The Federal Reserve is on track to become the single-largest holder of U.S. Treasury bonds (overtaking China in the process) before time of the midterm elections.

Currently the Fed holds the rapidly-rising bundle of $821.1 billion worth of USTs. The Federal Reserve is practicing what the IMF has repeatedly told all its bailout targets to never do — buy government debt in order to sustain otherwise impossible fiscal deficits.

This process in the world of economics is called “government debt monetization” and there isn’t a single example of it ever ending successfully (and don’t point to Japan where this has been ongoing since 1998 as the country is a freight train about to derail).

The Fed’s actions (or inactions thereof) are relevant for investors in emerging markets because they caused the unnecessary losses that we saw in 2008. Now, however, the Fed’s actions are actually adding to emerging market investors’ gains. In a strange way, globalization has caused monetary policy — aimed at stimulating the U.S. economy — to stimulate the BRIC and Latin American emerging economies more (especially as U.S. consumers and businesses are key users of Asian and Latin American exports).

How the Fed Affects the BRICs

The most repeated questions that I’ve received lately when I discuss the stock market:
1. “When is it going to get better?”
2. “When is it going to go back to the way it was before?”

Well…it has gotten better. Take a look:

Since the bottom in March of 2009, Chinese H-share large caps are up 90%, while Chinese H-share small caps are up 167%. Brazil, Russia and India, as measured by their large-cap benchmarks, are up 94%, 172% and 150%, respectively. In the same period, the S&P 500 is up 71%. Although emerging markets are a lot more volatile, I’ve discussed how at least there you can be a buy-and-hold-investor — and this is great news for our underlying strategy.

But I have bad news on the second most-often-asked question. It will never go back to the way it was before, in my opinion. The game is up.

Approaching 400%, total debt-to-GDP needs to be reigned in — this is the only viable solution. If no structural reform is introduced as soon as possible, we will have a government debt crisis in the U.S. and other western countries in the next five to 10 years.

For 25 years we had the luxury of borrowing ever-larger amounts at ever-lower interest rates in order to push economic growth in the West — this is not a U.S.-centric problem — beyond what otherwise would be sustainable. This was the equivalent of borrowing economic growth from the future in order to have “prosperity” today — this is what we are paying for right now.

So, if you are waiting for the old game of “borrowing growth from the future” to resume, you are out of luck. The future has little growth to lend — it has already been borrowed to the fullest extent possible.

I have repeatedly said that bonds are usually smarter than stocks, but it appears that I need to add a qualifier — if the Fed is out of the way. Clearly, the Federal Reserve has never been more involved in management of the U.S. economy as it is right now.

We have a massive rally in Treasury bonds and gold bullion, as well as respectable rallies in junk bonds and the S&P 500 — all at the same time.

The action is beginning to look like investors are trying to buy anything to get out of paper money as fast as possible — regardless of what the inflation numbers show at present. This is because at this printing speed, we will have the eventual arrival of (hyper)inflation.

The action in the chart above reminds me of the devaluation of the Argentine peso and the concurrent of default of Argentine government debt in 2001. Then, the Buenos Aires stock benchmark index, the Merval, went up 17% on the news and had huge gains for days after that as investors were getting rid of rapidly depreciating pesos in order to buy any stocks — you simply had a better chance of coming back that way, while the Argentine peso exchange rate would never go back to parity with the dollar (currently it is almost 4:1).

I have trouble believing that the Federal Reserve will successfully pick the “magic moment” when printing is about to produce inflation and reverse it for the benefit of society. If the Fed was so great at seeing turning points, why did it  not stop the unsustainable credit growth at large, or the runaway securitization of fraudulent subprime loans in particular, which culminated in the current mess? (The same people that are fixing the problem now were in position of considerable power while the problem was being created).

Still, as I write this, 10-year U.S. Treasury notes are trading at a new yield low for the year of 2.36%. And regardless of my long-term conviction that government borrowing at such unsustainable levels — and its rampant monetization — will backfire in the next five to 10 years, I need to come up with ways to make money in the present environment. There is a contraction in commercial loans on a year-over year basis, which means that printing at present is not producing inflation (the banks are not lending money).

This is why the economy is slow and is also the reason behind why we may yet see deflation, despite all the printing.

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