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 decisionstrees 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)

Creditrises,
Fed
US$
Deleveragin
Asset
Initial
Longer
Commo
Equity and
wider
term
ditie
commences
gUST
Consumer
jobless
sstructural
market
but
and
via rises
debt
surge
monetary
(yields
deflation/
price
changes
precious
retests
outperforms
low
fall),
tightening
risk
default
deflation
begin
metals
(dilution
equities
assets
fallvia
fall
recap)
Decision Tree: Scenario 2 (monetary easing)
Markets
Fed
US$
Stagflation
Consumer
Economic
No
Commo
Equity
Creditstructural
and
tighter
ditie
start
continues
UST
…oh
price
data
schanges,
markets
but
doing
and fall
dear
some
rally
just *
monetary
(yields
inflation
becomes
buying
precious
underperform
craz y things*
rise),
time
easing
risk
(imported
very
and
metals
equities
hoping
assets
erratic
surge -
riseprice
and
in
commo dity)

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)

See scenario
Fed does
2nothing
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.