Five Big Ifs for 2006

The likelihood of faster growth -- Europe and Japan are both supposed to show stronger economies in 2006, and that would suck up more exports from China and India -- is about balanced with that of a slowdown, because higher oil prices could cut growth in these energy-dependent but energy-inefficient manufacturing economies.

As with projections for the developed world, investors won't know if 2006 will be disappointingly different from projections until well into the year.

If No. 5: Whither Speculators?

If something zigs when speculators expect it to zag, we could get a spectacular blowup in 2006. A number of bad trends all look like they are headed toward convergence with the end of the Fed's rate hikes and the beginning of a new fiscal year in Japan in March.

We're at that point in the credit cycle when low loan-default rates have prompted lenders to cut back on credit checks on their borrowers and pump up earnings by slashing reserves for bad debt. Premiums for taking risk have fallen so far that investors don't get much in the way of extra yield if they buy junk instead of U.S. Treasuries.

However, because there's so much money sloshing around the global financial markets, instead of cutting the appetite for risk, low risk premiums have encouraged yield-hungry investors to buy even riskier vehicles, such as bundles of interest-only, no-income-verification mortgages. The risks of something going wrong will rise moving into 2006.

The Federal Reserve's last rate hikes will squeeze some debtors and change the patterns of cash flow in many debt instruments as borrowers pay back either more or less than expected. At the same time, the nearing end to the Fed's moves will be an opportunity for traders to put big bets on the direction of rates.

The strength of the dollar against the yen and the euro, and the conviction that the strength can't last, will also occasion huge macroeconomic bets by traders. Any misstep could be magnified into a systemic problem by a market for credit derivatives that has grown so fast that at any one moment, no one is quite sure what anyone else owns. Sounds like a great howdy-do to a new Federal Reserve chairman.