VOLUME II ISSUE XIV

December 17, 2012

Executive Summary

Dont 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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VOLUME II ISSUE XIV

THE OPPORTUNE TIME

December 17, 2012

Dont Fight the Fed Risk assets across the world generally

now refer to as QE3s. In addition to the $40 billion per month purchase of mortgage-backed securities (MBS) announced in September, QE3s is set to expand the Feds balance sheet to $85 billion per month. For the first time since the financial crisis, forward guidance on the benchmark federal funds rate will be based on economic thresholds. Instead of committing to virtually zero interest rates until 2015, Chairman Ben Bernanke and company decided that this target range will be appropriate as long as the unemployment rate is above 6.5%, inflation between 1 to 2 years ahead is no more than 0.5% above the long-run target of 2.0%, and longer-term inflationary expectations remain well-anchored. In our view, QE3s is undertaken in light of the most pressing economic headwind, the fiscal cliff. Although risk asset markets remain generally optimistic of a bipartisan resolution of some sort by the January 1 deadline the Standard & Poors 500 pared losses since the

outperformed those in the United States (U.S.) last week. The benchmark Standard & Poors 500 Index (S&P 500) ended the week down 0.32% after midweek gains that followed the Federal Reserve (Fed)s announcement of a new quantitative easing (QE) program. The S&P 500s fellow indices, the Nasdaq and Dow Jones Industrial Average (DJIA) followed a similar trend, finishing down 0.23% and 0.15% as Fiscal Cliff talks continued in Washington and Apple (AAPL) continued to struggle. The Feds monetary policy stance remains unsurprisingly dovish after President Obamas re-election in early November. The latest Federal Open Market Committee (FOMC) meeting on December 11 and 12 unveiled two fresh measures. As expected, 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, a program we

Despite the recent S&P 500 (red) rally, U.S. consumption indicators such as retail sales (orange) and CPI (blue) are moderating, showing that the fiscal cliff has started to weigh on consumer sentiment. | Image courtesy of Ycharts WWW.THEOPPORTUNETIME.COM PAGE 2

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post-election selloff the Fed is not taking any chances via inaction. In fact, the recent equities rally may well be driven by expectations of further monetary easing. Without the Feds action, the mild risk-off behavior could have easily gone into overdrive. With the budget negotiations currently gridlocked, the onus was arguable on the Fed to support market sentiment. Mixed economic data of late may also signal short-term weakness ahead. Despite the lower unemployment rate of 7.7% in November discussed in Volume II, Issue XIII, consumption-related indicators such as consumer sentiment, retail sales, and consumer price index (CPI) all disappointed on the downside in December. 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. From a fixed income perspective, we think that QE3s is likely to steepen the U.S. Treasury yield curve over the next few months. First, the unsterilized purchasing of Treasuries could elevate inflationary expectations, prompting nominal yields to rise on the long-end of the curve. Over the past 15 months, the Fed had financed the purchase of long-end Treasuries with proceeds from the sale of short-end ones. With the demise of Operation Twist, the central bank will have to create reserves effectively printing money to continue buying longterm Treasuries. Similar to previous QE editions, the additional liquidity in the financial
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system could weaken the U.S. dollar (USD) and trigger price inflation. Already, the spread between 10-year Treasury Inflation Protected Securities (TIPS) and 10-year Treasury notes, a market gauge of inflationary expectations, increased to 2.51% ahead of the latest QE announcement.

The 10-year TIPS-Treasury spread has spiked after every previous QE episode. | Image courtesy of Ycharts

Second, long-end Treasury yields could also remain elevated via the so-called portfolio balancing channel. Theoretically at least, 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. For example, investors who sold MBS to the Fed may replace them with investment-grade corporate bonds, thus lowering corporate borrowing costs. Depending on the size of the Fed intervention, the displacement of privately-held Treasury bonds, for example, may raise long-end yields and steepen the yield curve. Third, there should be less upward pressure on short-term yields when the Fed stops selling Treasury notes, thereby creating a steeper yield

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curve. If anything, 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. 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, the federal funds rate should remain zero-bound for a while, putting more downward pressure on short-term yields.

end rising, the price of the long-end falling, or both. Since the prices of long-end Treasuries are more sensitive to interest rate changes than short-end Treasuries, investors should also weigh their long-short positions based on the relative level of price sensitivity of the two Treasuries. This weighing of positions is also known as a hedge ratio. For example, if a 20year bond is 10 times more sensitive to a 1 basis point (bps) change in interest rate than a 2 -year bill, then the long position on the 2-year bill should be 10 times larger than the short position on the 20-year bond. To take advantage of a steepening Treasury yield curve, investors can also look into specific exchange-traded notes (ETN) such as the iPath U.S. Treasury Steepener ETN (STPP). In line with our investment thesis, the price of STPP has risen while that of the iPath U.S. Treasury Flattener ETN (FLAT) has fallen since the announcement of QE3s.

The iPath UST Steepener ETN (orange) and the iPath UST Flattener ETN (green) have risen and fallen respectively this month. | Image courtesy of Bloomberg

Game May be Over for Super Mario On the other hand, European indices like Germanys Deutscher Aktien Index (DAX) and Englands FTSE 100 Index outperformed their American counterparts, ending the week up 0.19% and 0.27% respectively. European markets did suffer a brief setback early in the week, however, after Italian Prime Minister Mario Monti announced that he would be resigning after the authorization of Italys 2013 budget. The budget should be approved before
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In light of a steepening Treasury yield curve, we recommend a market neutral fixed income trade: buying short-end bills (i.e. 2-year bills) and short-selling long-end bonds (i.e. 20-year bonds). 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.THEOPPORTUNETIME.COM

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Parliaments Christmas break, and a snap election is now expected in February to find Monti's replacement. The FTSE Milano Italia Borsa (FTSE MIB), Italys benchmark index, fell 3.3% following the announcement. Monti's resignation came as a surprise to the two individuals intending to run in the general election originally planned for April. Pier Luigi Bersani of the Democratic Party and former Prime Minister Silvio Berlusconi of the People of Freedom Party will both be seeking office, hoping to shed their respective past problems in the minds of moderate voters. Monti will announce his future intentions via a national speech at an unspecified date in the future. 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. Nonetheless, Monti did help resist unpopular German austerity policies, often siding with French and Spanish policymakers in helping avoid what they felt were excessive measures. However, many like Berlusconi feel that he was not strong enough against German Chancellor Angela Merkel. According to a poll by the Financial Times and Harris, 83% of Italians believe that Germanys influence in the European Union (EU) is too strong. Berlusconi has already begun taking advantage of the sentiment, accusing Monti of implementing German-centric policies. With Merkel also facing an election in 2013,
WWW.THEOPPORTUNETIME.COM PAGE 5 Pier Luigi Bersani (left), Mario Monti (middle), and Silvio Berlusconi (right) will bring Italy back into the euro area spotlight in the coming months. | Photo courtesy of Lettera43

Monti's successor, and his relationship with other euro area policymakers, will be important in the success or failure of EU austerity measures championed by Merkel in the coming months. The euro area remains sluggish, with industrial output falling 1.4% in October and a flash Purchasing Managers Index (PMI) indicating an ongoing contraction with an under -50 reading of 47.3 so far for the month of December. We expect to see an increase in talks following the fiscal negotiations in the U.S., as European policymakers assess the post-fiscal cliff markets and prepare to push policies ahead of elections. Given the renewed political uncertainty in the region, we also expect the equity and debt markets to be fairly volatile in the coming months.

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Hawks Flying Over Japan Japans Nikkei 225 rallied to a gain of 0.94% today after the Liberal Democratic Party (LDP) won the countrys general election on Sunday. The victory for LDP means that incumbent Prime Minister Shinzo Abe will retain his position for a second term.

stated his intention to expand monetary policy in an effort to maintain strict inflation targets, seems to have gone over well with voters who are hoping for an improvement to their slowing country. Abe is likely to pursue more control over the Bank of Japan (BoJ) in an effort to secure his ideas in the central banks policies, as he suggested in his campaign. One way to do so would be through the appointment of new BoJ officials, albeit a move that the LDP would not be able to make without the support of the House of Councillors in the National Diet, Japans bicameral legislature.

Shinzo Abe will be expected to help Japan return to growth while remaining tough against China without escalating the conflict. | Photo courtesy of Guardian.co.uk

The LDPs reelection comes at a stressful time for Japan. Economically, the country remains in a recession In Volume II, Issue X we discussed Japans rising debt to gross domestic product (GDP) ratio, which continues to threaten its growth. Additionally, a rising level of foreign investment in Japan amid global uncertainty from fiscal concerns in the U.S. and the European sovereign debt crisis is weighing on bond yields. Politically, the country is in a diplomatic stalemate with China, in large part over the Senkaku Islands. Abes hawkish campaign rhetoric, in which he
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As the JPY weakens, 1 USD is worth an increasing number of JPY. | Image courtesy of Financial Times

The Japanese Yen (JPY) has already reacted to the election results by falling to 0.0119 against the USD, its lowest level since March. 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% - 3%. Although such policies may already be priced into the currency markets, investors may be able to benefit in the equity markets. Despite the poor performance of Japanese companies like Sony (SNE) and Sharp (SCHAY)
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last

month,

manufacturers

with

strong

exporting businesses may benefit from a lower JPY. In November, the Markit/JMMA Japan Manufacturing PMI fell to 46.5, the sharpest contraction rate in 19 months, due to slow growth in China and a relatively strong JPY during most of the month. However, toward the end of November the JPY began weakening against the USD ahead of the election, while our outlook on China improved as per Volume II, Issue XI. As a result, we believe Japans manufacturing PMI will see a recovery in the month of December as exporters benefit ahead of expected easing. Examples of beneficiaries may include automakers such as Toyota (TM) and Honda (HMC), two of Japans top exporters. Contributors: Jin Tik Ngai, Jose A. Alvarez

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About Us The Opportune Time, LLC was founded in September of 2011, when the first issue of the newsletter The Opportune Time was published. Prior to The Opportune Time, the founders of The Opportune Time, LLC had distributed a similar newsletter since the fall of 2010 The Opportune Time, LLC is about accessibility. We at The Opportune Time, LLC strive to make financial information available to all audiences via numerous avenues, including our free newsletters, online articles, and social media posts. We even simplify financial terms into everyday language to reach people of all backgrounds. We at The Opportune Time, LLC believe financial self -reliance is one of the most valuable assets in which we can help our subscribers invest. We invite you to check out the other resources we provide on our website.

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