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December 17, 2012

Executive Summary
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Don’t Fight the Fed • 2 Game May be Over for Super Mario • 4 Hawks Flying Over Japan • 6

After announcing a new quantitative easing program, the Fed is poised to steepen the Treasury yield curve. In Europe, Italy returns to the spotlight after Mario Monti's resignation announcement inserts a new dose of political uncertainty into the European sovereign debt crisis. Finally, we expect a relatively aggressive monetary policy in Japan following a rhetorically hawkish campaign from Shinzo Abe, leader of the victor of the latest general elections, the Liberal Democratic Party. Photo courtesy of Journey to Alpha

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2012 Don’t Fight the Fed Risk assets across the world generally now refer to as QE3s. As expected. In addition to the $40 billion per month purchase of mortgage-backed securities (MBS) announced in September.S. U. consumption indicators such as retail sales (orange) and CPI (blue) are moderating. In our view. Instead of committing to virtually zero interest rates until 2015.S. finishing down 0. The latest Federal Open Market Committee (FOMC) meeting on December 11 and 12 unveiled two fresh measures. the Nasdaq and Dow Jones Industrial Average (DJIA) followed a similar trend. Although risk asset markets remain generally optimistic of a bipartisan resolution of some sort by the January 1 deadline – the Standard & Poor’s 500 pared losses since the outperformed those in the United States (U. QE3s is set to expand the Fed’s balance sheet to $85 billion per month. Chairman Ben Bernanke and company decided that this target range “will be appropriate” as long as the unemployment rate is above 6.23% and 0.5% above the long-run target of 2.15% as Fiscal Cliff talks continued in Washington and Apple (AAPL) continued to struggle. For the first time since the financial crisis.0%. | Image courtesy of Ycharts WWW. The benchmark Standard & Poor’s 500 Index (S&P 500) ended the week down 0. inflation between 1 to 2 years ahead is no more than 0.32% after midweek gains that followed the Federal Reserve (Fed)’s announcement of a new quantitative easing (QE) program. a program we Despite the recent S&P 500 (red) rally.VOLUME II • ISSUE XIV THE OPPORTUNE TIME December 17. forward guidance on the benchmark federal funds rate will be based on economic thresholds.COM PAGE 2 . and longer-term inflationary expectations remain well-anchored. The S&P 500’s fellow indices.THEOPPORTUNETIME. QE3s is undertaken in light of the most pressing economic headwind.5%. showing that the fiscal cliff has started to weigh on consumer sentiment. The Fed’s monetary policy stance remains unsurprisingly dovish after President Obama’s re-election in early November. the Fed will follow up on the expiration of Operation Twist with the purchase of longer-end Treasury securities at the pace of $45 billion per month. the fiscal cliff.) last week.

S. Depending on the size of the Fed intervention. the Fed had financed the purchase of long-end Treasuries with proceeds from the sale of short-end ones. and consumer price index (CPI) all disappointed on the downside in December. retail sales. thereby creating a steeper yield PAGE 3 . long-end Treasury yields could also remain elevated via the so-called portfolio balancing channel.VOLUME II • ISSUE XIV THE OPPORTUNE TIME December 17.51% ahead of the latest QE announcement. The absence of further monetary stimulus from the Fed thus had the possibility of undoing the effects of the labor and housing market recovery so far. the mild risk-off behavior could have easily gone into overdrive. In fact. Third. the recent equities rally may well be driven by expectations of further monetary easing. consumption-related indicators such as consumer sentiment. the onus was arguable on the Fed to support market sentiment. increased to 2. Treasury yield curve over the next few months. thus lowering corporate borrowing costs. there should be less upward pressure on short-term yields when the Fed stops selling Treasury notes. the displacement of privately-held Treasury bonds. the spread between 10-year Treasury Inflation Protected Securities (TIPS) and 10-year Treasury notes. With the budget negotiations currently gridlocked. a market gauge of inflationary expectations. dollar (USD) and trigger price inflation. Over the past 15 months.7% in November discussed in Volume II. Similar to previous QE editions. The 10-year TIPS-Treasury spread has spiked after every previous QE episode. for example. investors who sold MBS to the Fed may replace them with investment-grade corporate bonds. Theoretically at least. may raise long-end yields and steepen the yield curve. | Image courtesy of Ycharts Second. From a fixed income perspective. Issue XIII. unconventional monetary policy in the form of asset purchases should lower the yields of these assets and push yield-seeking investors to other assets with similar characteristics like credit risk or duration. the unsterilized purchasing of Treasuries could elevate inflationary expectations. 2012 post-election selloff – the Fed is not taking any chances via inaction. Already. First.THEOPPORTUNETIME.S. Despite the lower unemployment rate of 7. With the demise of Operation Twist. prompting nominal yields to rise on the long-end of the curve. we think that QE3s is likely to steepen the U.COM system could weaken the U. the additional liquidity in the financial WWW. Without the Fed’s action. Mixed economic data of late may also signal short-term weakness ahead. the central bank will have to create reserves – effectively “printing money” – to continue buying longterm Treasuries. For example.

20-year bonds).S. If anything. The budget should be approved before PAGE 4 In light of a steepening Treasury yield curve. after Italian Prime Minister Mario Monti announced that he would be resigning after the authorization of Italy’s 2013 budget.COM .e. we recommend a market neutral fixed income trade: buying short-end bills (i.27% respectively. investors should also weigh their long-short positions based on the relative level of price sensitivity of the two Treasuries. To take advantage of a steepening Treasury yield curve. ending the week up 0. Treasury Steepener ETN (STPP).S. | Image courtesy of Bloomberg Game May be Over for Super Mario On the other hand. European markets did suffer a brief setback early in the week. or both. Treasury Flattener ETN (FLAT) has fallen since the announcement of QE3s. however. the price of STPP has risen while that of the iPath U.e. the price of the long-end falling. 2-year bills) and short-selling long-end bonds (i. This strategy only captures the relative rates along the curve and provides upside in all three possible scenarios that constitute a steepening yield curve: the price of the shortWWW. European indices like Germany’s Deutscher Aktien Index (DAX) and England’s FTSE 100 Index outperformed their American counterparts.VOLUME II • ISSUE XIV THE OPPORTUNE TIME December 17. the federal funds rate should remain zero-bound for a while. then the long position on the 2-year bill should be 10 times larger than the short position on the 20-year bond. In line with our investment thesis. putting more downward pressure on short-term yields. The market may also view the use of economic thresholds in forward rate guidance positively as it lowers the uncertainty on when the Fed could normalize rates again. Given that both the unemployment and inflation rates are projected to be at least 3 years away from the target thresholds. investors can also look into specific exchange-traded notes (ETN) such as the iPath U.19% and 0.THEOPPORTUNETIME. For example. 2012 curve. short-term yields could face a downward bias as risk-averse investors seek to readjust their portfolios in favor of safe haven assets ahead of the fiscal cliff. This weighing of positions is also known as a hedge ratio. end rising. Since the prices of long-end Treasuries are more sensitive to interest rate changes than short-end Treasuries. ——— The iPath UST Steepener ETN (orange) and the iPath UST Flattener ETN (green) have risen and fallen respectively this month. if a 20year bond is 10 times more sensitive to a 1 basis point (bps) change in interest rate than a 2 -year bill.

2012 Parliament’s Christmas break. often siding with French and Spanish policymakers in helping avoid what they felt were excessive measures. will be important in the success or failure of EU austerity measures championed by Merkel in the coming months. Berlusconi has already begun taking advantage of the sentiment. 83% of Italians believe that Germany’s influence in the European Union (EU) is too strong.THEOPPORTUNETIME. We expect to see an increase in talks following the fiscal negotiations in the U. Monti did help resist unpopular German austerity policies.3% following the announcement. WWW. Nonetheless. The FTSE Milano Italia Borsa (FTSE MIB). accusing Monti of implementing “German-centric” policies. hoping to shed their respective past problems in the minds of moderate voters. The euro area remains sluggish. Mario Monti (middle).VOLUME II • ISSUE XIV THE OPPORTUNE TIME December 17. and Silvio Berlusconi (right) will bring Italy back into the euro area spotlight in the coming months. According to a poll by the Financial Times and Harris. Pier Luigi Bersani of the Democratic Party and former Prime Minister Silvio Berlusconi of the People of Freedom Party will both be seeking office. and a snap election is now expected in February to find Monti's replacement. with industrial output falling 1. Monti's resignation came as a surprise to the two individuals intending to run in the general election originally planned for April. However. ——— . many like Berlusconi feel that he was not strong enough against German Chancellor Angela Merkel. fell 3. Given the renewed political uncertainty in the region.S. | Photo courtesy of Lettera43 Monti's successor. Italy’s benchmark index. we also expect the equity and debt markets to be fairly volatile in the coming months. With Merkel also facing an election in 2013.3 so far for the month of December..COM PAGE 5 Pier Luigi Bersani (left).4% in October and a flash Purchasing Managers’ Index (PMI) indicating an ongoing contraction with an under -50 reading of 47. as European policymakers assess the post-fiscal cliff markets and prepare to push policies ahead of elections. Monti was often criticized by Italians for raising taxes and generally failing to overcome Parliament in order to enact structural reforms aimed at reducing spending. Monti will announce his future intentions via a national speech at an unspecified date in the future. and his relationship with other euro area policymakers.

0119 against the USD. in which he WWW. in large part over the Senkaku Islands. Economically. | Image courtesy of Financial Times The Japanese Yen (JPY) has already reacted to the election results by falling to 0. Japan’s bicameral legislature. Shinzo Abe will be expected to help Japan return to growth while remaining tough against China without escalating the conflict. a rising level of foreign investment in Japan amid global uncertainty from fiscal concerns in the U.3%. Despite the poor performance of Japanese companies like Sony (SNE) and Sharp (SCHAY) PAGE 6 . albeit a move that the LDP would not be able to make without the support of the House of Councillors in the National Diet. Abe is likely to pursue more control over the Bank of Japan (BoJ) in an effort to secure his ideas in the central bank’s policies. 2012 Hawks Flying Over Japan Japan’s Nikkei 225 rallied to a gain of 0. Politically.94% today after the Liberal Democratic Party (LDP) won the country’s general election on Sunday. Abe’s hawkish campaign rhetoric. as he suggested in his campaign. the country is in a diplomatic stalemate with China. its lowest level since March.THEOPPORTUNETIME. seems to have gone over well with voters who are hoping for an improvement to their slowing The LDP’s reelection comes at a stressful time for which continues to threaten its growth. the country remains in a recession – In Volume II. 1 USD is worth an increasing number of JPY. stated his intention to expand monetary policy in an effort to maintain strict inflation targets. investors may be able to benefit in the equity markets. Although such policies may already be priced into the currency markets. Additionally. Issue X we discussed Japan’s rising debt to gross domestic product (GDP) ratio. The victory for LDP means that incumbent Prime Minister Shinzo Abe will retain his position for a second term. The JPY will likely see further weakening if Abe succeeds in influencing an increase to monetary policy in order to hit an inflation target of 2% .VOLUME II • ISSUE XIV THE OPPORTUNE TIME December 17. and the European sovereign debt crisis is weighing on bond yields.COM As the JPY weakens. One way to do so would be through the appointment of new BoJ officials. | Photo courtesy of Guardian.

As a result.5. due to slow growth in China and a relatively strong JPY during most of the month.VOLUME II • ISSUE XIV THE OPPORTUNE TIME December 17. However. two of Japan’s top exporters. ——— Contributors: Jin Tik Ngai. the sharpest contraction rate in 19 months. while our outlook on China improved as per Volume II. In November.THEOPPORTUNETIME. Jose A. Issue XI. Alvarez WWW. toward the end of November the JPY began weakening against the USD ahead of the election. manufacturers with strong exporting businesses may benefit from a lower JPY.COM PAGE 7 . 2012 last month. we believe Japan’s manufacturing PMI will see a recovery in the month of December as exporters benefit ahead of expected easing. the Markit/JMMA Japan Manufacturing PMI fell to 46. Examples of beneficiaries may include automakers such as Toyota (TM) and Honda (HMC).

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