How global currency woes sparked a U.S. market meltdown

Stocks collapsed on Friday, capping the worst week for U.S. stocks in 19 months in a day of brutal, relentless selling. The Dow Jones industrial average lost 318 points, or nearly two percent, as it dropped below the 16,000 level with all the grace and finesse of a piano falling from a third-story balcony.

A toxic brew of catalysts are to blame, including slowing factory activity in China, trouble in the Chinese banking system, a reversal in the Japanese yen, and currency value collapses throughout the emerging world from Thailand to Argentina.

All have a common thread: We've apparently reached the limit of what cheap money stimulus can do, at least in its current form. And that's causing ripples to spread through the global currency markets.

Every bull market features, at the terminal stage, a raison d'être for the suspension of disbelief. In the late 1800s, it was that you couldn't lose in the railroads. In the 1920s, is was that the Fed's bond purchases would continue to bolster stocks (sound familiar?). Then anything with a dot-com in the name was a surefire hit. Then it was about how home prices could never go down.

After a historic market performance in 2013 fueled by the belief the Fed's cheap money could solve all -- when investors ignored realities on the ground like growing inequality, stagnant wages, swollen rolls of food stamp recipients, and overreliance on credit to bolster earnings per share and lift stocks -- that seems to be happening again.

This time, the ever-so-slight withdrawal of monetary policy stimulus by the four major central banks is causing shockwaves in the foreign exchange market.

The Federal Reserve, after months of warning, trimmed the monthly run rate of its ongoing "QE3" bond purchase stimulus by $10 billion to $75 billion. After a drop in the unemployment rate to 6.7 percent (driven mainly by folks dropping out of the labor force), Fed officials have been banging the drum that another $10 billion taper is likely at its next policy announcement on Wednesday.

Also, for months the market had assumed the Bank of Japan would continue to pursue its yen destruction strategy -- in an effort to boost export competitiveness via currency depreciation -- by expanding its own bond purchase stimulus program as soon as this spring.

But that's looking less likely now, as the yen's fall hasn't translated into the growth spurt Tokyo was hoping for: Import prices are up, food and energy inflation is pinching consumers, and wages and the trade deficit keep going in the wrong direction.

The European Central Bank, for its part, continues to hold off on its own bond purchase program because of possible legal hurdles (the Germans, in particular, are against the idea).

And finally, the People's Bank of China has been desperately, but cautiously, trying to rein in a fast growing problem in its shadow banking system that I discussed in a recent post.

That combination of all this, over the past week, has caused liquidity to be pulled out of many emerging market economies -- trades fueled by the assumptions that the cheap money stimulus had stoked for months. Mainly, that the yen would continue to weaken and that the major central banks would keep the flow of cheap money going.

So as the yen popped higher this week, so-called "yen carry trades" were frantically closed. And that meant assets, from U.S. stocks to Argentinian bonds, were dumped at any price.

The flip side of this is that the currencies of these emerging market economies are falling hard as investors repatriate their capital. For instance, for a U.S.-based hedge fund using the yen carry to invest in Petrobras Argentina (PZE) on the Buenos Aires Stocks Exchange, they would need to buy yen, sell PZE, and sell the Argentine peso to close the trade.

As stocks and bonds across the emerging world lose value, from Latin America to Asia, it drags down their currencies, which in turn causes more investors to sell (since the value of their investments are dependent upon both the currency and the underlying asset price). The cycle feeds on itself.

That's forcing central banks in vulnerable countries to respond, deepening the worry.

Argentina announced it will no longer defend the peso's value as it runs low of the foreign exchange reserves it needs to do so. Volatility is hitting Turkey, Brazil, Russia, and South Africa as well. Central banks in India, Taiwan, and Malaysia are believed to have intervened in the markets Friday to support their currencies.

Many of these countries are suffering from economic stagnation and high inflation, a nightmare for a central bank since fixing inflation and stabilizing the currency necessitates higher interest rates, which in turn deepens the economic stagnation. That's the quandary faced by Russia and Turkey, among others.

All of this has eerie parallels to the 1997 Asian crisis, which like now was triggered by a drop in the yen and a tightening of policy by the Federal Reserve.

As for the end game, it's not as simple as restarting the spigots of cheap money. Because, with the unemployment rate here at home falling fast, inflation will eventually become a concern. And there are structural problems with the Fed's ongoing monetization of the Treasury's debt, such as the shortage of high-quality collateral that results as the banking system has less debt to work with when they make loans to each other.

It's a complicated problem. And there are no easy solutions. For investors, after such a gentle and easy rise in 2013, this year is already proving treacherous.

I continue to recommend clients batten down the hatches and focus on safe havens like long-term U.S. Treasury bonds. The leveraged Direxion 3x Treasury Bond Bull (TMF) is up nearly nine percent since I added it to my Edge Letter Sample Portfolio on January 10.

Disclosure: Anthony has recommended TMF to his clients.

Anthony Mirhaydari is founder of the Edge, an investment advisory newsletter, as well as Mirhaydari Capital Management, a registered investment advisory firm.