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Some traders ruefully describe 2011 as “shockingly volatile,” even as others are pricing new Ferraris in sleek showrooms on Park Avenue and in Mayfair. What combination of asset volatility and fast-car returns is in store for 2012?

In the June 2011 issue of Institutional Investor, I described a reference scenario of the events that global macro traders believed to be moving markets last year, based on a two-day conference at Ditchley Park in Oxfordshire, England. According to this scenario, global macro hedge funds were focused, laserlike, on just four key events: the Federal Reserve Board’s monetary stance, a Chinese hard or soft landing in terms of GDP growth, euro zone stresses and that perennial favorite, oil prices. As I explained in my previous article, “with four big events, there are 16 possible outcomes (two to the fourth power) in the reference scenario ‘decision tree.’”

With the benefit of hindsight, how did these scenario events actually play out, and how skillfully did our traders predict the four outcomes? Are the same cyclical and secular drivers of these events still at work? Looking forward, will these be the four key variables in 2012? And as the accountants tally up hedge funds’ year-end winners and losers, what is the reference scenario for 2012—and with what odds?

The Fed’s Stance: Loose or Looser

The Federal Reserve’s monetary stance is the first big event under traders’ scrutiny, as the Federal Reserve Open Market Committee’s decisions will drive asset markets around the world, for good or for ill.

One branch leading from this decision is moderate economic recovery, reflation of price levels, sustained U.S. government deficits, a slightly tighter Fed stance (and no more quantitative easing), gradual improvement in job creation, gradual repair of household and bank balance sheets, and a sideways movement of the trade deficit. In this branch continued dis-saving by Washington is matched by household savings and the purchase of Treasury debt by foreigners and Ben Bernanke’s Fed, and this is what powers GDP recovery—at least for a while.

The other branch of this part of the decision tree says this party can’t go on for much longer and leads to slower economic recovery, flat employment and selective deflation (or the dreaded “stagflation”), some nominal reduction of the federal deficit, a continued expansive Fed stance and gradual shrinkage of the trade deficit. The former branch might be described as “business as usual,” the latter as “malaise” or “painful adjustment.” At the end of the day, the latter scenario writes off QE2 as a dangerous illusion.

“Future Shocks,” June 2011

Original Prediction: Painful Adjustment

Traders in our poll overwhelmingly bet on the “malaise/painful adjustment” outcome, 68 percent to 32 percent (with a standard deviation of 17 percent). The individual arguments supporting this view reflected global macro traders’ conviction that long-term adjustment is crucial—“This party just can’t go on forever,” one trader explained. The traders were also confident, in some cases adamant, that financial markets would force a fiscal deficit reduction in Washington: “If Moody’s gives the Treasury a downgrade, even Congress will have to pay attention,” was a popular comment. Most traders have a visceral dislike of quantitative expansion in any form—“QE is just a central bank’s monetization of government debt, any way you look at it,” observed one trader.

I should add that all quotes in this article are guaranteed genuine, but some of our traders’ firms have blanket policies forbidding their employees from being quoted in the financial press.

Actual Outcome: Business as Usual, Plus ‘Twist and Shout’

Contrary to the traders’ average prediction, we are still heading up the “business as usual” branch at the start of 2012, with no real deal on the U.S. fiscal deficit and with another shot of QE via September’s Operation Twist, although, unlike QE1, the Twist was balance-sheet neutral for the Fed.

The U.S. federal deficit in fiscal 2011 was -8.6 percent of GDP, barely down from 2010’s -9 percent. According to International Monetary Fund forecasts, the U.S. fiscal deficit will shrink only slowly, stubbornly sticking above 6 percent five years out. Consensus forecasts for U.S. economic growth are 1.8 percent for 2011 and 2 percent for 2012, with unemployment running at 9 percent and 8.7 percent, respectively. Even as government debt continues to climb, households will deleverage very slowly, and the external trade deficit will keep running at the 3 percent–of-GDP level more or less indefinitely.

The benefits of QE may still be a dangerous illusion in the minds of many financial professionals and has encountered a groundswell of political opposition in the Republican Party. But all indications are that the dominant dove faction on the Federal Reserve Board is keeping this option open. “Public political criticism of the Fed is nothing new and won’t have more than a marginal impact on its policy actions—maybe just on how it communicates them,” says Thomas McGlade, a Greenwich, Connecticut–based portfolio manager and director of U.S. operations for London-based hedge fund firm Prologue Capital.

Drivers: Deflation and Unemployment Fears Trump Deleveraging

As an example of the communication style described by McGlade, in a November 15, 2011, speech at the Council on Foreign Relations in New York City, Chicago Fed president Charles Evans made the case that inflation was essentially under control, displaying slides showing that the FOMC “central tendency” forecasts have core inflation running well under 2 percent for several years while unemployment slowly creeps down from the 9 percent level, still hovering in the 8 to 9 percent range a year hence and not going below 7 percent until 2014. If Evans’s view indeed reflects the central tendency of the Fed, the cyclic driver of slow U.S. recovery and sideways unemployment will wash the urgency out of deleveraging.

The persistence of secular leveraging was called rather rudely to the Fed’s attention by the now-famous paper on “the real effects of debt” by Brandeis University finance professor Stephen Cecchetti and his colleagues, presented at the Fed’s August 2011 Jackson Hole meeting; it later appeared as the Bank for International Settlements’ BIS Working Papers 352. I have seen copies of the graphs from this paper (see graph below, left) taped to traders’ screens and pinned to the corkboard over a trading floor’s espresso machine.

According to the BIS team’s calculations, total nonfinancial debt in 18 OECD countries grew from 167 percent of GDP to 314 percent between 1980 and 2010, an increase of almost 5 percent of GDP per year for three decades, as shown in the graphs. This trend has brought us to the point in many of these countries where debt levels are stifling GDP growth, according to economists Carmen Reinhart and Kenneth Rogoff. This implies that households and then governments must go through a sustained and painful deleveraging process.

Says Paul Brodsky, co–managing member of New York–based hedge fund firm QB Asset Management: “The issue across the board in developed economies is solvency—not discrete liquidity flare-ups among sovereigns, banks or households. Nor is a lack of confidence among consumers the issue. It all comes down to the extraordinary gap separating systemic debt from existing base money. The world needs to deleverage.”

The FOMC may think that deleveraging and adjustment are necessary someday, but putting more of the 25 million unemployed or involuntarily part-time employed Americans back to work appears to be more pressing—the central banker’s version of Saint Augustine of Hippo’s famous prayer, “O Lord, grant me chastity and continence, but not yet.”

Prediction for 2012: The Fed Will Make It Too Dangerous to Hold Bonds

Looking forward into 2012, our sample of traders believes the important choice is no longer between business as usual and adjustment, but between more quantitative easing or not, and the vast majority believe the Fed will engage in QE3. The average bet is 70-30 in favor of QE3, with a standard deviation of 22 percent.

There is broad consensus among traders that U.S. growth and employment are sliding sideways in an L-shaped, “slow and fragile” recovery through 2012, and the real question at this point is when and how much the doves at the Fed will resort to QE3. “How many bullets does the Fed really have left in its gun at this point?” asks Prologue’s McGlade. “From now on, the only remaining impactful policy option is additional QE, which could be balance-sheet neutral or expansive. And sometime in the first half of 2012, provided that the data continues to undershoot the hurdles of the dual mandate, I think we will see additional QE involving balance-sheet expansion rather than another balance-sheet-neutral move like Twist, and most likely involving mortgages this time.”

There is disagreement over what the transmission mechanisms from QE3 back into the real economy are—if any. “By pressing rates so low, the Fed is just making it too dangerous to hold cash and bonds,” concludes a skeptical global macro trader. “If you need yield, you are being forced up into equities and other real assets—not a comfortable position to be in.”

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