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'Hot money' ride could be getting put on ice

Steve Bronstein | Photographer's Choice | Getty Images

On Wall Street they call it "hot money"—that seemingly endless flow of cash that goes to the most profitable country du jour—but in the real economy it's gone cold.

That hot money has come mostly in the form of a low-yielding U.S. dollar, which investors have borrowed en masse to fund investments in other higher-yielding currencies across the globe. The so-called carry trade has helped fuel an investment bonanza across the world that has boosted risk assets thanks primarily to the U.S. Federal Reserve's easy-money policy.

But with the Fed tiptoeing away from what initially was an $85 billion-a-month infusion of liquidity, investors are beginning to prepare themselves for a world of rising rates in which the endless cash flow to emerging market economies begins to ebb, then cease.

Consequently, global equity markets have been on a wild ride in 2014, with many market pros expecting the volatile wave to continue.

(Read more: Good intentions paved way to market mayhem)

"We're back to the old normal again," Nicholas Colas, chief market strategist at ConvergEx, said in an interview. "The old normal is a less-correlated market. ... We are creeping back to the way the world used to work pre-2007."

Since the financial crisis began to erupt in 2007, and more to the point when the Fed began dropping rates to the zero bound, yield-seeking investors plowed into the carry trade, with the dollar-yen being the most popular combination.

But the roots of hot money spread far and wide, with emerging market economies seeing foreign exchange reserves surging past $7.7 trillion, after standing at just $1 trillion in 2001, according to the International Monetary Fund.

In the 2014 selloff, however, the tide has begun to turn.

(Read more: 'Spoiled' market getting hit with 'one-two punch')

Exchange-traded funds that track emerging markets have been losing money at a rapid pace, contributing to the unusual trend of the rapidly growing $1.6 trillion ETF industry actually seeing outflows of $19.7 billion this year.

Some of the biggest losers are funds that track emerging markets—the iShares MSCI Emerging Markets and the Vanguard FTSE Emerging Markets funds have surrendered $8.7 billion combined, according to XTF, which compiles data on the ETF space.

The Asian Development Bank warned in a white paper in 2013 that the unwinding of the carry trade and the siphoning of hot money would rattle global markets, and advised then that the Fed should up its target policy rate to 2 percent so as to stave off the effects of a rapid interest rate increase and global inflation.

Whereas the interest rate cuts in the industrialized world aimed to stabilize domestic economies during crisis events, the resulting rise of speculative capital inflows in emerging markets has contributed to rising inflationary pressures, speculative booms in local real estate markets, and hikes in food and energy prices. This has led to rising monetary, macroeconomic, and political instability in the emerging world

The S&P 500 has risen more than 160 percent since the March 2009 lows, but the economic recovery for the U.S. has been nowhere near as rapid. Unemployment remains a substantial problem and wealth inequality has surged during the hot money years.

In its analysis, the ADB said the hot-money trade has encouraged global speculators who are likely to get throttled should the world experience another financial crisis and banks shut off the dollar spigots to risky customers.

Although the low interest rate policy is claimed by the Federal Reserve to have stabilized US growth and, therefore, to also have had positive spillover effects in the emerging world, the zero interest rate policy per se is unlikely to have stimulated US growth. Conventional thinking has it that the lower the interest rate the more opportunities there are for credit to expand. But this is only true when interest rates—particularly interbank interest rates—are comfortably above zero.

Japan provides a disturbing parallel for what could await the U.S.

Both countries are engaged in significant monetary easing, and while Japan's growth is lackluster and behind the pace of the U.S., both countries have seen a boom in equity markets that the new year has dampened.

(Read more: How bad will the Nikkei meltdown be?)

The ADB report warned of such a phenomenon.

The longer the Federal Reserve's zero interest rate policy stays in place, the more difficult it becomes to get out of the resulting liquidity trap and restore a more normal flow of financial intermediation within the US. Such a restoration is needed to avoid in the US the perpetual stagnation we now see in Japan

Peter Boockvar, chief market analyst at The Lindsey Group, warned recently that the Fed's aggressive monetary policy has led to investors putting on "beer goggles" when viewing the markets.

"The perilous state of the economies in many of the emerging markets and undeveloped world was ignored by investors," Doug Kass, president of Seabreeze Partners, said in a note Tuesday. "The adoption of a less liberal monetary policy in the U.S. might expose those who are swimming naked."

—By CNBC's Jeff Cox. Follow him on Twitter @JeffCoxCNBCcom.

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