Current Rally Is Inflationary: Not the First, Won't Be the Last

In a mid-February editorial we took a look at some factors that were beginning to confirm one of our proprietary indicators that pointed to a bottoming in consumer prices in December 2008. Writing such an article at the time was a big risk since it flew in the face of a trend that had been firmly in place for the past half-year. The price of nearly everything was falling – or so it seemed. For those who understand and appreciate the function of money supply in the determination of prices, the article made perfect sense. However, for those who believe that economic growth or the absence thereof determines prices, there was a great deal of consternation regarding our assertions.

Nearly three months have passed since then and almost every piece of data that has come across this desk has validated the claims made back in February. Just aside of the factors we mentioned in the February article, which were the CRB Index, Gold, and West Texas Intermediate Crude, there is another major indicator of this phenomenon and that is the stock market. From the 3/6/2009 bottom through today, the Dow Jones Wilshire 5000 Index raced from 6935 to 9342; an increase of 34.71%. More importantly though, lets look at it in terms of dollars. The value of the Wilshire 5000, which is one of the broadest measures of US market capitalization increased by $2.407 Trillion during that relatively short period of time.

It is utterly preposterous to assume that Mr. and Mrs. America dug in the couch and found that kind of money and decided to invest it. It is even more preposterous considering the environment that the real economy is dealing with at this time. Job losses have been staggering and persistent, it is demonstrably difficult for the unemployed to find work, and house prices are still falling like an elephant dropped from the Empire State Building. How else do we know this increase didn’t come from the real economy? Let’s look at past behavior. When the government handed out $168 billion in stimulus checks – essentially ‘free money’ - did the public invest it in the stock market? No. The public paid bills, or saved it – much to the consternation of the government.

So where did this dramatic bear market rally come from? In my opinion, it came from large institutional investors – many of the same people who had their coffers stuffed with TARP money over the past 6 months and the same folks who were essentially given a free pass a while back when the rules for mark to market accounting were relaxed. So what we have here is largely an inflationary rally. Certainly, this is not the first such rally, and it will most assuredly not be the last.

But it isn’t just the stock market. It is the commodities markets as well, and this is where it gets bad for consumers. We are about to witness a wave of inflation, a magnitude of which has never before been seen in America. Dr. Marc Faber had this to say about the subject:

"I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate. He also added, “The global economy won’t return to the “prosperity” of 2006 and 2007 even as it rebounds from a recession".

Let’s revisit our charts and positions from February and see how much things have changed in just three months:

Reuters/Jefferies CRB Index

The 15% increase in just the past 3 months will not immediately be seen on store shelves, but it is already being seen at the gas pump and in the prices of many consumer items. It must be noted that the US economy contracted at a rate of 5.7% (annualized) in the first quarter of 2009, which is on the heels of a 6.1% decrease in the fourth quarter of 2008, yet consumer prices, commodities, and other inflation assets are rising. If this doesn’t strike down the notion that demand (economic growth) alone determines prices, then nothing will.

West Texas Intermediate Crude Oil (WTIC)

This one says it all – a 45% increase in the price of oil just since the middle of February. Keep in mind this increase in price has occurred during a period of a contracting US economy. It is high time that the mainstream press and every one of us stop being US centric when it comes to oil – and everything else for that matter. World demand has remained robust, but at the same time has not exploded over the past six months for sure. The problem is there are untold trillions of dollars parked around the globe. Remember last fall that it wasn’t just the US Fed who was printing like crazy. The Europeans were following suit, much to the dismay of any country that possesses a scarce resource.

Gold – Contract Price

Despite a major rally in equities and assertions from media and government alike that the economy has bottomed and will begin to heal soon, Gold has not taken the bait. After once again breaking through the $1000/oz level for a brief period in late February, Gold was pushed down to the $860 area, but has rallied nearly $100/oz in relentless fashion and is looking for its fourth straight week of gains. It is very obvious that the powers that be would prefer if Gold remained below the psychologically critical $1000/oz mark. A serious breakout to the upside would once again light the 1970’s-esque fire of inflationary expectations.

The US Dollar – Heads they win, tails we lose

The story for the US Dollar over the past year has been a fairly simple one: if there is a major crisis and stock markets are falling 700 points in a day, then people want dollars. Otherwise, forget it. So the only way holders of dollars get a break is if the wheels are falling off everything else. During periods of relative calm, such as what we are seeing now, the Dollar has retaken its outcast position as the whipping boy among currencies. The damage done by numerous bailouts and stimulus packages is common sense. The future damage of persistent trillion dollar annual deficits and tens of trillions in unfunded liabilities from Social Security and Medicare still remains. The 11% move in the Dollar from 2/20/09 to the present will result in higher prices paid for imports, and in part has been one of the reasons for oil’s recent surge. However, oil’s move has been far in excess of what would have been necessary to merely keep pace with the dollar’s decay. Look for a return to higher trade deficits unless demand drops concomitantly, which is entirely possible.

The return of the Bond Vigilantes

Perhaps worst of all has been the Fed’s inability to keep bond yields under control. Despite open monetization to the tune of $300 Billion, and the 2009 purchases of upwards of $1.25 Trillion in mortgage bonds in an effort to keep rates low, bond rates have shot up dramatically. Perhaps even worse, mortgage bond yields are now starting to move up as well. The most alarming trend is the 10-2 spread for 10-year and 2-year Treasury notes. It cannot be ignored that with each recession, the spread grows. That is because each time the fears of inflation as well as actual inflation itself increase dramatically. It cannot be ignored that with each spike we have seen a large bolus of inflation enter the system resulting in a period of ‘prosperity’.

Anyone care to stretch their thinking a bit and notice how those periods of ‘prosperity’ are getting shorter and shorter despite greater infusions of fiat cash? It should now be apparent to all that a massive inflationary wave has been unleashed. Policymakers are aware of this and are already preparing the public by discussing deficits in the trillions rather than billions as the government will make a futile attempt to keep pace. What is most alarming in all of this is the precarious position of the consumer. Nearly wiped out in 2008 by job losses, falling home prices (which had previously been regarded as income), stagnant wages, and dramatic losses in retirement and other investments, the consumer is not in the position to deal with the inflationary blow that is now in progress. The green shoots theory was a nice try, but those shoots are about to be buried under an avalanche of another type of green – the green of increasingly worthless fiat paper money.

Comments

[Dave Wrixon:]

Well Faber is wrong here.

“The global economy won’t return to the “prosperity” of 2006 and 2007 even as it rebounds from a recession".

What he should have aid is the "US" won't return to the “prosperity” of 2006 and 2007. What many fail to understand is that China did not experience anything remotely close to a recession by normal definitions.

More perspective from the Gold Fish Bowl, I am afraid.

May 31 07:15 AM

[tobi:]

Good article. I never understood why the market was cheering higher oil prices in the first place as there is clearly no sign yet of a demand increase as an indicator for a speeding up economy.
There is a big difference between inflation on a good producer level being able to push through higher prices to a consumer that is able to pay them and inflation driven by energy and raw materials as the later torpedoes consumer purchasing power as well as margins. Energy inflation does not urge to hire or increase production, but the opposite, every dollar americans have to spent at the pump they can not pay down for their mortgage or any other product. Stagflation again ? I yet have not seen how the recent inflationary tendencies have helped the overall economy.

May 31 07:42 AM

[Roger Knights:]

"The green shoots theory was a nice try, but those shoots are about to be buried under an avalanche of another type of green – the green of increasingly worthless fiat paper money."

Green? "Shoot!"

May 31 08:53 AM

[Dave Dorgan:]

Oil has been driven up by demand outside the US? This has been a GLOBAL recession. Who are these unsung countries that have dodged the economic bullet? One other theory on the rise in oil prices - and commodity prices in general - is that it has driven by the same thing that happened to oil prices in '07 & '08. Pure speculation on a massive scale - Commodity Index Funds (a self-fulfilling prophecy), financial houses with lots of TARP money (this time around). The oil has not been consumed. It is sitting in the holds of many, many tankers floating around the world. When reality sets in, rather, profit taking, the house of cards will come crashing down. That would have been in July of '08 (oh, I think we're in a recession i.e. no demand for this overpriced stuff): oil, gold & crb peaked, the Dow breaks below 12000 support, the US$ starts its upward move. I'm not saying that this is the cause of the world wide recession. It's all perception. Right now everyone thinks that bad news that isn't as bad as the previous month is really good news. Economies don't move like perfect sine waves. That is why we have double bottoms, triple bottoms and head & shoulder patterns. It is possible that we are just waiting for the second coming of reality setting in.

May 31 10:41 AM

[untrusting ...:]

Dave,

Yes perception is important, but oil and all other economic matters are also a complex web of multiple, ever shifting factors and considerations as well.

If you take the example of oil, some of the factors would include:
1. Oil is priced in dollars for worldwide use. Since the US dollar has fallen dramatically in the past few months (at least 11%), then the price of oil has to go up just to maintain it's same value in other countries relative to the decline in the dollar value. If you assume oil at say $50, then this alone would effectively price oil at about $56-57 now.
2. Then you have the perception/expectation that maybe the dollar may even fall further in future months. Say maybe another 3-5% and that could price in maybe another few dollars of price increase, as it takes time to move the oil through the production to consumption phase.
3. China purchases/stockpiles - then there's the perception or news that China is stockpiling more oil which would tend to increase prices just because they have the bucks to buy more and sellers will take that into account.
4. Cost of production/replacement cost - cost of new production varies widely by location, etc- but estimates I have seen ranges anywhere from about $25-90/barrel to find and produce new oil. Examples include relatively low cost in Saudi Arabai and relatively high cost of oil shales. That plus it is estimated that worldwide supply of new oil has peaked and the easiest oil to find has already been found and it will become increasingly more expensive and more difficult to find more. There is a great series of information on this and other economic issues at:

www.chrismartenson.com...

A very interesting and informative free series of videos about oil, money, economics, debt, etc. Well worth the time to view and consider.
5. Speculation - sure there is some speculation in oil and other commodities at this point. Who knows how much that accounts for the rise in oil prices recently? My guess would be about $5-10/barrel, as the rapid rise from $55 to $65 has been much to fast based on dollar devaluation, major excess US supply at this point, etc.
6. Probably dozens of other factors as well, but too difficult to predict with any degree of certainty. Reminds me of Long Term Capital Management back in late 90's. Supposedly the best and brightest finance, economic, math, traders, programmers, etc. of their day. They developed a hugh market model with hundreds of factors to predict market moves. They did great for a few years and far outperformed the market. Then in about year 3 or 4, it totally blew up on them, because they missed a few factors and they were grossly over-leveraged. Lost everything they had and a lot more in a very short period. Damn near brought down the market then, but because they were just one player, the rest of the market along with the Fed were able to absorb them and ride it out over time. Kind of a precursor the the current market meltdown, but this time it affected way too many large players to avoid the extended damage this time.

It is also certainly true that US oil stockpiles are at record 15 year highs and that estimated offshore tanker storage is estimated at over 100 million barrels (3x onland inventory), all purchased in about the $35-45 range. It also true that US demand has fallen considerably and there is little evidence of much increase in US demand. It is also true that IEA has forecast reduced worldwide demand in the ST. Thus certainly US ST oil fundamentals do not support the degree of oil price increases recently. Thus it seems to me that oil maybe at about $55/barrel might be justified given the dollar devaluation and fundamentals. That implies to me a speculation/manipulation cost of about $10 or $11/barrel at this point. Just a guesstimate based on what I see right now.

With regard to the overall stock market and oil price continued upward moves since the March lows. I would certainly agree that on balance it seems to be way overdone at this point. Some bounce off the lows was to be expected, but the amount and duration of the move certainly seems to be unjustified by economic conditions, past metrics, fundamentals, etc. Your point and many others comments suggest manipulation and unusual behavior in market actions. Personally that makes sense to me, as the TARP banks have hugh amounts of government money and very active trading operations. In fact the TRAP banks have clearly indicated that much of their alleged profits in Q1 came from trading profits, and it is highly likely they will show the same in Q2. Thus it just seems that the most likely explanation for this unusual behavior in the market is the result of manipulation by the TARP banks. They have the motive, ability, operations, and resources to do it, so they probably are. The bigger question is when are they going to stop? Who knows, but it can't go on forever, and at some point the market probably will have to have some downward correction. Just wish I did know when, as I would have thought the market would have started some downward correction by now, but it hasn't. So guess that puts me in the unusal behavior/manipulation camp at this point in time.


On May 31 10:41 AM Dave Dorgan wrote:

> Oil has been driven up by demand outside the US? This has been a
> GLOBAL recession. Who are these unsung countries that have dodged
> the economic bullet? One other theory on the rise in oil prices -
> and commodity prices in general - is that it has driven by the same
> thing that happened to oil prices in '07 & '08. Pure speculation
> on a massive scale - Commodity Index Funds (a self-fulfilling prophecy),
> financial houses with lots of TARP money (this time around). The
> oil has not been consumed. It is sitting in the holds of many, many
> tankers floating around the world. When reality sets in, rather,
> profit taking, the house of cards will come crashing down. That would
> have been in July of '08 (oh, I think we're in a recession i.e. no
> demand for this overpriced stuff): oil, gold & crb peaked, the
> Dow breaks below 12000 support, the US$ starts its upward move. I'm
> not saying that this is the cause of the world wide recession. It's
> all perception. Right now everyone thinks that bad news that isn't
> as bad as the previous month is really good news. Economies don't
> move like perfect sine waves. That is why we have double bottoms,
> triple bottoms and head & shoulder patterns. It is possible that
> we are just waiting for the second coming of reality setting in.

May 31 01:39 PM

[TradingHelp...:]

Agree. Inflation the 2010 problem. seekingalpha.com/insta...

May 31 01:43 PM

[EUARTE:]

In the end though China must develop a home grown consummer demand. The American consummer will not be buying their goods for some time. So there is the possibility of China going under also. It will just take longer. Their currency games will be useless if nobody is buying. You must note that China is buying from overseas. It is not a developed consummer base at home.


On May 31 07:15 AM Dave Wrixon wrote:

> Well Faber is wrong here.
>
> “The global economy won’t return to the “prosperity” of 2006 and
> 2007 even as it rebounds from a recession".
>
> What he should have aid is the "US" won't return to the “prosperity”
> of 2006 and 2007. What many fail to understand is that China did
> not experience anything remotely close to a recession by normal definitions.
>
>
> More perspective from the Gold Fish Bowl, I am afraid.

May 31 03:58 PM

[Albertarocks:]

Thanks Andy. This is a relationship I'd never seen before. It certainly offers a pretty clear perspective. All this incredible fiat liquidity that's been produced will eventually have be put to finally enter the economy and be put to use somewhere. As impossible as it seems, that may well be the stock market. Irrational exuberance all over again? I'm starting to think that's a real possibility after all.

May 31 06:42 PM

[Fighting Yoda:]

Author for some curious reason mentions CRB data as indicator of inflation but not CPI. CPI is the official measure. Lot of people I imagine do not like CPI stat especially core CPI that excludes volatile energy and food. But CPI is the official stat and CPI is down - suggests deflation and not deflation. Future “inflation expectations” as measured by TIPS are suggest very low inflation.

Here is Paul Krugman's latest take on inflation in his May 29th OpEd in NYT:
"... It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger.

So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt.
The first story is just wrong. The second could be right, but isn’t.
...Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself."

It is Deflation all the way.

May 31 08:15 PM

[mariocavolo:]

Hi Dave,

Hi Dave,

just one that one question of yours to inform you who is prospering outside the U.S. the answer is China and related areas....yes, despite the drop in exports due to the global meltdown, internally China has plenty of strength, ...1. it is becoming the new booming auto industry of the world, therefore consuming massively increasing amounts of oil, and 2. the country is cash rich, consumers in China are at the beginning of their country's ecoonomic boom....they have very little mortgage debt, credit card debt and oodles of cash in the bank as the greatest savers in the world....I live here in China for 10 years...Cheers, Mario

On May 31 10:41 AM Dave Dorgan wrote:

> Oil has been driven up by demand outside the US? This has been a
> GLOBAL recession. Who are these unsung countries that have dodged
> the economic bullet? One other theory on the rise in oil prices -
> and commodity prices in general - is that it has driven by the same
> thing that happened to oil prices in '07 & '08. Pure speculation
> on a massive scale - Commodity Index Funds (a self-fulfilling prophecy),
> financial houses with lots of TARP money (this time around). The
> oil has not been consumed. It is sitting in the holds of many, many
> tankers floating around the world. When reality sets in, rather,
> profit taking, the house of cards will come crashing down. That would
> have been in July of '08 (oh, I think we're in a recession i.e. no
> demand for this overpriced stuff): oil, gold & crb peaked, the
> Dow breaks below 12000 support, the US$ starts its upward move. I'm
> not saying that this is the cause of the world wide recession. It's
> all perception. Right now everyone thinks that bad news that isn't
> as bad as the previous month is really good news. Economies don't
> move like perfect sine waves. That is why we have double bottoms,
> triple bottoms and head & shoulder patterns. It is possible that
> we are just waiting for the second coming of reality setting in.

May 31 11:28 PM