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Top 2011 Fears: Rates, Euro, Muni Default, Flash Crash

Even as bullishness abounds on Wall Street with the S&P 500 at 2-year highs, traders are still kept up at night by events they believe could happen in 2011 to derail this rally. Topping the list are a global rise in interest rates, a break-up of the Euro, a municipal bond default and another flash crash. A retrenchment in housing prices, a gold bubble and persistent unemployment are also among the worries mentioned on trading floors and in boardrooms during year-end discussions.

“I foresee international turmoil,” said Steve Cortes, founder of Veracruz Research LLC. “The euro breaks apart and China meets a hard landing as it tries to rein in inflation.”

Despite bailouts of Greece and Ireland, the euro is ending the year on a relatively high note on news that China — a major trading partner — would step in to buy Portugal debt. While this may soothe concerns temporarily, traders worry what will happen as austerity measures fail and yet another country needs a bailout that will be largely-backed by the coffers of a recovering Germany. Investors predict a possible split in the euro where the weaker countries are booted out to form a second regional currency.

“The story of 2011 will be the global rise in interest rates,” said Peter Boockvar, chief U.S. equity strategist for Miller Tabak. “Many countries in Asia and Latin America will hike to ward off inflation. European rates go higher as lenders continue to demand more, and U.S. rates go higher for all the reasons of inflation, better growth and rising debts.”

After a period of an equity-posting retreat, the yield on the 10-year Treasury — a benchmark for mortgage rates — looks to end 2011 at a seven month high. Meanwhile, China’s central bank is trying to raise rates on purpose, enacting higher bank reserve ratios and even price controls to stop inflation.

Higher rates could not only curb consumer borrowing and slow demand for commodities, but also create unwanted competition for equities in the form of higher-yielding bonds.

“The major story of next year is likely to be the federal government providing financial support (probably via a partial guarantee) to states and some local municipalities,” said Sean Egan, founder of Egan-Jones Ratings Service and an expert at spotting trouble where others don’t. “The upshot is likely to be the SEC’s review of the accounting for municipalities, since the major problem has been unrealistic assumptions for the muni pension plans.”

A few delayed municipal bond offerings by California and a whole lot of negative press has speculators worrying about a municipal bond default, yet prices of various bonds have recovered from their December lows. Still, falling tax receipts and public pension shortfalls keep this as a concern going into the New Year.

“Something eventually needs to give here,” said Joe Saluzzi of Themis Trading. “If the economy is really growing, then interest rates will rise and QE will come to an end. But if rates were to rise, the rally may fizzle as all that cheap money which has been fueling stock and commodity prices begins to go elsewhere.”

But the biggest worry for Saluzzi, who gained notoriety this year for his analysis of the May 6 flash crash on 60 Minutes, is another market collapse of 1,000 Dow points as the result of high-frequency and ETF trading dominating market action. Exchanges are testing circuit breakers on individual stocks but other than that, regulators have not done enough to prevent another market dislocation, he said.

On Thursday, new home sales for November came in less than forecast, according to data released by the Commerce Department. The median price for a home fell almost 3 percent from the same month a year ago.

“The potential for a significant down-leg in home prices is being underestimated,” wrote David Rosenberg, chief economist and strategist for Gluskin Sheff, in a note today. “The unsold existing inventory is still 80 percent above the historical norm, at 3.7 million.”

Rosenberg believes prices may not hit bottom until 2015.

Gold doubled the return of the S&P 500 this year, rising 26 percent, while silver prices jumped 74 percent. Gold will end 2011 near a record high with a five-year chart that looks like a diagonal line from left to right. Quantitative easing by the Federal Reserve has boosted inflation fears and gold prices accordingly. It’s also easier than ever to participate in the commodity markets with actively traded exchange-traded funds.

“Gold will drop 30 percent and there will be tighter regulations on ETFs and positions limits, which have only served to bid up commodities,” predicts Stephen Weiss of Short Hills Capital.

To be sure, these are the biggest fears of investors. While many of them believe these events will occur next year, they don’t necessarily believe their occurrence will lead to a bear market for stocks. Many traders agree with the Wall Street strategist consensus that the S&P 500 will have double-digit gains next year, despite some of these setbacks. Strategists cite improving consumer demand, a rising global middle class, tax cuts and multiple mergers as the main reasons to stay positive on next year.

Of course, with unemployment near 10 percent, all those so-called value-creating mergers could have negative consequences as well.

“I believe the story will be a record year for M&A, but unemployment rate goes higher,” said JJ Kinahan, chief derivatives strategist for Thinkorswim, a division of TD Ameritrade. “As so many of these companies are sitting on large amounts of money. I would look for them to put it to work. Unfortunately with many of these deals, what happens is people lose their jobs.”

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