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 US$ rises, Commodities Equity Credit wider

commences UST rises and precious market retests but
monetary (yields fall), metals fall low (dilution outperforms
tightening risk assets fall via recap) equities

Longer term Deleveraging Asset and Initial jobless

structural via debt Consumer surge
changes deflation/ price
begin default deflation
Decision Tree: Scenario 2 (monetary easing)

Fed continues US$ and UST Commodities Equity Credit tighter

monetary fall (yields and precious markets rally but
easing rise), risk metals surge underperform
assets rise in price equities

Stagflation… No structural Consumer Markets start Economic

oh dear changes, just price inflation doing some data becomes
buying time (imported and crazy things* very erratic
and hoping commodity)

* - 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 See scenario

nothing 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.