The Four Scenarios For 2010

Tyler Durden's picture

New report out of DB strategist Jim Reid highlights the 4 main scenarios for 2010 from the German bank's point of view. These are as follows:

  • Scenario 1 – This scenario is the most optimistic and is one where the authorities have as good a year as they did in 2009. They likely keep stimulus extremely high in the system without there being any noticeable consequences of their actions (e.g. rates at the short and long-end stay low). Under this scenario we would expect equities to be significantly higher, credit spreads be much tighter but with bond yields only edging slightly higher as the authorities are seen to have firm control of inflation expectations and may even be continuing to buy bonds.
  • Scenario 2 – This scenario is the most likely and suggests that we start to see gradual easing off the gas from the authorities but only as it’s proved that there is some momentum in the underlying economy. Under this scenario risk assets have a good year but returns are checked to some degree by rising bond yields and less stimulus being injected into markets. A satisfactory year for risk, especially equities, but a mildly negative one for fixed income. Credit investors will likely have to rely on spreads (and higher beta credit) to get positive total returns.
  • Scenario 3 – This is the second most likely scenario overall in 2010 but one that potentially becomes more likely as the year progresses. Here we are likely to see sharply higher bond yields start to disrupt the positive momentum in markets. These higher yields could be either due to Government supply starting to overwhelm demand (especially as the impact of QE, and similar schemes, wane), or because of inflation fears. It seems unlikely that actual inflation will be a concern in 2010 but it’s quite possible for expectations to become unanchored. We would also have to include the potential for a Sovereign crisis somewhere in the Developed world within this scenario. We would note that the higher yields in this scenario are not based on positive growth momentum but by inflation/Sovereign risk. Such a scenario is incorporated in Scenario 2.
  • Scenario 4 – This is the nightmare scenario of Deflation or in less extreme terms perhaps a double-dip. Given that much of the world is currently still in negative YoY inflation territory it is difficult to completely rule out even if we do live in a fiat currency system and even if inflation is expected to return to positive territory in early 2010. For deflation to be sustained we would probably need an exogenous event to hamper the authorities ability to continue to successfully fight this credit crisis. Such events could be a fresh banking crisis arising, a political backlash encouraging immediate increases in economic regulation or withdrawal of stimulus, or possibly a Government bond/currency sell-off that forces the authorities to aggressively reign in stimulus for fear of a sovereign crisis. A Sovereign crisis outside the Developed world could also encourage this scenario as there would be a flight to quality into Developed market bond market in spite of the fact that these markets have their own large fiscal issues. Bond yields would eventually rally strongly but risk assets would experience a very poor year. As time progresses this scenario becomes less likely as the system gradually repairs itself and the authorities are allowed more time to inflate the global economy. As we discuss in scenario 3, the more likely risk scenario is inflation, especially as time progresses.

Here is how DB views the various scenario probabilities:

Some other observations from DB, include:

A comparison of relative cheapness of equities vs fixed income:

A look at Shiller P/E ratios over numerous business cycles, going back all the way to 1881:

Cumulative fund flows over the past year iinto various asset classes

Earnings trends since 1988: the bubble pop is clearly evident.

And some observations on sovereign risk - as Zero Hedge has been saying for long time, and as many prominent hedge funds have been executing, buying US CDS at current levels is a no brainer.

We’ve been discussing Sovereign risk at length recently and at the front of this piece. A big event in this complex remains the biggest concern in 2010. It’s worth showing a graph of a basket of Sovereign CDS spreads with Financial Senior spreads as a comparison. We also plot Greece CDS spreads as this has been the recent topical concern in Europe.

For us the wider world of risk looks a much more attractive proposition if you can assume massive ongoing global Government intervention. With this view of the world shorting Sovereign risk as a pro-risk hedge makes some sense. The market has increasingly been convinced that the private sector risks are still being underwritten by Governments and will be for some time. With this the risks to their credit quality must surely have increased. As a long-term trade, buying protection in Sovereign CDS does have obvious problems in that you could have significant inflation and/or currency adjustments instead of defaults. However one can see why it’s a useful 'cheap-ish' hedge on the hope that someone else will want to hedge at a more expensive level further out. An outright short in Government bond markets should also be contemplated.

Lastly, observations on the "end" of the dollar carry trade:

Since early 2008, risk assets have generally moved in tandem with the Dollar with an inverse relationship. This is shown in Figure 21 which plots the Dollar (DXY Index) against the S&P 500 (used here as a barometer of risk).

What we don’t know at this stage is whether risk assets could withstand a strengthening of the Dollar that most currency strategists expect in 2010. The bulls would argue that Dollar strength would represent further normalization in markets and risk assets could de-couple from their near two-year trend. However the jury is still out and if the Dollar strengthens because of a perception that the US rate cycle is starting to turn, then it’s possible that the whole “Dollar Carry Trade” could reverse leading to investors selling risk assets regardless of the fundamentals.

Much more in the full report found here


Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
heatbarrier's picture

Scenario 4, widely misundertood. In a balance sheet recession it is the deflation of the assets stock, not the GDP, that kills you. Assets are 10-15x GDP in developed economies; they are all in asset deflation and there is no entity big enough to stop this, housing in the US (only one asset class) down 40% by the time it reaches equilibrium.

Anonymous's picture

I'll take what's behind curtain 4 Joe!

Psquared's picture

I find it interesting that to get the most realistic scenarios for 2010 you have to read an analyst from DB. What ... American banks and macroeconomists don't give honest assessments? Of course not ... and neither would you if your hand was in the government cookie jar.

I think we start 2010 in Scenario I and perhaps well into the year. By late spring we begin to see rates increase. I say this because the Fed will either do what it said and stop buying MBS's from FNM and FRE or it will have to print more money. If the former there will be a sovereign crisis in the US as there is NO ONE else to buy that crap. The other banana peel to slip on are the repos and reverse repos. Why would banks enter into reverse repos for assets on the Fed Reserve balance sheet that are worth 50 cents on the dollar unless the Fed allows them to go galactic with leverage ... again!!

At that point we have the potential for a bond market dislocation. To avoid that implosion the Fed will have to roll FNM and FRE into FHA and directly guarantee all debt in order to prop up the bond market. The question is whether the Chinese will buy into it.

I see us slipping into Scenario II, then III and then finally, when the money is all gone (or they run out of paper to print it on) complete deflationary collapse.

And you wondered why they wanted to put more troops into Afghanistan. Silly Americans.

Psquared's picture

Oh ... and I don't necessarily think deflation is a bad thing. However, by prolonging the inevitable for so long it will be more painful than necessary. I said this in October 2008. The government would have been wiser to take the 700 Billion and either capitalize 10 new banks or use it to fund the public assistance that will be necessary when deflation strikes hard ... and it will strike hard.

SWRichmond's picture

Always interesting to see the framing of the debate as information itself.  What is built into the description of the scenarios?

  1. Deflation is bad.  Why?  What is wrong with falling prices?  Consumers love falling prices.  The computer industry thrived with falling prices while it matured.  It is banks that hate falling prices because it makes fractional-reserve lending so unprofitable due to the usually attendant low interest rates.  Governments and central banks hate deflation because it prevents theft-by-inflation.  What they are really afraid of is asset / balance-sheet deflation, and that's of course their own fault for leveraging up so high.  Sucks to be them.
  2. It is not inflation itself that is bad but "inflation expectations".  This is very interesting as it reveals the desire to steal-by-inflating, but unnoticed. 
Psquared's picture

I think what scares GS/BAC/JPM/Treasury is falling "asset" prices. Inflation is the only way to go for them.

Falling prices at the grocery store, the gas pump and Best Buy is not a bad thing as long as everyone is willing to accept it. American businesses start laying off people when asset prices and general deflation strikes. Instead, they should ask for wage concessions as the cost of living goes down.

Of course, there is the concomittant strengthening of the dollar. But wait ... I thought TurboTim was in favor of a stronger dollar? I'm so confused.

Anonymous's picture

I find DB's comments bizarre. The last seven years of "growth" was due to exploding trade deficits (or supluses, depending on where you live.) This is where the vast bulk of the money creation came from.

This whole idea of money creation by central banks is silly. If governments create dollars that are stashed on balance sheets never to reappear, this is a shell game, not money creation.

The only way the economies of the world improve is either a drastic increase in worldwide trade. Nothing else works. There's too much capacity and not enough customers.

The problem with economists is they fixate on government policies and esoteric theories instead of simply looking out the window.

Anonymous's picture

scenarios 2&3 are most likely but the real problem is the timing. equity markets will believe in scenario 1 untill it will be very obvious it is not the case. exiting the markets today might end up in great losses.

bugs_'s picture

4 Scenarios, 3 Amigos (Ben, Timmay, Larry)

Miles Kendig's picture

It is nice to know that DB views the removal of free money as the biggest threat in 2010.

Anonymous's picture

Are they an AIG counterparty? It's even better when the free money comes from another country.

GoldmanBaggins's picture

Scenario # 5: Inflation, particularly in food comes roaring along and make us all wistful for the bygone days of 2009. Take that to the bank.

Anonymous's picture

Mine is more akin to scenario 3, but with Bernanke doing whatever is necessary to keep bond rates down, including tanking the stock markets:

GuyFawkes's picture

CBs will always inflate at regular intervals in order to prevent a deflation scenario.  It is built into their DNA because no one voluntarily chooses deflation (mass unemployment, pitchfork mobs, etc.).

Therefore, we are headed towards progressively higher levels of inflation, puncuated by brief downturns in a losing attempt to mitigate the damages of inflation.

This will play out over a far greater time horizon than Zimbabwe for instance, because the USD is the current reserve currency for the world.  When the dollar is inflated, it is global inflation and we are its chief exporter.  In this interconnected world with a dominant reserve currency, the scenario culminates in utter collapse (ala Zimbabwe).  Like a phoenix, the world returns to a level playing field employing an Austrian/Mengerian de facto gold standard.




Greyzone's picture

In my opinion there is a flaw in the inflationary argument. It is only when money escapes into the general populace that the dilution effect on the currency actually occurs and drives up prices. By giving the majority of the new money directly to his buddies, Bernanke is simply changing the ratio of cash held in favor of the big banks and against the general populace. If the big banks fail to spend this money with wild abandon and instead hold on to most of it, inflation will be moderate or even nil.

Thus, I view the current Fed policies as simply a way to steal from Peter to enrich Paul with little or no inflationary impact whatsoever. At worst we may see inflation in equities (which we are seeing right now) but little or no general inflation since the money is not out there in the malls and grocery stores competing for common goods and services. It may take years for this extra cash to leak out into the general economy and meanwhile asset prices, like the entire housing stock of the United States, continue to fall.

Anonymous's picture

Don't discount the Iran/Israel situation. Any conflict there would be disastrous for the economy.

Gordon_Gekko's picture

Funny how this nonsense fails to mention the most important and probable occurrence of all - a catastrophic decline (or loss of confidence) in the dollar.

Shameful's picture

It's the 800lb turd in the living room.  Everyone can see it, everyone can smell it, but no one is willing to say "Why is your living room full of shit?".

I'll bet all the Bernake Fun Buxs I own that even when the dollar is in a total free fall they won't talk about it, or if they do they blame "speculators" or some such magical boogeyman.

Hephasteus's picture

Well because on the one hand you have congress asking if turbo timmy will voluntarily step down and refusing while on the other hand saying that if banks cut bonuses people will "leave". Because that's just how insanely crazy bankers are at processing social signals.

WaterWings's picture

Let's summarize: the stimulus isn't working. Go directly to jail.

J.B. Books's picture

Did you read Scenario 4 –!  My God, break in down my sentences.  I bet we could all come up with 5 ways that each sentence could happen. 

My bet is Scenario 4...


Reductio ad Absurdum's picture

The report is not negative. It predicts an expected increase in "Equity Total Return" of 9.6% --- in other words, an almost 10% rise in the stock market next year, if I'm reading this right. However, the variance is pretty big.

Grand Supercycle's picture


The long term charts for US indices remain bearish.



Anonymous's picture

"They shall cast their silver in the streets, and their gold shall be removed: their silver and their gold shall not be able to deliver them in the day of the wrath of the LORD: they shall not satisfy their souls, NEITHER FILL THEIR BOWELS: because it is the stumbling block of their iniquity.” Ezekiel 7:19

Anonymous's picture

"They shall cast their silver in the streets, and their gold shall be removed: their silver and their gold shall not be able to deliver them in the day of the wrath of the LORD: they shall not satisfy their souls, NEITHER FILL THEIR BOWELS: because it is the stumbling block of their iniquity.” Ezekiel 7:19