Fed Decision Tree

It is clear that the market is almost evenly divided on the subject of Fed action and thus the potential for the polarizing forces of deflation/ inflation. For me there are three potential alternative scenarios currently in play: 1. Fed effectively reverses course by announcing any or all of the following: • Softening of statement wording and 50bp increase in overnight cash by end of 2009; • Announced closure of Qualitative Easing (credit easing) by end of 2009 and portfolio run-down commencing sometime in 2010; • Announcement to not activate Quantitative Easing. 2. Fed maintains easing course by announcing any or all of the following: • Announcement of activation of Quantitative Easing; • More explicit cash target commitments (e.g. New Zealand “We expect to keep the OCR at or below the current level through until the latter part of 2010”) • Widening of Collateral Eligibility criteria (term, rating, asset class); 3. Fed does nothing and announces as little as possible for as long as possible. From these scenarios I then find it helpful to generate hypothetical decisions trees to help me get a clearer picture of how things may move about under each scenario. I would note however, that figuring out the timing on the individual events is where the real pay-off lies. Decision Tree: Scenario 1 (monetary tightening) Fed commences monetary tightening

US$ rises, UST rises (yields fall), risk assets fall

Commodities and precious metals fall

Equity market retests low (dilution via recap)

Credit wider but outperforms equities

Longer term structural changes begin

Deleveraging via debt deflation/ default

Asset and Consumer price deflation

Initial jobless surge

Decision Tree: Scenario 2 (monetary easing) Fed continues monetary easing

US$ and UST fall (yields rise), risk assets rise

Commodities and precious metals surge in price

Equity markets rally

Credit tighter but underperform equities

Stagflation… oh dear

No structural changes, just buying time and hoping

Consumer price inflation (imported and commodity)

Markets start doing some crazy things*

Economic data becomes very erratic

* - My belief as to why markets will start doing some crazy things under this scenario (like 1yr UST and Libor inversion, i.e. negative swap spreads) is due to the fact that any further monetary easing can only be done at a high level. That is, unlike typical monetary policy which affects every household, higher level monetary policy (either of the Q easings or cash target commitments) is largely only accessible and profited by a select few, namely global banks and hedge funds. Additional monetary policy easing therefore also has the significant added benefit or recapitalizing banks much faster by stealth. Decision Tree: Scenario 3 (do nothing) Fed does nothing

See scenario 2 with a 3 month time lag

So what are they going to do? For my mind I am leaning towards Scenario 2 or 3, basically continued or further monetary easing. But I must admit that it is almost a coin toss. In such a situation I still prefer to have a foot in either camp via mezzanine debt investments. For instance investment grade corporate prefs. That is, structural seniority to equity (for some but not total downside protection in scenario 1) but with some attached equity warrants (for upside in scenario 2/3). Equally, well structured and understood mezzanine pieces in some structured debt products can provide similar risk/return characteristics.