Why Stagflation Has Already Begun

by: Dr. O

Many have noted the inverse relationship that has existed since the previous bear-market lows of 2002-2003 between the US Dollar and stock and commoditiy prices: to wit, the US Dollar declines as stocks and commodity prices rise, particularly gold and oil.

Since the crash of stock and commodity markets began in earnest in the Fall of 2008, this relationship has played itself out on a near daily basis, as opposed to a general trend. Indeed, as stock markets crashed the US Dollar spiked higher, and as stock markets recovered the US Dollar sank.

I don't know why these markets are so highly correlated, but one has to formulate an opinion as to the direction of stocks, commodities and the US Dollar. At the present time, on cannot be bullish of stocks and the dollar at the same time, or bearish on the dollar and bearish on commodities, for example.

Perhaps hedge funds have automated these trades to such an extent that they have created the seemingly perfect recent correlations.

Be that as it may, on Tuesday, for the first time in months, there was a distinct break down in this pattern. The US Dollar was down over 1% against almost all major currencies including the Euro, Aussie, Loonie, Yen, and Pound. Commodities went up as expected, with oil in particular spiking higher over $2 per barrel. Precious metals traded quiety.

However, the stock market did nothing. Traded flat. Tried to sell off, recovered, tried to rally, sold off. Volume was anemic. In spite of a well received auction in 3-year Treasury Notes Tuesday, bond prices have been plummetting recently, and yields rising.

If Tuesday's action becomes a trend, we could be seeing what many consider to be the inevitable end game of current US fiscal policy: A falling dollar, rising interest rates, flat equity prices, and rising commodity prices. In short, stagflation.

I believe stagflation has already begun. Does it not give one pause that oil is at $70 per barrel and gasoline $3 per gallon in the midst of the fiercest recession and decline in demand since the early 1980s? Does it not seem odd that oil prices are as high today as they were in 2007 following a 4-year world-wide economic up cycle? I think it odd given the world is now over a year into a world-wide bust.

Why is the price of oil, a key marker and maker of inflation, at $70 per barrel in the midst of an economic bust and ample supply? I would argue it's one of inflation's first shots across the US economy's bow. I'd say it's stagflation, but we're still in the midst of a severe recession with job losses, economic contraction, and falling housing prices.

If this is the early phase of a new trend, we can expect higher interest rates, higher commodity prices including food and energy, economic stagnation, persistently high unemployment, high precious metals prices, a falling US dollar, and a declining standard of living.

In truth, the standard of living of most Americans has probably been declining for several years already. A country that produces relatively little, consumes a relative excess of world wide commodities and finished goods, and has to borrow trillions of dollars to do so, is a country, and a currency, and a standard of living existing on time borrowed from our creditors.

One has to be bearish on the US dollar, US bonds, neutral US equities, and bullish of commodities. Gosh, I sound like Jim Rogers or Peter Schiff. One complicating factor is that the US is not the only major economy flooding the world with money; the UK, Euro Zone, Japan, and even Canada are guilty as well. However, the US seems to be out borrowing and out printing these other economies not only on an absolute, but on a relative basis.

For this reason, currency conversion from US Dollars to Yen or Euros or Aussies may not be enough to preserve wealth. That probably will require investment in commodities.

Disclosure: Long FXA, FXE, FXC, BZF, GLD, SLV, DBO, as well as accumulating silver and gold bullion coins.