In the macro stream earlier, I talked about a normalisation in the US being priced into the markets. There are reasons why this might not happen: a policy mistake by the Fed (the end of QE, with their new data-based forward guidance, could be a tightening, as it was in 2011; if it was me, I would have stuck with time-based forward guidance), or the effect of fiscal tightening (delayed — the lesson from Europe is that the effect of tightening takes a while to be felt, and noticed by the markets), or a continued slowdown in the rest of the world. I am not forecasting that it will not happen; it’s just that one can see how it could not.

So, how to construct a portfolio? With US growth stronger than that in Europe, perhaps the thing to do would be to be short European equities, and long US equities. If growth is strong and US-led, US equities might outperform; if growth in the US falters, the knock-on effect on a perennially weak Europe should cause European equities to underperform. Either way, the US outperforms Europe. However, I don’t like this trade. First, vague ponderings on market reactions to differential growth outcomes are not a model of equity-market behaviour. Second, the European/US relative is already very low.

How could we trade the economy getting weaker. The obvious thing is perhaps to be long US Treasuries. Rates have already gone up along the curve and, while it is only moderately steep, the Fed is likely to keep it that way or flatter, as BB’s recent comments (making a distinction between QE and interest rates) seem to show. So, rates ought no to go up much further, because of the Fed reaction function, but could go lower, because if the economy weakens then the date of the first rate hike will be pushed out along the curve (model: long-term rates reflect expectations for short-term rates (plus a bit for the effect of the zero lower bound on the probability distribution)).

We could also be long gold. Gold is closely related to real interest rates (although it also appears to be affected by Asian currencies, as events in Q1 2013 showed). Real rates have risen as nominal rates have increased and inflation expectations have returned to about 2%, and hence gold has fallen. Now, if inflation expectations fall further, it is likely to be because of economic weakness, in which case nominal rates should also fall and the effect on gold should be neutral or positive. The Fed would then attempt to relax policy again, raising inflation expectations while keeping nominal rate expectations low, and the resulting fall in real rates should be good for gold. On the other hand, if the economy is strong, then inflation expectations are likely to rise, so even if nominal rates rise a little as well, real rates will struggle to get much higher. So gold’s drop should not continue.

In other words, both long TY and long gold should have upside if the economy weakens, and limited downside if it strengthens.

Now, what if economic growth does continue strongly? The best thing might be to be short GBP/USD. If the US economy weakens, GBP is unlikely to rise against USD (it tends to be positively correlated with risk assets). On the other hand, if things really are normalising, then USD ought to be beginning a long upward pull as we move towards normalised rates, while the UK remains moribund and the new governor of the BoE is likely to attempt to loosen policy. The problem is that the US normalisation, if it continues, will mean a slow rise in interest rate expectations: as I argue above, interest rates should not rise much further in the short term whatever the economy does. And if they do not, then why should GBP/USD weaken? So I fear this would be a long-term trade shoehorned into a medium-term strategy.

So, the question is, what position should we add to long gold and long TY in order to benefit if economic growth remains strong and risk remains on, without hedging away all the potential profit of the first two positions?