Halloween is one of my favorite times of the year as it signals the onset of cooler temperatures, the turn of the leaves and kids running amok in costumes begging for candy. However, it may be more "trick" as the Federal Reserve extracts the last bit of their ongoing liquidity "treat" from the markets.

Unfortunately, this extraction of support is coming at a time when the bulk of the globe sees economic growth rates begin to fall sharply as deflationary pressures increase. The latest bit of bad economic news came from Germany which is the lynchpin of the Eurozone economy. Germany just printed a 5.7% drop in industrial production orders which is the largest since the global financial crisis raged in 2009.

This was preceeded by worse news from Japan's Cabinet Office as they admitted this past week that "such a change in assessment provisionally indicates a likelihood that the economy has already fallen into recession."

Even the always overly optimistic IMF has cut their global growth forecast to 3.3% in 2014 which is still likely far too optimistic at this point.

Despite the resurgence of global economic weakness, market participants have remained ebullient in the belief that the domestic economy can remain a relative port of safety. The supporting evidence for this belief has been the detachment between domestic and Eurozone industrial production.

This is likely where the "trick" lays for overly complacent investors. The divergence has never lasted indefinitely, and either the Eurozone will quickly recover or the U.S. will slowdown. I would most likely bet on the latter as the deflationary pressures that are rising in Japan and the Eurozone flow back into the domestic economy over the next couple of quarters. The chart below shows the breakeven 10 and 5-year inflation rates as compared to real economic growth.

While the ongoing mainstream mantra remains that economic growth in the U.S. is set to improve in the months ahead, the deflationary feedback loop suggests the opposite. Furthermore, the downturn in current breakeven inflation, along with a sharp drop in U.S. Treasury rates, suggests that the U.S. economy is already being impacted.

This data continues to support my call from July, 2013 that the "bond bull market" is alive and well.

Why is this important? Because the Federal Reserve is suggesting that they will look to start raising interest rates in 2015. However, the inflationary data is suggesting that this will likely not be the case.

During the past 25 years, there has never been a period when the Fed has initiated a tightening cycle with inflation below its 2% target as it is currently. Furthermore, the decline in the breakeven inflation rates suggests that inflation will decline further in the months ahead which puts the Fed at risk of exacerbating economic weakness if they move forward with interest rate hikes.

The Fed will more likely than not be forced into a more "dovish" stance in the coming year but with fewer policy tools available to work with. As noted by Citi's Steven Englander;

"We are getting panic selling across markets today and panic buying of bonds on fears of slowing global growth. However, the new information on global slowing may be less important than the realization that policymakers have few tools to deal with any kind of slowing, let alone a major shock. G3 10yr government rates now average 1.27, within 10bps of the all-time pre-tapering low of 2013 (Figure 1).  So if the last 100bps of rate reduction did not stimulate global growth, it does not seem likely that another 20-30bps or so in the presence of negative demand shocks will do the trick.

The market takeaway from their comments is that the US economy is not strong enough to stand on its own, leaving little hope for the rest of the world, which is already slowing. Moreover since investors and business do not have particular confidence that the policy response will be effective, any upgrading of the risk of negative shocks raises the probability that we may be put into a zone to which there is no adequate response."

This is the risk to investors the in domestic markets. The news and data flows have been deteriorating post the "rebound" from the first quarter slump. With the Fed leaving the"party" the realization that a world without liquidity driven support could well turn "bad news" into "bad news." As Steven suggests, when economic growth is running on razor thin margins, even the threat of an exogenous shock, such as a widespread "Ebola panic," leaves a very low margin of error.

As shown in the chart below, the markets have historically had a fairly tight correlation to breakeven inflation rates. This makes perfect sense as inflation should be related to economic growth and better profitability. However, since the onset of the Fed's massive monetary intervention at the end of 2012, the markets deviated far away from that correlation. The risk now is a reversion back to historical trends as deflationary pressures continue to build in the months ahead.

Over the past five years, markets have been continually soothed by the Federal Reserve's policy regime their commitment to remain "extremely accommodative" for an extremely long period of time. The market is likely beginning to fear that this is no longer the case. If the Federal Reserve does begin to increase interest rates in the near future, it will likely crush the inflationary embers along with any chance of stronger economic growth.

The real concern for investors and individuals is the actual economy. There is clearly something amiss within the economic landscape, and the ongoing decline of inflationary pressures longer term is likely telling us just that. The big question for the Fed is how to get themselves out of the potential trap they have gotten themselves into without cratering the economy, and the financial markets, in the process.

The problem is that despite the inflation of asset prices on a global scale, there is scant evidence that the massive infusions of liquidity are doing anything other that fueling the next asset bubbles in the real estate and financial markets. The Federal Reserve is currently betting on a "one trick pony" which is that by increasing the "wealth effect" it will ultimately lead to a return of consumer confidence and a fostering of economic growth?  Currently, there is little real evidence of success, and the Fed is getting ready to take their candy bowl off the porch and shut off the lights.

Trick or Treat.