1. The Fed restarts Quantitative Ease
The second and third round effects of the oil price collapse have not fully surfaced. A significant contraction in the energy industry would lead to higher unemployment in the US – unfortunately in areas that led job creation coming out of the financial crisis. Adding to the woes could be a deflationary impulse rippling through the economy. All of this puts the Fed’s inflation targeting at risk and will cause them to revisit the importance of the 5 year-5 year forward inflation breakeven rate which was their reaction function from 2009-2014. It’s unlikely they would look to lower rates and possibly go into negative territory after having just begun the normalization process. Lowering rates would also penalize savers, once again. It would be more likely they crank up the printing presses and buy bonds…which would, incidentally, keep a lid on rates and help keep the debt burden sustainable.
2. Brazilian local debt returns 40+%
Brazil 10 year bonds are yielding over 16% with not much good happening: inflation is high, growth is recessionary, the political system is facing corruption charges, oil continues to sink, exports to China are at risk and the currency is unhinged. But, we saw a few of these issues in Russia in 2014…commodity price weakness, declining ruble, political stress with Ukraine/Crimea…leading to bond yields rising to over 13%. Yet, Russia 10 year local debt has returned ~40% in 2015. While there was little improvement on any front, the lack of further deterioration forced managers to cover both their outright shorts and relative return underweights. We could see the same thing in Brazilian debt.
3. 30 year US Treasury bond yields settle at 2 ½%
The rule of thumb has long been that as long as the Fed is raising the Fed funds rate, government bond yields will need to adjust higher. But this cycle is different. The Fed is raising rates to normalize markets and to stop penalizing savers. There is little growth and inflationary pressure on the horizon for them to lean into. Ultimately, markets will begins to flatten the government yield curve around where they believe the terminal Fed funds rate is for this cycle. Put differently, unless the Fed raises the lower bound of the Fed funds target above 2%, 30 year yields at 2 ½% are too high.
4. The Euro rises ~15% versus the USD
Certainly the expectations are that steady and expanding US GDP will encourage the Fed to raise rates by at least 1% in 2016, at a time when the ECB expands QE in both size and type of assets available to purchase…all very USD friendly. But it is also possible that rising rates in the US will slow growth as Europe grows more rapidly. There are three very important tailwinds to growth in Europe that are entirely opposite of the US: the central bank is delivering highly expansionary policy, the currency has adjusted lower by over 20% in the last several years and the economy is an importer (and in no way a producer) of commodities, thus a beneficiary in the form of lower input costs.
5. Commodities are the best performing asset class
If commodity prices simply return to the average level of 2014, they would return ~60% from current levels. It would certainly mean seeing some discipline on the production side, especially out of OPEC. It would also mean a continued and expanding global economic recovery so that consumption picks up. But at these levels for both prices and expectations, it wouldn’t take much.