December 22, 2009 The Fund achieved a 0.60% return in November, is up an estimated 0.

16% so far this month and up approximately 12.5% year to date. The 12-month rolling return stands at approximately 16.33% (all figures net). The Fund s annualized volatility is 4.03% with a Sharpe ratio of 4.391. Last month, we profited from short volatility strategies in the US, US curve steepeners, and directional US trading. In Europe, we profited from long Germany vs. Spain, short UK vs. Europe, long UK basis, and Shatz vs. Eonia spread wideners. Gains were also made in long gold calls. Losses came from long UK inflation, curve positioning in AUD and CAD, and European money market steepeners. The global economy is ending 2009 with good momentum and the stage is set for further positive growth surprises during the first half of next year. Looking further ahead, there is considerable uncertainty about the viability of the upturn. After all, significant imbalances remain, not least on the fiscal side. Headline inflation will generally pick up early in the year and then drift down towards lower core inflation levels. As the year progresses, we foresee significant departures in inflation performance among the G3 economies, a dispersion we aim to profit from.

Most recently, the United States has had the most noticeable pickup in activity with the economy growing well above potential for the second quarter in a row. Part of the story is inventories, a positive tailwind that should last for most of next year, while final demand has come back quicker and stronger than most observers expected. The latter should improve further as job growth returns early next year. Investment is also improving and is set to add noticeably to GDP over the next few quarters. Our base line scenario is for growth to continue to surprise to the upside throughout the first part of next year. The expansion during the first half will only create a small dent in the output gap. Over capacity remains a dominating force, not least in the labor market, and will continue to exert
1

12 month average of the 12 month rolling Sharpe ratio using the effective Fed Funds rate as the risk free rate.

This letter is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instruments. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Prologue Capital LLP is authorised and regulated by the Financial Services Authority.

downward pressure on core inflation. Although our profile suggests that headline inflation will increase close to 3% early in the year courtesy of base effects and energy prices, we are confident that core inflation will continue to trend down. Our proprietary inflation framework indicates that core inflation should trough around +0.5% year on year by the summer and stay around that level for the rest of the year. Inflation running that low may re-ignite deflationary fears should the growth stall in the second half. Consequently, the investment environment has the potential to look very different in the second half of the year compared to the first. With no inflation pressures in sight and balance sheet vulnerabilities still present the Federal Reserve will keep its main policy rate unchanged for some time. The market is nevertheless likely to test policy makers resolve as the economic data continues to improve and several of the Federal Reserve s non-conventional measures roll off in the first quarter. Another key issue that will weigh on Treasuries next year is a significant supply-demand imbalance caused by large scale issuance and diminishing public demand. For example, Deutsche Bank estimates that the demand gap for Treasuries will be around $580bn. The US Treasury has also indicated that it wants to increase the average duration of its issuance, a factor that will contribute to keeping the term structure steep. The Gilt market should experience an even greater supply-demand imbalance when Bank of England s Quantitative Easing (QE) program ends. Estimates vary but somewhere between £80bn and £140bn of Gilts need to find new buyers. The key issue then becomes when QE will end with ready decided purchase finishing in late January. Judging by the noticeable improvement in economic activity, upward revisions to past data and upward pressure on inflation argue against an extension of QE. Importantly, the rhetoric from some MPC members supports the notion that QE will not be extended. That said, it has been extremely difficult to second guess Bank of England s strategy in this cycle so we will carefully evaluate our expectation of an end to QE in light of the data that will be reported in January. One key reason why we expect QE to come to an end is the aforementioned deterioration in the inflation outlook. Our investors are well aware of our long held view that UK inflation will run noticeably above inflation rates in the rest of the developed world. Recent developments have further cemented that view and we are confident headline CPI will be above the 3% letter writing territory for several months, starting in January. In Europe, the economic recovery is overshadowed by fiscal challenges and associated policy responses. The dire Greek outlook has been the focal point so far but several other European economies display similar fiscal problems. A central issue is the policy response to these challenges. Comparing Ireland and Greece is the clearest example of this. Key variables of fiscal distress are of similar magnitude but the two governments have displayed vastly different policy responses. Ireland s attempt to clean up its fiscal mess appears credible while there are severe doubts to what extent the Greek government is willing to go down the right path. The financial market has responded accordingly and the outlook for the two countries is vastly different with the financial markets assigning and pricing in almost twice the probability of a Greek default compared to the Irish. This sort of dispersion is likely to become more accentuated next year for all Eurozone countries, including the core countries. For example, we expect the pricing between French and German bonds to start to diverge more meaningfully thanks to the relative deterioration of the French fiscal outlook. The European Central Bank began its normalization process with the indexation of the last 12 month Long Term Refinancing Operation. The unwinding of non-conventional measures will take time; already implemented and forthcoming scheduled measures will remain in the system until September of next year. Although technically feasibly our understanding is that there is considerable resistance among Governing Council members to adjust the refi rate until all fixed tenders have rolled off. Put differently, a tightening of the main policy rate is unlikely until the fourth quarter of next year. There are fundamental factors to suggest that it may take even longer than that. For example, vulnerabilities in the banking system remains (as illustrated by the recent nationalization of Austria s 6th largest bank), inflation is likely to stay substantially below the target for the foreseeable future and the labor market should face headwinds as emergency labor supporting measures roll off. That said,
This letter is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instruments. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Prologue Capital LLP is authorised and regulated by the Financial Services Authority.

we still expect the stealth tightening to take place as the ECB allows the Eonia rate to drift up towards the target. One key supporting factor for European bonds is the lack of a demand gap . Europe never engaged in any large scale purchases of government bonds and do not have to deal with the elimination of a large scale buyer. On the margin this should support European bonds compared to UK Gilts and US Treasuries. As we enter the New Year we aim to generate returns through the following strategies: Ø Ø Ø Ø Ø Ø Ø Forward curve steepeners in the US and the UK. Continued exposure to higher UK break even inflation. Short UK gilts outright and against Europe. Asset swap narrowers in Germany. Cross market Eurozone bond strategies that short fiscally challenged countries against core Eurozone countries with healthier fiscal outlooks. Long gold via options. Continued active participation in the underwriting processes of government bonds.

We are confident that the Fund is well positioned to take advantage of these opportunities and thank you for your continued support. We also want to take this opportunity to wish all our investors a happy holiday and a prosperous New Year. Tomas Jelf Chief Economist

Performance since Inception
Prologue Feeder Fund Ltd (main A Class)

Year 2006 2007 2008 2009

Jan N/A +0.06% +3.20% +2.63%

Feb +0.60% +0.51% +1.20% +0.81%

Mar +0.70% +0.21% -0.76% +2.14%

Apr +1.44% +0.53% -0.42% +0.96%

May +0.62% 0.00% +0.07% +2.26%

Jun +1.26% +0.83% +0.45% +1.29%

Jul +0.45% +0.56% +1.31% +1.01%

Aug +0.40% -1.59% +1.12% -0.56%

Sep +0.91% +3.46% +0.24% +0.29%

Oct +1.12% +0.49% +3.78% +0.35%

Nov -0.17% +2.05% +3.81% +0.60%

Dec -0.59% +0.28% +3.55%

YTD +6.92% +7.47% +18.86%

AUM $599m $618m $600m $927m

+0.16%*

+12.5%*

Estimate*

This letter is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instruments. All market prices, data and other information are not warranted as to completeness or accuracy and are subject to change without notice. Prologue Capital LLP is authorised and regulated by the Financial Services Authority.

Sign up to vote on this title
UsefulNot useful