Image: Japan © Stockbyte, SuperStock

This is a befuddling time for investors. The economic data have been consistently disappointing. Growth and job creation are stalling again. Commodities, especially copper, are warning of a serious global slump. Corporate profit margins have dropped back to 2010 levels. And in a few weeks, Washington will be embroiled in another budget battle as the Treasury once again hits its debt ceiling.

Yet Wall Street has barely noticed.

The Russell 2000 Small Cap Index (RUT.X) is just 3.1% off of its recent high. The Dow Jones Industrial Average ($INDU) is down just 1.2% from recent all-time highs. Hope and enthusiasm are feeding on themselves as a self-reinforcing cycle of greed replaces careful consideration of fundamentals. Just as it did in 2000, when dot-com mania captivated investors. Just as it did in 2007, when housing seemed so bulletproof.

But the reality on the ground is changing, proving cheap money from central banks cannot solve the problems that ail us. Key industry groups have already rolled over. And soon, investor sentiment will break -- unleashing a long-postponed wave of selling pressure.

The real wild card that could set this wave off is something nobody is talking about: the specter of a new currency crisis in Asia.  

A singular motive

It's worth remembering that the market's recent surge has been driven, almost exclusively, by the Bank of Japan's decision last month to double its monetary base over the next two years, in an effort to restore some vigor to a deeply indebted, deflation-plagued Japanese economy.

This extreme monetary policy easing -- going all-in on the same strategy being used by the Federal Reserve, the Bank of England, and, to a lesser extent, the European Central Bank -- has crushed the Japanese yen and made it attractive as a funding currency for hedge fund "carry trades." Carry trades are simply two-sided trades. First, you sell yen "short" in the futures market. Then, with the cash raised, you buy things like Spanish or Italian bonds (denominated in euros) or U.S. stocks (denominated in dollars). The trade pays when the yen falls, the assets you bought rise, or the currencies your assets are denominated in rise against the yen.

Image: Anthony Mirhaydari - MSN Money

Anthony Mirhaydari

Thus, the U.S. stock market has moved, tick-for-tick, with the yen-dollar and yen-euro exchange rates over the past few weeks as hedge funds buy and sell stocks based on currency fluctuations.

This is the situation we're in: It doesn't matter that Dow heavyweight McDonald's (MCD) posted its first year-over-year sales decline in a decade or that IBM (IBM) posted its worst quarterly result in eight years or that Caterpillar (CAT) posted its weakest quarter of operating cash flow since early 2010. All that matters is that the yen continues to weaken against the dollar and the euro in order to keep the carry trade alive.

If only it were that easy.

Japan's endgame isn't pretty. Let's not sugarcoat it: The BOJ's efforts are a last-ditch Hail Mary attempt.

Japan's ratio of debt to gross domestic product stands at 245%, the highest in the developed world and more than twice the size of U.S. relative indebtedness. And like America, Japan's fiscal woes are being fueled mainly by an aging population and the welfare entitlements promised to seniors.

The country is already in fiscal quicksand. Tax revenues currently don't even cover the government's required expenditures on social security programs, education and debt service. And that's with 10-year government bond yields at just 0.59%.

Now, what happens if the BOJ achieves its target of boosting inflation to 2%? Bond yields and interest expense would more than quadruple, effectively bankrupting Japan and forcing the BOJ to monetize government debt outright. The result would be a rout in the yen and turbulence in the foreign exchange markets.

But it would be great news for carry-trade hedge funds, right? Possibly.

Unintended consequences

Yet this ignores an important dynamic. As the Dow has surged to new highs, Chinese stocks have been crushed as China's currency, the renminbi, has soared relative to the dollar. This damages China's export competitiveness, which is critical to Chinese companies. The iShares FTSE China 25 (FXI) exchange-traded fund is down 14% from its January high. South Korea has also been hit, with the iSharesSouth Korea Capped Index (EWY) down 14% from its January high.

China's Flash PMI manufacturing activity report fell to 50.5 in April versus the 51.5 expected, with the new-export-orders subcomponent falling to 48.6 versus 50.5 -- indicating month-over-month contraction. This slowdown in China is real. It's growing. And it's happening to an area that, not too long ago, was expected to lift the world economy out of its funk.

This has Société Générale strategist Albert Edwards concerned that we could be looking at another 1997-style Asian currency crisis, this time focused on China. A slowdown in exports and a strengthening renminbi have caused growth in China's foreign exchange reserves to stall, sucking liquidity out of a country that has grown increasingly dependent on credit-fueled infrastructure projects and housing development.

Growth in Capital Economics' China Activity Proxy -- which uses indicators such as passenger transport volumes and trade volumes to track Chinese growth without relying on manipulated official GDP numbers -- has already plunged to levels not seen since the depths of the 2008 financial crisis. The decline is being driven by a fall in construction activity and a rise in developers' inventories -- both credit-dependent areas.

Already, there are signs foreign investors are pulling cash out of China as growth slows, building new factories become less desirable and the housing bubble there prepares to burst. As a result, the country ran its first balance-of-payments deficit since 1988 last year -- an accounting concept that indicates wealth is beginning to leave the Middle Kingdom for the first time since the Reagan administration.

All of this risks throwing many of the dynamics that have supported the global economy over the past decade-and-a-half into reverse -- with unknowable social and political consequences for China. The other big question? With China out, the eurozone still a mess and Japan scraping the bottom, can the U.S. economy grow enough keep the world out of a new recession?

I don't think it can. Not with taxes rising. Not with new health care regulations. Not with job growth stalling. Not with consumers as tapped out as they are.