The Fed, Emerging Markets and the Money Bubble

Feb. 8.11 | About: SPDR S&P (SPY)

Even I am surprised by how rapidly inflation pressure has risen in the U.S. over past few weeks. You don't see this in the official CPI. But if you go shopping, pay variable-rate utility, fill up gas, or read financial markets, there's plenty of evidence.

This must be the nightmare scenario for the Fed: inflation takes off before employment recovers enough to get off life support. But if they didn't see this coming, they have nobody but themselves to blame. Here's how I see it came to be:

USD being the reserve currency, U.S. monetary policy has broad and immediate global implications. This can be good and bad for the Fed. The good is that Fed can print much more than any other central bank before paying the same price in inflation, as a good portion of printed money will go abroad without domestic inflationary costs. The bad is that the international factor could make the effects tricky to predict.

Fed enjoyed the good part immensely for QE1 and the first few months of QE2. Then it got too good and backfired. The enormous and seemingly perpetual stimulus pushed inflation up around the world, mostly emerging markets and especially BRIC (China and India have their fair share of blame for their own inflation, but Fed's inflation export helped exacerbating the problem). But they wised up this time. With conspiracy-worthy uniformity and synchronicity, they all tightened up capital-control measures while trying to minimize interest-rate hiking. The result is all the hot money got squeezed out and fended off of emerging markets and tsunamied to the U.S.

What we're seeing in the past few weeks is a classical monetary inflation bubble. There's an enormous amount of non-real money in the system (QE1, QE2). There's not enough long-term investment opportunities (low capex by corporations). So the bulk of this free gift from Santa Fed goes into short-term, speculative markets. In 2010 we saw a series of mini-bubbles come and go: junk bonds, treasuries, munis. Now everything is in bubble phase except bonds despite mediocre earnings, mediocre macroeconomic prospect, and still dismal housing market.

Happy days are here again. Of course, such happy days invariably end in tears for most people. But that's for tomorrow, which nobody cares about today.

Moral of the story: No matter what you do, don't sit on cash; No matter what you buy, be ready to run.

Disclosure: I am long GLD, DBA, SLV.