Why I'm Starting to Fear Inflation

One problem with pumping oceans of money into world economies is that noone can say where they will eventually erupt. Is the magma we had to print turning into lava and nasty volcanoes?

I am still of the opinion that ominous creatures still lurk beneath the bubbly surface of many markets – what we see crawling are speckled vipers, not green shoots. In a way, it got worse these past weeks. I thought there was slightly more than even a chance of deflation, with inflation a distant threat. Now I think I smell the sulfur of the first rude eruption of inflation.

click to enlarge

Quite an eruption, as we can see. DBC (commodities) is up by 31% and SPY (S&P500) up by 39% since early March. IOO the international equity ETF, is also up a similar amount, closely shadowing SPY.

But notice that when DBC hesitated between mid-March and early May, it temporarily stopped following SPY higher. For more than a month, commodities were not confirming US stocks presumably because the market did not believe that the green shoots were real enough to justify second thoughts about deflation being (slightly) more probable than inflation.

I next plotted TLT (20+ years US Treasury Bonds) against DBC and this is the interesting thing we get:

Both commodities (DBC) and long-term Treasury Bonds (TLT) were hesitating until late-April/early-May but they then threw in the towel and rushed to form a cross. This means that both commodities and interest rates (the yield on falling Treasury Bonds) practically took off together.

This is quite a clear confirmation that, in late April and early May, the market’s thinking changed, dumping a fear of deflation and starting to fear inflation.

As to equities, the market seems to have an appetite for US equities (SPY), European equities (VGK), and emerging markets (EEM), although, as expected, the pace varied. (For example, during the last three weeks of May, the US main markets seemed to be getting tired.)

The following graph shows gold (GLD) and silver (SLV), both acting in conformity with commodities.

Energy and agriculture (not shown) are following commodities as well.

And, in the meantime, what is happening to the US dollar versus the other major currencies ?

Notice the sharp fall starting in late April as the inflation scenario took hold, the dollar piercing the recent low set in mid-March, when the supposed green shoots started getting perkier.

Points to ponder:

• It seems that equity valuations have been cushioned from sharper falls (and more appealing prices for buyers) by the “wall of money”. It is difficult to argue that March prices, let alone today’s prices, offered cheap stocks. At the same time, despite the Fed’s efforts, long term interest rates are rising. These conditions usually make for weak holders and very choppy markets since they increase uncertainty.
• If commodities, energy, and precious metals are not dead cats bouncing, we are already in the process of creating various future bubbles. Worse, it seems this time there will be bubbles across the board.
• If medicine is not to turn into poison, monetary authorities around the world must urgently review the “zero interest” and quantitative easing policies they adapted to fight the crisis.
• For bubbles not to form, money must have its own income stream and money must be perceived to be a scarce commodity, not easily printable. Otherwise, nobody in his or her right senses will hold money but instead buy something else.
• The big test is: can the authorities bite the bullet and raise interest rates with unemployment still on the increase? If not, prepare yourself for some serious inflation and bubble-mania.
• With widening fiscal deficits and mounting debt, maybe a falling US dollar and inflation will come to be seen as saviors, after all. If the market seriously starts to believe this, one would prefer to open Pandora’s box.

The charts here are courtesy of StockCharts.com. This article does not constitute advice, a recommendation or an offer or solicitation to buy or sell the securities mentioned. This article is for information only and expression of an opinion and the ETFs mentioned are used only to illustrate the movements of the assets discussed.

Disclosure: Long position in SLV. No position in the other ETFs mentioned.

Comments

[tedfoo:]

"The big test is: can the authorities bite the bullet and raise interest rates with unemployment still on the increase? If not, prepare yourself for some serious inflation and bubble-mania."

The short answer: No.

I believe the Fed knows that the only way to get out of this economic debacle in a politically popular manner is to inflate. The authorities are much more committed to getting banks healthy than protecting what true wealth remains. Old debt will be eaten off the balance sheets of lending institutions, and profit margins on lending grow higher as they borrow at 0% and charge whatever rate treasuries decide to rocket to.

Meanwhile, it will be the silent destroyer of middle class wealth, and the key is that it will be silent. Sure we will all notice higher gas (but we'll blame that on the Arabs and evil oil companies). But our 401ks and home values will appear to be going up. Yet it will be less than the rate of inflation, and most will not take notice.

On the surface, inflation is win-win all around. Is this healthy for the economy? Long term, absolutely not. We'll be back to deal with the next bubble crisis soon enough. We are a culture of instant gratification, the "buy now, pay later" generation. Can we really expect fiscal policy of our elected leaders to reflect otherwise?

Jun 02 03:23 AM

[Donald Ingram:]

Ludwig von Mises has given us the answer years ago, quote, "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crises should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system."

The choice is clear - bite the bullet or open Pandora's box?

Jun 02 03:28 AM

[TradingHelp...:]

We briefly mentioned oil. It’s worth taking a closer look at the market as the recent price action, we suggest, is a fore-taste of further inflationary pressures to come in other areas of the global economy. Reflecting for a moment, a barrel of oil fell from $147 during mid-2008, to a little over $32 by December of the same year. Since then oil has pursued a near-relentless recovery to pass $65 on Friday, twice its cyclical low. Statements from OPEC members have reinforced the view that the current rally is not a false dawn for oil bulls. The Saudi Arabia Oil Minister, Ali al-Naimi, long respected for moderate and reasonable analysis of the sector commented the market is “ready” for $75-$80 per barrel prices later in 2009. His views are based on already firming Asian, Middle Eastern and Latin American demand, not pie-in-the-sky guess work. The start of the US holiday driving season also suggests we are more likely to see $80 than $50, next. From a technical view, the price of oil has crossed its 200 day moving average and a number of oil analysts are now suggesting $60 is the new floor in prices. Politicians who side-lined their pro-green sound bites through the worst of the recession will soon be marketing their renewable energy credentials again.

Jun 02 12:12 PM

[Mayascribe:]

My most recent favorite word is "sentiment." It appears the market sentiment has drastically switched over the past two months from fear of deflation to fear of inflation.

Jun 02 02:20 PM

[Fighting Yoda:]

Here are the comments of a Deflationist Paul Krugman in a recent NYT OpEd on May 29-

"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.
...
But when it comes to inflation, the only thing we have to fear is inflation fear itself."

Jun 02 04:58 PM

[The Geoffster:]

Regardless of where you stand on the inflation/deflation question, the market is speaking loud and clear. Unlike Krugman, the market is apolitical. My bet is the US is trying to inflate itself out of the debt bubble and China is resisting by trying to establish an alternative reserve currency. I suspect this what Geithner's trip to China was all about.

Jun 02 06:59 PM

[Market Folly:]

definitely share your concerns re: inflation. And, you're definitely not alone as numerous prominent hedge fund managers see inflation as the next big wave. Michael Steinhardt, Jim Rogers, and Julian Robertson all think massive inflation is on the way and they all dislike treasuries as an investment. Julian Robertson even shorted them recently via steepener swaps. It's a fascinating play: www.marketfolly.com/20...

Jun 03 03:23 PM