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The risk that our economy has entered a substantial downturn has actually increased markedly over the past several weeks. Importantly, energy costs have risen significantly to the point of being economically destabilizing. The combination of spiking energy and food costs has created the worst global inflationary backdrop since the seventies – a dangerous predicament only belatedly appreciated by global policymakers. Central banks across the globe have begun to react, and vulnerable global bond markets are under heavy selling pressure. There is today great uncertainty as to the consequences of a global spike in bond yields.

Importantly, the Fed’s aggressive "reflation" is being stopped dead in its tracks by market forces. U.S. market yields are moving sharply higher, with benchmark MBS yields now all the way back to last summer’s levels. This is forcing another round of speculative de-leveraging in the highly leveraged mortgage Credit market, which is tantamount to a further tightening of already tight mortgage finance conditions. This is another huge blow for the vulnerable Bubble Economy.

The University of Michigan Consumer Confidence index posted its high of 112 back in the first month of 2000. By the beginning of 2003, it had sunk all the way down to 78. Yet during this period of weakening consumer sentiment and general economic conditions, benchmark MBS yields dropped from over 8.0% in mid-2000 all the way down to 4.2% by June 2003. Repeatedly over the past ("dis-inflationary") 20 years, waning economic activity has been bolstered by sinking mortgage yields and resulting stimulus to housing and home-equity withdrawal. It was like clockwork, but now this important cycle has been broken. Since January, Consumer Confidence has plunged from 78.4 to 56.7, while MBS yields have jumped from 5% or so to above 6%.

I have argued that the Fed’s latest reflation would prove problematic. On the one hand, reflationary forces would bypass burst Bubbles in Wall Street finance and U.S. real estate markets. On the other, an over abundance of cheap U.S. and global liquidity would further destabilize heightened inflationary pressures globally and stoke Acute Monetary Disorder. As has become clear of late, the upshot to this dynamic is intensifying inflationary pressures in the face of a weakening U.S. economy. Indeed, one can look to spiking energy, food and borrowing costs and make a strong case that Fed reflationary policies have become dangerous and counterproductive.

From examining Q1 "Flow of Funds," one could identify how double-digit growth in Bank Credit, agency MBS, and the Money Fund Complex was carrying the load for a busted Wall Street securitization Credit apparatus. Recent developments, however, have the sustainability of robust Bank Credit and MBS in serious doubt. And while 9.7% fiscal y-t-d federal spending growth (see "Fiscal Watch") has thus far played a meaningful role in supporting the economy, the bond market for the first time in years must come to grips with the confluence of surging yields and the prospect of massive ongoing federal deficits. Similar to the Fed’s reflation policies, federal government stimulus is not without significant costs and risks. Acute global inflationary pressures ensure the old "free lunch" monetary and fiscal stimulus come these days with a hefty price tag.

It has not taken long for Stage II of this unfolding historic crisis to demonstrate some of the classic old financial and economic headaches. I’ve always believed the most problematic scenario for the highly leveraged U.S. Credit system and Bubble Economy would be an inflationary surge and resulting spike in market yields. Curiously, just as the possibility of such a dismal scenario gains momentum a bullish consensus develops that the worst of the crisis is behind us.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.