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Busch: ‘Risk-Off’ Danger Zone for the Year Begins

The global financial markets are beginning to show signs of distress and volatility after an exceptional strong rally in US equities and global risk. The market narrative is shifting from a positive discussion on earnings and a US recovery to a negative conversation over global inflation, fiscal imbalances and political turmoil. This shift should mean uncertainty will rise and investor sentiment will pullback in reaction to this unstable environment.

One of my major concerns at the beginning of the year was food inflation and the potential for domestic instability. The dramatic rise in the price of corn, wheat and rice has generated anger and extreme actions like the self-immolation in Tunisia that sparked unrest. When food inflation is coupled with high unemployment, it creates an explosive atmosphere. I think the lesson is that when a population loses hope over its future then it gains an ability to act in desperation.

A youth with an Egyptian flag painted on his face stands in Tahrir Square in Cairo, Egypt.
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A youth with an Egyptian flag painted on his face stands in Tahrir Square in Cairo, Egypt.

With Egypt, the surprise was the lack of bloodshed and the relatively peaceful resolution to the protests. While Egypt has an uncertain future, at least they now believe they have a future and that should help them in transition. Oil prices and risk initially spiked on the protests and then prices dramatically came down in response to the outcome.

Libya is the opposite.

Reports of the military shooting protestorsand Qaddafi's son striking a militant stance indicate that this will not end well. Oil companies stating they will evacuate their workers calls into question whether Libya will continue to produce their 1.5 million barrels per day of oil. Oil has risen almost 10 percent in the last 48 hours and global stocks markets are down 1-2%.

Along with the Middle East risk, both the United States and the Euro Zone have to resolve serious fiscal and financial issues in the next 6 weeks. The U.S. will not only have to decide if they will fund the federal government by hiking the debt ceiling, but also create a budget for where those monies will be going. Europe will have to find a structure for their permanent (post-2013) EFSF or bailout fund that all nations must be in agreement to pass. With this, they will also have to agree to new fiscal rules that punish nations who overspend.

It's unlikely that either of these situations will be resolved by the end of March. This will generate demand for safe haven investing like buying US Treasury securities and selling global equities. The US dollarwill be initially mixed as there isn't a clean play with the ECB talking about raising rates earlier than expected to deal with inflation and Moody's downgrading its outlook to negative for Japan. However, I still believe the US dollar will outperform against most currencies during this time frame.

We are now in the "Risk-Off" danger zone for the year.

Andrew B. BuschDirector, Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.