The Federal Reserve Board of the US released the minutes of its Open Market Committee (FOMC) meeting held on January 31. In that meeting, the Federal funds rate target was set at 4.5%. Both the minutes of the meeting and subsequent economic data must have persuaded financial markets that the Federal funds rate was headed towards at least 5.0%.

We believe that the Fed rate should settle between 5.0% and 5.5% in this cycle. That would still be about 100 basis points lower than the peak in the previous monetary policy tightening cycle in 1999-2000, when the rate peaked at 6.5%. That is a tribute to globalisation and the disinflation that follows from it. It is possible that the reluctance (shed recently) of the long rate in the US to climb might compel the Federal Reserve to do more in the short-end to achieve the desired effect of restraining an economy fast approaching its full resource utilisation levels.

All of this should normally be good news for interest rate-sensitive assets and for emerging markets. However, the problem is that investors had priced in a peak in the Federal funds rate of around 4.5%. Further, at this rate for the US dollar, only a few emerging market bonds and currencies have attractive risk-reward ratio. Hence, it is time to say good-bye to the easy carry-trades that have been put in place in the past three to four years. Of course, investors would try to finance their carry-trades in Japanese yen. That would be dangerous, not because interest rates in Japan would inevitably rise. That may be some time away. It is dangerous because valuations in emerging market and other assets are at frothy levels.

For instance, Brazilian debt maturing in 2015 was trading at a yield of just above 6% in late February. It was difficult to defend such a low yield, given the yield on a 3-month USD deposit at 4.5%. Not surprisingly, in the past one and half weeks, the yield on the said Brazilian debt has climbed to nearly 6.6%. In other words, the price of the bond has dropped significantly.

Anecdotal evidence suggests that boys bringing in coffee trays with the newspaper in hotels in Rio in Brazil are offering stock tips and office assistants are piling on to IPOs. Investors in Indian stocks are convinced that the market is protected by the invisible hand of God and that normal rules of valuation are suspended for India, since it is backed up by an economy that has climbed on to a higher structural growth rate level.

However, these arguments would be credible if investors had only bid up the assets of those countries that have shown such fundamental improvements/re-rating. Unfortunately, it is not the case. In the past few years, equities markets with little or no history or with shambolic market mechanisms have gone up far in excess of those that attribute their rise to fundamental improvements.

• The US Fed rate target is set at 4.5%, but is likely to settle between 5% and 5.5%
• At this rate, few emerging market assets have an attractive risk-reward ratio
• But their valuations are at frothy levels as investors continue to search for yield

Investors have continued their search for yield and sought our currencies with double-digit or high single-digit yields such as Brazil, Turkey, Indonesia, South Africa and New Zealand. Evidence of real pain suffered by exporters, weak economic growth and industrial production in Brazil, rising current account deficits in Turkey, South Africa and New Zealand were ignored. Financial markets are about greed and fear.

Investment decisions are better made when both are factored into the decision at the same time. Investor behaviour, alas, is different. It is either greed or fear and hence, it is either boom or bust. Usually, there is no-thing in between.

The simple, yet rarely heard, explanation for this exuberance is the low level of short rates in the developed world in the past few years. As they begin to rise, and as valuations flirt with levels more associated with irrational exuberance rather than rational fundamentals, it is time to leave the party and drive home safely.

One of the commodities that benefited from the combination of low interest rates and fundamentals and eventually succumbed to financial speculation was crude oil. Earlier in February, as the price of crude oil dropped below $60, there were frantic reiterations of the target of $75-85 by many commodity analysts. However, even as the Iran issue inexorably heads to the Security Council and it is becoming somewhat clearer that the US government is working towards a regime change rather than deal with the threat of a nuclear Iran alone, the price of crude oil is unable to sustain upward momentum.

The relentless oil price surge of the past three years has brought forth the necessary demand side response. The US Congress passed a bio-fuel bill this week and crude oil inventories are at levels very close to their five-year highs. Barring a major terrorist attack on oil installations and a messy end to the Iran-US clash, the price of crude oil is headed towards a level of $50 per barrel, if not lower.

Surely, it would bring relief to many consuming nations, particularly India. However, it would be a folly to think that a lower price of crude oil should lift stock market indices. Prices of real assets and financial assets in the developing world have surged to such levels that it is hard to argue they do not reflect all the good news could be priced in. The test of whether emerging economies are now structurally sounder and less vulnerable to external shocks is yet to come. I suspect that only a few would pass the test.

The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views