Montreal, Canada

It should come as no surprise that China is trying to curb lending. Excessive bank credit – unique mostly to China in an environment of tight credit in most countries – prompted to belt-tightening in Beijing this week. The result was a major sell-off for commodities, especially the base metals, which are heavily linked to China's growth cycle.

The usual beneficiaries of heightened risk aversion came into play again yesterday as the U.S. dollar, the Japanese yen and Treasury bonds posted gains at the expense of risk-based assets like stocks and commodities. Resource currencies were also hammered.

The Chinese have a vested interest in keeping inflation in check. China and several other emerging markets like Brazil and India are the few centers of real economic growth in the post-credit crisis rally since March 2009. While other nations, mostly in the developed world, continue to struggle amid a wall of government spending, rising unemployment and deflation in bank credit, the Chinese are home to unrelenting loan growth -- until now.

Though I suspect the Chinese, like most governments, fudge their economic data, it's quite obvious that inflation is now accelerating across China, mostly in real estate, bank credit growth and stock prices. China is attempting to gradually deflate an asset bubble and curb bank lending, which is expanding rapidly.

Local media in China assert that banks lent more than $146 billion dollars the first two weeks of January compared to about $1.4 trillion dollars in all of 2009. At this rate, bank lending would top $3.5 trillion dollars this year, which is unsustainable.

The question therefore is how far will Beijing go to curb credit without risking an overshoot and triggering a wholesale crash in domestic markets?

The Chinese do things pragmatically and in small steps. It's hard to believe the authorities will rapidly drain excess credit and cause a massive sell-off in domestic markets, namely property. Yet this is becoming a dangerous game.

The trend now is for gradually tighter credit in China and if the government continues to drain liquidity then global markets will suffer more declines. Increasingly, the last few years have shown a high degree of correlation between China's economic growth cycle and the performance of world markets; ten years ago China didn't cause a dent. Today, all eyes are focused on the world's third-largest economy and its biggest exporter. This week we've been reminded once more that China has big muscles and all investors are vulnerable to the events occurring in that country.

I'm not sure events in China this week will continue to cause a further reduction of risk. So far, moving averages in the major markets remain in bull market territory.

In this environment the best values are not stocks or non-Treasury bonds but hedges like the VIX, the U.S. Dollar Index and selective shorts in global indexes like FXP (China) and SH (S&P 500 Index). Treasury bonds, though a poor long-term bet over the next decade will probably post further gains should risk assets continue to falter.

Gold, though a disappointment yesterday, should be accumulated on weakness because dollar strength is only temporary as the Fed continues to fight unemployment, battered housing and fractured credit intermediation. It's hard to believe the Fed will tighten this year when these three critical pillars of growth remain so impaired.

The only country in the world that should be tightening is China. The rest of the global economy – especially in the West and Japan – are still deeply entrenched in deflation and have no business to curb credit growth or drain massive fiscal priming since late 2008. But the risk that other governments will follow China and curb spending and hike rates is growing. That would mark a bungled policy initiative and result in a double-dip recession. The world simply can't handle higher rates so soon after the biggest credit shock since the 1930s.

When this historical post-March 2009 rally eventually ends we can blame it on the central banks. The big boys are growing nervous about sovereign debt levels, rapid spending and commodity inflation. The bad news is that central banks usually get it wrong.