The document provides an investment outlook from Fasanara Capital for May 2012. It anticipates three phases in the markets: (1) short-term weakness, (2) medium-term intervention and credit expansion following a more pronounced sell-off, and (3) long-term "bursting of the bubble" leading to defaults or inflation. It argues the recent ECB liquidity is already evaporating and fresh intervention will be needed. It also discusses factors that could trigger a larger market move and the opportunities in hedging tail risks.

1. Fasanara Capital | May 2012 Investment Outlook
Investment Outlook
As presented two weeks ago, we anticipate three consequential phases to play out going
forward: Phase (1) Short-Term, within the next few weeks: ‘Deflating Further’. Phase (2)
Medium-Term, within the next few months: ‘Reflating Back, following new intervention’,
and Phase (3) Long-Term, within the next few years: ‘Busting of the Bubble, to the left tail
(Defaults) or to the right tail (Inflation) of the distribution curve’. Please refer to this link for
a detailed rendering of the market phases we expect.
A few comments may be added to what previously presented. Short term market weakness
first, in a wide range bound, with downside risks and digital sell-off paving the way in the
medium term to fresh intervention and more credit expansion. Such view lies on three basic
assumptions: (i) We believe the liquidity provided by the ECB on LTRO2 is insufficient to
justify a structurally higher market than we have today. (ii) We also believe that a new
fresh intervention by monetary engineers is likely at some point in the months to come,
and (iii) We finally believe that a more pronounced sell-off and a resurgence of risk off
markets will be needed to build the political support behind a fresh new intervention.
First of all, the liquidity produced by the ECB’s LTRO operations is insufficient, as most of it
has evaporated already: it served the purposes of a re-allocation of capital amongst
countries and amongst investors’ classes, whereby public funds have substituted the private
sector whenever possible, so as to prevent a disproportionate impact on the economy of
the (dis)orderly deleverage in the private sector currently underway. Rephrased, banks in
peripheral Europe have already exhausted most of the extra liquidity (Read), when taking
into account withdrawn deposits and exited Repos, government bond purchases and
refinancing debt (even after accounting for the net positive effect deriving from the
anticipated reduction in loan portfolios). They might be forced soon to desert public
auctions or sell some of their holdings outright. On the other hand, banks in core Europe
have kept their money comfortably at the ECB, where the Deposit Facility is a most un-
volatile figure of Eur 780 bn, in what is a capital destructive market practice (contributing to
the vivid picture of a Liquidity Trapped economy), as opposed to lending that to other banks
(reinstating normal funding market conditions) and to businesses and households (re-

2. igniting growth). It makes you wonder, as the fresh liquidity provided by the ECB (after
stripping out the value of maturing repos) was even lower than that, at Eur 500 bn. And the
anomaly of the monetary trap gets perpetuated by the constant inability of banks to fund
themselves in the capital markets at any usable rates: it was best put by the CEO of Garanti
Bank this week, as the bank will avoid the Eurobond market given their ‘’inability to create
assets that yield higher yields than Eurobonds’’ (no one’s is going to borrow money from
them at that rate).
Interestingly, the evaporation of LTRO money may also be cross-checked by the changes in
the term structure of volatility in Europe this week, where we saw spot volatility (V2X)
going up markedly and closing the gap to forward volatility, at times even inverting
(differently and disconnecting from the US, were the vol curve is still quite steep). Recent
history has shown an high correlation between volatility shifts and money printing, with
volatility shrinking during monetary expansion phases.
Furthermore, the IMF reminded us that European banks look set to shrink their balance
sheets by Eur 2 trillions in the next 18 months (Read). Consequentially, credit supply should
contract further, together with the disposal of securities/inventories, driving feverish
markets into even thinner volumes and increased hecticness. By the same token, this week
we saw, somewhat of a resurgence of high frequency trading systems and algorithmic
trading strategies, with yet more volatility potentially generated by them.
With this in mind, not only the current liquidity provided by the ECB is already insufficient,
but a fresh new intervention is made probable, and can be assumed to be on the European
policymakers minds as the crisis unfolds. As discussed in our previous Outlook (link), various
forms of intervention are plausible in the short term, although we tend to believe that
increased SMP activity by the ECB would be the most effective (as an alternative to LTRO3
or fiscal firewalls), despite Draghi’s lack of enthusiasm for the programme thus far. Nor we
believe the US can come to the rescue with QE3, as rising inflation expectations (differently
than in Europe) have prevented such intervention by the FED this week, and the next
available meeting is only on June 20th (if anything, the market may react to the end of the
FED’s Operation Twist in June).
Determining the timing of such intervention is determining the timing of a more
pronounced market sell-off, in our eyes. At a minimum, we see few catalysts at play:

3. (i) We expect rising yields on 10yr government paper to fail to cause the downside
shock we anticipate. To trigger such larger move we suspect that a flattening of
the government bond curve on rising short end rates will be necessary. Front
end rates could drift upward on failed auctions (or lower than consensus cover
ratios) following local banks getting short of ammunitions (see recent noise from
BBVA/Santander/MPS). Such drive up in short term rates can be expected to put
the same local banks out-of-the-money on the supposedly risk free carry trades
on government paper established in the last couple of months (around the
LTRO2 liquidity event) at yield levels not far from today's rates. Such dynamics
may be reflected and confirmed by rising margin call accounts at the ECB. Carry
trades may not be MTM accounting-wise, but they may be margin called by the
ECB itself at right the wrong time, creating cash extraction from local banks
balance sheets, and exacerbating then the sovereign pressures and increasing
the momentum and the odds of digital equity downside. One of the unintended
consequences of Central Bank’s activity.
(ii) Most obviously, May 6th may pose a threat, with the combination of Greece
and France exiting elections. With Greece risking to produce a modern times
remake of the Weimer Republic, and Hollande in France radically disagreeing
with both Merkel and Draghi simultaneously, over the most appropriate recipe
for Europe’s woes, the stage is set for potential volatility there.
(iii) Velocity of Money is often understated, and is assumed to be close to zero in
modern advanced economies. Conventional wisdom rules out the possibility of
market participants giving up on capital destructive markets and running for the
exit in any significant amount. So far, such behavioural economic dynamics have
held, with outflows from Italy and Spain, for example, at low levels. Whilst we
believe that 30 years of declining rates, credit expansion and generalized welfare
have created the premises for such market resilience, we also think that market
status could shift promptly and unexpectedly. Capital mobility is the highest in
history and the velocity of money could resurface abruptly. If history is any
guide, in several instances in the past velocity has proven lethal, especially in
the presence of fixed exchange-rate regimes, like the Euro. (Read). If anything,
capital mobility together with the risk of contagion is higher now than it has ever
been: one element amongst many that is often overlooked is the derivatives
exposure of major banks, for instance. Please have a look at the attached
thought-provoking visualization of it for a self-explanatory argument.

4. In the Long-Term, we prepare for what we called ‘’Bursting of the Bubble Phase’, as we
advocate for such renewed government intervention (maybe the last one, maybe not) to
inflate the bubble even more and set the stage for one of two events under our Multiple
Equilibria Markets theory: Inflation Outcome (Nominal Defaults, Debt Monetization and
Currency Debasement) on the one hand or a Default Outcome (Real Default and Debt
Rescheduling/Haircut) on the other (see our March Outlook for how we define them). We
still doubt we will manage to stay in the middle of the distribution curve and avoid tail
scenarios, as another month has gone by and we saw further deterioration of the economic
environment, as reflected by data on GDP, Unemployment, Productivity, Imbalances across
Europe. GDP in particular, the only factor which could represent a game-changer, is the only
certain casualty of Eurocrats’ policymaking. As Soros intelligently encapsulated it in a recent
interview ‘’you can grow out of excessive debt, you cannot shrink out of excessive debt’’.
European planners have taken the route of quantitative easing and money printing, financial
repression, market manipulation and stock prices levitation, zero interest rate policy and
negative real yields. Japan has attempted a similar strategy for the last 20 years, resulting
in two lost decades and an equity market 70% off its highs. At the time, at least, the rest of
the world was healthy and growing (under the powerful drive of lower and lower-able
interest rates and expanding leverage): today such buffer is unavailable. Indeed, in the past
week, 2yr German Bund yield was lower than Japan’s equivalent for the first time in
history (also indicating a potential further rally of 10yr Bunds of 80bps before going flat on
JGBs). Similarly to Japan, Europeans are attempting at reducing an unsustainable chronic
level of debt by driving aggregate demand to grow less than income and productivity for
many years in a row. But such adjustment may become growingly unbearable to specific
classes of market participants, who may then trigger the bust of the bubble: EUR holders
and taxpayers have multiple elections this year to manifest their discontent and attempt
to change the course of action. Such awakening would increase the odds of our Default
Scenario. On the other end, should they not awake from their deep-sleep, our Inflation
Scenario would then be made more probable, as money printing is a finite resource itself
and not one without unintended consequences.
Critically, market levels and market depth for positioning for such Tail Scenarios are
available and cheap. For both events we see the market supply of deeply asymmetric
profiles, making their risk/reward ratios overly appealing. The market does not price in as
yet such extreme outcomes, in what we believe is a replica of an hard-to-die irrational

5. exuberance, except for VIX and most celebrated ‘fear factors’ which are therefore over-
crowded and over-priced. As long as you can look beyond the VIX, which does not represent
a viable instrument at current rates in our eyes, into what we call Embedded Options and
Dislocation Hedges, you are off to a successful hunting season on Tail Risk Hedging.
What I liked this week
Must Read, Ed Nolan: What Happened When Poland’s Fixed Exchange Rate Experiment
Failed: Lessons for a Euro Divorce. Poland’s experience with its crawling band provides a
practical example of that strategy: a gradually widening corridor that created room for two-
way movement of the exchange rate and, eventually, an uneventful exit to a free float.
Read
Egypt announced that it is cutting off its natural gas supplies to Israel, which just so
happens relies on Egypt for 40% of its energy needs. Read
Spanish property crisis will require Ireland-style banking system recapitalization. There are
at least 21,000 "zombie [property developers] companies" in Spain that owe banks 126
billion euros Read
W-End Readings
Jeremy Grantham Explains How To "Survive Betting Against Bull Market Irrationality" Read
Navigating the channel is treacherous for to err too far to one side and your ship plunges off
the waterfall of deflation but too close to the other and it burns in the hellfire of inflation….
Our fear of deflation may damn us to hyperinflation. Even if we fall over the waterfall of
deflation first at the very bottom of that abyss may be the hyperinflation fire. Read
Interview with Jim Grant: he goes on to discuss the hypocrisy of Bernanke (noting the
importance of free market prices to his students and yet controlling interest rates overtly in
the market-place) and highlights interest rates role as the traffic light signal in a market
economy providing a critical input to our perception of value in stocks, bonds, real estate,

6. Silicon Valley Startups, and so on and because these rates are manipulated we live and
invest in a hall-of-mirrors leaving us with a distorted vision of the real-world. Video
China’s Numbers are Unreliable: Dr. Chovanec points out that the official numbers for
inflation, the GDP growth, and corporate earnings may all be misstated to look materially
better than reality. Video
Porsche Mongolian Push Shows Chinese Wealth Heading West Read
Hans Rosling on Global Population Growth: new facts and stunning data visuals Video
Francesco Filia
CEO & CIO of Fasanara Capital ltd
Mobile: +44 7715420001
E-Mail: francesco.filia@fasanara.com
16 Berkeley Street, London, W1J 8DZ, London
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