The risk-on trade that has driven equities and commodity prices since the Federal Reserve started talking about the second round of quantitative easing last year is under threat from inflation, according to Philippe Gijsels, the head of research at BNP Paribas Fortis Global Markets.
"The turning point in the markets last year was at the end of August when Ben Bernanke started talking about QE2," Gijsels said.
"Interest rates shot up and the 'risk-on' move started which drove up more risky assets like equities, emerging markets, commodities and commodity currencies like the Aussie dollar ."
"This move happened in the most correlated way I have ever seen in the markets," he said, and was provoked by the Fed putting liquidity in the system.
"The fact that Barack Obama unexpectedly extended the Bush tax cuts put even more oil on the bonfire," he added.
The change from deflation worries to soaring inflation is behind the crisis in the Middle-Eastand will have big implications for the market as the year progresses, Gijsels said.
"We have moved from the perception of deflation back in August last year to the perception of inflation. In a world that is becoming inflationary you do not want to hold cash anymore," he added.
"Remember that hunger starves civilization, food price inflation has clearly been a big driver for the turmoil in the Middle-East."
The Fed still thinks that inflation expectations in the US are too low, focusing on the weak labor markets and keeping quantitative easing going, Gijsels explained.
"This inflates everything everywhere else and is provoking a policy response in emerging markets in general and China in particular. This is potentially dangerous for our economies and our markets," he said.
"We should be given the debt situation and a lot of other characteristics of a Kondratieff winter, which should be deflationary. However, we see inflation popping up. So in fact in fighting deflation, the Fed may be creation inflation. What the outcome will be, nobody can say," Gijsels warned.
On the surface, growth conditions look good but a lot of this growth is artificial because it has been driven by an unprecedented amount of fiscal and monetary stimulus, he said.
"QE2 changed the rules of the game. Markets will be vulnerable once that the liquidity flow dries up or reverses but the timing of this is notoriously difficult," Gijsels added.
Commodities, a traditional inflation hedge, have some way to run but at a slower pace than in recent months, he said.
"We should remember that in the long run returns of commodities corrected for inflation are quite low, eventually there is always a supply reaction."