of high volatility and               0.4
  extreme uncertainty. The VIX is currently under 15 compared to levels
  over 40 during the peak of financial market stress in Q3 last year. So         0.2
  establishing a long VIX exposure via ETFs at current VIX levels
  appears attractive as it implies a large potential upside, of 4-5 times, in    0.0
  the case that a negative shock, such as that seen in 2010/2011, pushes
  the VIX above the 40 level.                                                                    Macro HF: beta to S&P500
• And with most investors being long equities or risky assets more                 Jan-10 Jun-10 Nov-10 Apr-11 Sep-11 Feb-12
                                                                                Source: Bloomberg, J.P.Morgan
The certifying analyst is indicated by an AC. See page 7 for analyst
certification and important legal and regulatory disclosures.
Global Asset Allocation
Flows & Liquidiity

  broadly, and most positioning indicators approaching overbought levels (see           Chart 3: Difference between net spec positions on
  Charts 2 and Chart 3), the flow into VIX ETFs is likely to rise further in the near   risky and safe haven assets
                                                                                        Net spec position is USD amount of long positions minus
  term. But there is a natural limit: as more money flows into long VIX exposures       short positions across a range of futures contracts; including
  the VIX futures curve steepens (Chart 1) making the negative roll more                commodities, equities, bonds and currencies. The net
  onerous and the cost of holding a VIX ETF more prohibitive. As a result of the        positions are aggregated and scaled by open interest. The
  record steepness in the VIX futures curve, popular VIX ETFs are currently             chart shows this scaled difference between net positions in
  losing around 10% per month due to negative roll. If no shocks materialise            risky minus safe haven assets.
  over the coming months, it is likely that negative-carry long-VIX positions are
  taken off, exerting downward pressure on the steepness of the VIX curve, from
  currently “bubble” like levels.
• The combination of low volumes, overweight positions in equities, and strong
  demand for hedges, such as long VI X exposures, are reflective of still wide-
  spread fear and a general lack of conviction. In other words, the market
  remains very fragile despite stronger price momentum.
A restructuring of Irish promissory notes seems inevita-
ble                                                                                     -0.1
                                                                                           Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12
• Of the €63bn of capital injected by Ireland’s government into its banks, €31bn
                                                                                        Source: Bloomberg, CFTC, J.P.Morgan
  came in the form of promissory notes given to Anglo Irish Bank and Irish
  Nationwide (€17.5bn came from the national pension fund). Irish Nationwide
  and Anglo have now been fully nationalised, and combined into the Irish
  Banking Resolution Corporation (IBRC). The promissory notes allowed the
  government to recapitalise these banks without having to borrow the money
  immediately. However, the notes now require payments of €3.1bn each year
  (see Chart 4, which shows the split between interest and principal repayment
  each year). For Ireland, this is a very significant sum, almost the same as the
  annual fiscal consolidation in each of the next three years. The Irish govern-
  ment is negotiating to restructure the notes to extend duration and reduce the
  coupon (but not principal) before the next payment falls due at the end of this
  month. These negotiations reportedly also involve shifting loss-making
  tracker mortgages from domestic banks to IBRC.

• Because IBRC is fully state-owned, in a sense, promissory note payments
  involve the government paying itself money. But the cash is the means by
  which IBRC in turn will repay its emergency liquidity assistance (ELA) debt to
  the Central Bank of Ireland. Thus the promissory note repayment schedule can
  be seen roughly as a repayment schedule for ELA (see “Briefing Paper on the
  IBRC, ELA and Promissory Notes”,, for a comprehensive
  discussion of this point).

• The main benefits for Ireland in extending the duration/lowering the coupon of
  promissory notes are a reduced near-term government borrowing require-
  ment, which at the margin makes it easier to return to public debt markets, and
  lower interest payments. But the former (extending duration) rather than the
  latter (lowering the coupon) matters far more. This is because interest flows
  from the Central Government to IBRC (at 7%-8% via existing promissory
  coupons) to the Central Bank of Ireland (CBI at ~3% via ELA) to the
  Eurosystem (at 1% via Target2). So the net cost to Ireland as a whole of
  funding promissory note payments is around 3.7% (the cost of government
  borrowing from EU/IMF) less 1% (what Target2 charges the Central Bank) i.e.
  around €84m per annum to fund €3.1bn.

Mar 16, 2012                                                                                                                                 2
                                                                                     Chart 4: Irish promissory note principal and
• The split between interest and principal payments does makes a difference in       interest payments
  the short term from an accounting point of view: promissory note payments
  classified as interest, rather than principal repayment, increase the Eurostat        3
  measure of the government deficit. So classifying a larger proportion of the
                                                                                     2.5                                                 Principal
  payment as principal would reduce the deficit from 2013 onwards (when
  interest payments start, amounting initially to around 1% of GDP).                    2

• The main sticking point is that extending the promissory notes means that it
  will take longer to pay off ELA. That requires the ECB’s consent. The ECB             1
  Governing Council can block ELA by a 2/3rds majority. In addition, the longer      0.5
  the maturity of the lending, the more it becomes akin to a fiscal rather than a
  monetary policy operation.                                                            0
                                                                                            2012     2015      2018        2021   2024   2027       2030
• What are the options for Ireland?                                                  Source: Irish Department of Finance

  1) To alter existing promissory notes. It could be that amending the existing
  promissory notes sparks market concern, especially in the wake of the recent
  bad legal precedents of Greece introducing and activating CACs retrospec-
  tively. Against that, this would be a change affecting a security entirely held
  by a state-owned bank, and not affecting private sector investors as in the
  case of Greece. And importantly, Ireland has already changed the terms of
  these promissory notes without incident in 2010, by inserting an interest

  2) Debt restructuring by the back door. Issue new promissory notes with
  lower interest and longer duration. This avoids any legal challenge of altering
  existing contracts, but it is equivalent to prolonging monetary financing for
  Ireland. As we explained above, prolonged ELA is a form of monetary financ-
  ing and lengthening the duration of promissory notes implies slower repay-
  ment of ELA which by itself will add further fuel to the debate about the ECB’s
  tolerance for monetary financing of governments.

  3) Replacing promissory notes with EFSF bonds or other collateral. This is a
  less damaging solution. Ireland would have to borrow from the EFSF to
  receive EFSF bonds, which IBRC could then post as collateral with the ECB.
  This means that the IBRC would be able to replace ELA with normal ECB
  borrowing. The ECB in return would receive high quality EFSF collateral. And
  it would be EU governments (via the EFSF) on the hook rather than the ECB.
  Press reports this week pointed to a related approach, whereby EFSF borrow-
  ing would fund the transfer of mortgages from Irish domestic banks to IBRC,
  which could then be used by IBRC as collateral for ECB borrowing.

• Ireland’s Finance Minister said yesterday that the ECB was “never particularly
  happy” with the promissory notes and would like “stronger collateral”. The
  ECB desire for stronger collateral suggests some version of option 3 is the
  most likely.

• In our opinion the drive by Ireland to restructure its promissory notes is a
  reflection of the very serious situation the country is in terms of deficit/debt
  dynamics. As our colleague Gianluca Salford highlighted (see GFIMS Mar 3rd)
  debt to GNP reached 132% at the end of 2011 while the deficit remained at an

Mar 16, 2012                                                                                                                                         3
  alarming 12.6% of GNP. Assuming a 2% deficit reduction per year, the debt of
  Ireland could easily exceed 150% of GNP by 2016. And we believe that GNP,
  output produced by residents only rather than total production in the country,
  is a fairer measure of the resources that the country has to sustain its debt.

• Irish GDP is inflated by multinationals who record output in Ireland, where it is
  taxed at a low rate (corporate tax is 12.5%), but remit the profits abroad. This
  means that GDP is not the best measure of the resources Ireland has to sustain
  its debt, as if the government sought to increase the tax burden on these
  companies in its effort to increase revenues, many of them would probably
  leave the country or reduce their operations there, as the tax advantage for a
  multinational of having a base in Ireland declined. The €29bn or 23% GNP
  difference that the GDP-GNP gap makes to Ireland’s output statistics makes a
  big difference to its debt dynamics.

An increase in Greek collateral values by the ECB gives
breathing space to Greek banks
• The successful completion of the PSI and the ratings upgrade by Fitch to B-,
  resulted to an increase in the value of the Greek collateral that Greek banks had
  posted with the ECB. We believe that this mostly affects government or
  government guaranteed paper of around €60bn (Fitch did not upgrade Greek
  RMBS transactions). This should allow Greek banks to borrow an extra €15-
  €20bn from the ECB according to press reports, on top of the €73bn they
  currently borrow. This should help Greek banks to reduce their dependence
  on Emergency Liquidity Assistance, which likely exceeded €60bn in February.

Hellenic Railways bonds
• Further to questions regarding treatment of Hellenic Railways bonds in the
  Greek PSI, we believe these bonds, almost a €3bn universe, will be treated the
  same way as Hellenic Republic international law bonds. The CACs for the
  international law bonds will be activated, where possible, at the end of this
  month. Final meetings concerning the exchange of foreign law bonds will take
  place on or around March 27th. It is possible that we see several of these
  international issues failing to have their CACs activated. This makes it likely
  that the bond holders of some of international law bonds will be eventually
  paid in full.

• There are press reports about the €430mn Apr 2013 4.5% Hellenic Railways
  bond, which apparently has a clause that allows bondholders to argue that
  Greece is in default if Greece tries to change the terms of its debt. This means    Chart 5: Downgrade reviews of Western Euorpean
  that these bond holders could in theory start a process of accelerating             financials by major rating agencies
  payment and perhaps be paid in full immediately if Greece wants to avoid            Quarterly total across four major rating agencies,
                                                                                      Moody’s, S&P, Fitch and DBRS.
  trouble. We are not legal experts but find it hard to see how credible or serious
  this threat can be at this stage.
• Also, the fact that Greece paid a 5% coupon last week on a €200m Italian Law
  bond, is not a surprise. The exchange of international law bonds is set to be
  completed by March-end and it is normal that Greece pays coupon on these            200
  bonds until then. Even after the exchange, Greece will likely continue to pay
  coupons to those international bonds that fail to see their CACs activated.
                                                                                             02         04           06          08    10   12
                                                                                      Source: Moody’s, S&P, Fitch, DBRS, J.P.Morgan.

Mar 16, 2012                                                                                                                                4
Global Asset Allocation
Flows & Liquidiity

                                                                                       Table 1: Sensitivity of ECB haircuts to each
                                                                                       agency’s European bank ratings
What are the implications of mass bank downgrades by                                   ECB haircutsare based on the highest rating of 4 rating
                                                                                       agencies: Moody’s, S&P, Fitch and DBRS. In the table,
Moody’s?                                                                               ‘Rated by’ is % of the sample of 63 European banks
• On February 15, Moody’s placed the ratings of numerous European financial            with long-term senior unsecured ratings from each
  institutions on review for downgrade. Yesterday, they published a timeline for       agency. ‘% Highest Rating’ is the % of the sample
                                                                                       which is rated most highly by that issuer. ‘3 Notch to
  this process to continue into May. As roughly 70% of reviews typically end in a
                                                                                       below A-’ shows how many issuers would cross the
  rating change, Chart 5 shows that the largest wave of bank debt downgrades in        A- threshold if all bank ratings were downgraded 3
  Europe in a decade has been initiated through 4Q11 and 1Q12.                         notches, keeping the other agency’s ratings constant.

                                                                                                                  Moody's          S&P       Fitch   DBRS
• What are the implications of fresh downgrades by Moody’s? There could be
                                                                                             Rated By 68.3%                       81.0%      68.3%   20.6%
  some impact on borrowing costs, although this should already be priced in
                                                                                     % Higest Rating 30.2%                        14.3%      25.4%   11.1%
  spreads. The other concern is the extent to which haircuts on bank bonds posted
  as collateral at the ECB increase, in turn squeezing bank funding.              3 Notch to Below A-   3                               2      1         2

                                                                                       Source: Moody’s, S&P, Fitch, DBRS, J.P.Morgan.
• For senior unsecured bank debt, haircuts increase 2-3 times if a bond’s rating
  falls below A-, from an average of 12% to 33%, across maturity buckets. The          Chart 5: Japanese buying of foreign bonds
                                                                                       $bn, 3-month average
  rating thresholds the ECB uses is based on the highest rating on a bond from
  any one of four rating agencies.                                                    200

• Using a sample of 63 European banks rated by Moody’s, S&P, Fitch and DBRS,          150
  only 3 European banks would move to below A- if Moody’s downgrade all bank
  ratings by 3 notches (Table 1). As these banks are quite small, mass downgrades     100
  by Moody’s should have little impact on ECB collateral. What this table also
  shows, is that unless rating actions are co-ordinated, because of split ratings,     50
  deep downgrades by any one agency has little effect on the ECB’s haircut on
  unsecured bank bonds. Table 1, which shows the sensitivity to any particular          0
  rating agency, also suggests that at the margin DBRS, which only rates 20% of
  these banks, can increase haircuts for the same number of banks as S&P, which       -50
  rates 80%.                                                                                07          08              09              10      11           12
                                                                                       Source: J.P. Morgan, Bloomberg
Selling by Japanese banks a risk to bonds
• We have in the past drawn an analogy between the heavy Japanese buying of
  foreign bonds over the past few months (Chart 5), and the 2010 experience, when
  Japanese investors bought heavily in the summer as bonds rallied on
  expectations of QE2, but switched to selling towards the end of the year, as
  yields rose. With QE3 seeming ever less likely, and the recent pace of buying the
  highest aside from 2010, a slowing of Japanese purchases is one risk to bond
  markets, and indeed there were anecdotal reports of Japanese selling this week as
  yields broke out of their long-standing ranges.

Mar 16, 2012                                                                                                                                         5
Global Asset Allocation
Flows & Liquidiity

Flows&Liquidity Weekly Monitor                                                                         Weekly Spec Position Monitor
$bn per week. Mutual fund flows are across all domiciles and by fund                                   Net spec positions are the number of long contracts minus the number of short
objective. The gap from 2006 is the difference between the 4wk average and                             using CFTC futures only data. This net position is then converted to a USD
the 2006 average. 2006 Avg. is the weekly average over 2006. Corporate                                 amount by multiplying by the contract size and then the corresponding futures
gross issuance includes financials and non financials, HG and HY. The region                           price. To proxy for speculative investors, commodity positions use the
of issuance is by the parent company of the issuer.                                                    managed money category while the other assets use the non-commercial
                                                                                                       category. The chart shows the z-score of these net positions, i.e. the current
                                                                                         4wk avg-
       Mutual Fund Flows                  This Week 4wk Avg. 2006 Avg                                  net position minus the average over the whole sample divided by the standard
                                                                                         2006 avg
                                                                                                       deviation of the weekly positions over the whole sample. US rates is a
All Equity Funds                               9.6             0.3            1.2             -0.8     duration weighted composite of the individual UST series plus the Eurodollar
All Bond Funds                                 7.0             5.8            0.2             5.7      contract. The sample starts on the 13th of June 2006. A trading rule which
                                                                                                       goes long the assets with the lowest spec position and short the assets with
EM Equity Funds                                0.5             0.7            0.0             0.7
                                                                                                       the highest spec position, produced an information ratio of 0.5 with a success
EM Bond Funds                                  1.4             1.1            0.1             1.0      rate of 55% (see Flows&Liquidity, 8th Apr 2011 for more details).
DM Equity Funds                                9.1            -0.4            0.4             -0.8                  Standard devations from mean weekly position
DM Bond Funds                                  5.5             4.7            0.1             4.7              Crude Oil
US Equity Funds                                9.1             0.3            -0.1            0.4                    USD
US Bond Funds                                  4.7             3.8            -0.1            3.9           US T-Bonds
W. European Equity Funds                       -0.9           -0.7            0.2             -0.9                   AUD
W. European Bond Funds                         0.1            -0.1            0.0             -0.1                   Corn
US HG Corporate Bond Funds                     1.9             1.5            -1.0            2.5                US 5YR
US HY Corporate Bond Funds                     0.5             0.7            0.8             -0.1                   NZD
US Muni Funds                                  1.0             0.9            0.0             0.9                   Silver
Equity Supply                             This Week 4wk Avg. 2006 Avg Gap from 06                                    Gold
Global IPOs                                    0.3             2.1            6.9             -4.8                Copper
Global Secondary Offerings                     2.9             7.4           10.4             -3.1                   MXN
Gross bond issuance                       This Week 4wk Avg. 2006 Avg Gap from 06                                US 2YR
US                                            17.3            32.7           29.3             3.3                    CAD
W. Europe                                     21.3            22.6           29.6             -7.1                   RUB
Corporate activity                        This Week 4wk Avg. 2006 Avg Gap from 06                                     VIX
Global M&A                                    17.6            30.2           76.6          -46.4     US Rates (incl. ED)
US share buybacks                              7.4             4.5            7.5             -3.0                   BRL
Non-US share buybacks                          0.4             1.3            3.3             -1.9           US Equities
                                                                                                               US 10YR
Source: Bloomberg, EPFR, Dealogic, Reuters, Federal Reserve, ECB, J.P.Morgan

Monthly Trading Volume Monitor                                                                                       CHF
Equity volumes are in trillions of USD. All data are updated on a monthly
basis. USTs are primary dealer transactions in all US government securities.                                         EUR
JGBs are OTC volumes in all Japanese government securities.
                                                                                                                             -3.0       -2.0   -1.0       0.0      1.0      2.0         3.0
                                                                                                                                                   06-Mar 12    28-Feb 12
Equities ($tr)                 Feb-12 Trading Volume                 1Yr. Avg        2007 Avg          Source: Bloomberg, CFTC J.P.Morgan

EM                                         $1.33                      $1.21           $1.19
DM                                         $3.22                      $3.82           $5.92
Govt Bonds (tr)                Feb-12 Trading Volume                 1Yr. Avg        2007 Avg
USTs                                        $2.4                       $2.4            $2.5
JGBs                                       ¥832                       ¥679            ¥991
Credit (bn)                    Feb-12 Trading Volume                 1Yr. Avg        2007 Avg
US HG                                      $283                       $239            $178
US HY                                      $125                        $90             $88
US Convertibles                             $24                        $24             $45
Source: Bloomberg, Federal Reserve, Trace, Japan Securities Dealer Association, WFE, J.P.Morgan

Mar 16, 2012                                                                                                                                                                      6
Global Asset Allocation
Flows & Liquidiity

S&P500 sector short interest                                                             Option skew monitor
                                                                                          Skew is the difference between the implied volatility of out-of-the-money (OTM)
Short interest as a percentage of shares outstanding. A strategy which
                                                                                          call options and put options. A positive skew implies more demand for calls than
overweights the S&P500 sectors with the highest short interest (as % of
                                                                                          puts and a negative skew, higher demand for puts than calls. It can therefore be
shares outstanding) vs those with the lowest short interest, produced an
                                                                                          seen as an indicator of risk perception in that a highly negative skew in equities
information ratio of 0.6 with a success rate of 58% (see Flows&Liquidity,
                                                                                          is indicative of a bearish view. The chart below shows a z-score of the skew,
8th Apr 2011 for more details). This trading rule currently suggests a long
                                                                                          i.e. the skew minus a rolling two year average skew divided by a rolling two
position in Discretionary against a short position in Staples.
                                                                                          year standard deviation of the skew. A positive skew on iTraxx Main means
                                                                                          investors favour buying protection, i.e. a short risk position. A positive skew for
 Discretionary                                                                            the Bund reflects a long duration view, also a short risk position.
       Telecom                                                                                 EURUSD
        Energy                                                                               iTraxx Main
  Health Care                                                                                    S&P500
                                                                                           German Bund

                0.0%       0.5%      1.0% 1.5%    2.0% 2.5%       3.0%     3.5%                              -1.0             -0.5            0.0            0.5                1.0
                                       15/02/12      31/01/12                                                                 09-Mar-2012           15-Mar-2012

Source: NYSE, J.P.Morgan                                                                   Source: Bloomberg, J.P.Morgan

Risk perception indicators
Difference between flows into risky asset funds and safe haven asset funds                    Difference between net spec positions on risky and safe haven assets
Risky assets include equity and high yield credit funds. Safe haven funds include             Net spec position is USD amount of long positions minus short positions across a
bonds funds excluding high yield credit. Funds include both mutual funds and ETFs.            range of futures contracts; including commodities, equities, bonds and currencies.
The indicator shows the 4-week average of this difference.                                    The net positions are aggregated and scaled by open interest. The chart shows
                                                                                              this scaled difference between net positions in risky minus safe haven assets.
 10                                                                                            0.5

   5                                                                                          0.4



-20                                                                                           -0.2
  Jan-07       Oct-07       Jul-08    Apr-09   Jan-10   Oct-10   Jul-11                          Jan-07        Oct-07      Jul-08    Apr-09    Jan-10    Oct-10    Jul-11
                                                                                               Source: CFTC, J.P.Morgan
Source: EPFR, J.P.Morgan

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Mar 16, 2012                                                                                                                                                                7
Global Asset Allocation
Flows & Liquidiity

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Mar 16, 2012                                                                                                                                                           8

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