New Year 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 US rates go higher for all the reasons of inflation, better growth and rising debts."

After a period of an equity-poosting 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."

For the best market insight, catch ‘Fast Money’ each night at 5pm ET and the ‘Halftime Report’ each afternoon at 12:30 ET on CNBC. 


John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team.

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