Nov 05, 2013 02:06 PM

Heading toward a Cliff

The U.S. Federal Reserve is unlikely to taper its quantitative easing in 2013. The recent improvement in the global economy is due to its surprise decision in September to not taper. The resulting return of hot money or increase in leverage for speculation boosted the economy.

The market is again increasing the odds for Fed tightening. It may trigger some deleveraging, which would cool the economy again. The Fed would be forced to postpone tapering again.

The Fed's QE policy has caused a gigantic liquidity bubble in the global economy, especially in emerging economies and asset markets. The improvement in the global economy since 2008 is a bubble phenomenon, centering around the demand from bubble goods or wealth effect. Hence, real Fed tightening would prick the bubble and trigger another recession. This is why some talk of the Fed tightening could trigger the global economy to trend down.

Only inflation will force the Fed to tighten. Inflation at present is mainly in emerging economies. The United States' dysfunctional financial system is slowing monetary velocity there. It is delaying inflation. But, it is a matter of time. Inflation in the United States could come through imports and expectations. When its financial system is emboldened to lend like before the 2008 crisis, inflation will surge.

As the economy is so sensitive to the Fed's tightening, its pace will be slow, even when forced by inflation. It means that inflation will stay high and for long.

U.S. inflation would trigger the bursting of the bubbles in emerging markets, similar to what occurred in the 1980s. They will face the choice of devaluation or deflation. The global economy has seen high inflation in emerging economies and low inflation in the United States. The roles may reverse in the years ahead.

Return of the Dotcom Bubble

Wild speculation in Internet stocks brings back the bubbly days of 2000.

Facebook is trading above 100 times earnings, Amazon over 1,000. AOL and Yahoo did not go that high in the last dotcom bubble. I am sure that some clever analysts could come up with stories to sort of justify the valuation. And, of course, no one can be absolutely sure about a bubble until it bursts, which was Alan Greenspan's justification for not acting against bubbles. I suspect that this dotcom bubble will burst in 2014, as soon as the Fed is forced to tighten.

The extremes in the new dotcom bubble tell us what the monetary condition is in the world. The real interest rate is practically negative everywhere. This is happening for probably the first time in modern history. Negative real interest rates also trigger bubbly valuation in credit, property and stocks.

Bubble Globalization

The Fed's QE policy inflated emerging markets first, while a bad financial system at home slowed the circulation of money and the rise of bubble. Property usually becomes bubbly first in emerging economies in an environment of rising liquidity. Rapidly rising prices and falling rental yields are sure signs of a bubble. From Mumbai to Beijing, the bubble has taken root.

An interesting phenomenon this time is how the property bubble in emerging economies, triggered by the Fed policy, spread back to the United States. Buyers from China, Russia and other emerging economies have pushed up property prices in central London and Manhattan. So their rental yields resemble that in hot emerging market cities rather than that in other cities in Britain or the United States.

The tight linkage between the Fed and emerging economies is mainly due to a lack of independent monetary policy in the latter. Emerging economies are much more dependent on trade than developed economies. The dollar is the currency for global trade. It is impossible for emerging economies to allow their currencies to reflect entirely financial flows and disregard the impact on trade. This tendency to resist the impact of hot money on the exchange rate is why emerging economies are so tightly linked to the Fed's policy.

Hot money does not just disappear into emerging markets. It flows back into the U.S. financial system either through official foreign exchange reserves or private investment seeking higher returns. When hot money first emerges, the former tends to dominate, which keeps down the U.S. bond yield. As the bubble takes hold and yields on property and real interest rates decline, private investment also flows to the United States for higher returns, which pushes up the prices of risk assets, like property, stock and credit, in the United States.

The relationship between the Fed and emerging economies is like a turbocharger for asset prices around the world. The bigger the share of trade in emerging economies, the more power the turbocharger has. With China's rise in global trade, it has played a powerful role in this dynamic. It is not a coincidence that China's property bubble inflated so much during the Fed's QE, despite a weak economy that would have destroyed the confidence for bubble making.

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