TACTICAL NOTES FOR EARLY 2009

There is incredible amount of uncertainty. Any sustained recovery in risky assets looks unlikely in H1 2009. My preference remains for outlook neutral trades or investments that would benefit from incipient signs of a recovery but present minimal downside should such a scenario not materialize.

1. Long U.S. Credit: U.S. credit markets seem to be discounting economic cataclysm. Lehman’s U.S. Corporate Bond Index yields 7.66% (as of December 26, 2008; Source: WSJ) and the Baa sub-segment commands a YTM of 9.56% (versus 30-year and 10-year treasuries yielding just 2.60% and 2.14%, respectively). In comparison, Moody’s 30-year industrial spread measured 688bp in July 1932. The U.S. HY space seems priced for defaults exceeding the 3-year average rate observed during the great depression. The U.S. leveraged loan sector presents another compelling opportunity. Monetary policy remains focused on unfreezing credit markets and bringing interest rates down. In the event authorities fail, downside seems limited given already dire pricing. (long LQD and HYG)

2. Long U.S. Dollar: The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well. The INR will likely weaken above the 50 level over the next 6-months. Please refer to my previous piece for details: INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER. (long UUP)

3. Long 10-year U.S. TIPS versus treasuries: 10-year breakevens imply virtually no inflation. The market’s price escalation outlook seems at variance with the current level of 10-year real yields. If rates decline further, inflation protected securities should keep pace with nominals. More likely, there will be a vicious sell-off in nominal bonds at some stage. (long TIP vs. TLH)

4. Long Indian bonds (both Government and corporate): The Reserve Bank of India will ease again. The reverse repo rate will be cut by at least 100bp over the next 1-year. The market does not seem to be discounting that outcome yet. Please refer to my previous piece for details: LONG BOND TRADE NOT DONE YET: EXPECT LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN.