The perception that inflation is going to rise in the near future is common among traders in spite of the absence of solid data backing the argument. This week we’ll offer our updated opinion about the inflation outlook.

To have high inflation in this country, one of two conditions must be fulfilled. Either we need to have rising wages, justified by increasing employment, or perhaps productivity falling faster than employment, or we must see some external shock invalidating the profit expectations of firms, leading them to raise prices.

It’s all good news once again for Wall Street, as corporate earnings releases beat about 80% of analyst expectations for the latest quarter. This is surely a remarkable record, and a reason for optimism. So is the skyrocketing productivity growth among U.S. firms, although that is often regarded as a bad omen. On the contrary, we strongly believe that rising productivity is the surest catalyst of long-term growth, whether it is caused by scared workers working harder, or by technological innovation. Naturally, in the latest bout of productivity rises, both of these factors play a strong role; firms invest more in technologies that help increase employee output, so as to get rid of as many of them as possible in an uncertain environment. Nonetheless, opportunities are born out of adversity, and there is little doubt that the flexible adjustment observed in the American economy is overall a benefit to the long-term economic health of the nation.

The real problem is the nature of the investments that go into productivity, what drives managers in the direction that they take, and also the role of contracting credit in the equation that will determine the future of American economic growth. Managers are probably not as optimistic as numbers show them to be on the basis of improved profitability and better balance sheets, because they are still discharging workers. They are unwilling to tap into their credit lines for expansion, and try to improve performance by contracting activity. What is more, the lifeline of the economy, the liquidity supplied by financial institutions, is continuing to diminish, and credit standards are still tightening overall, in spite of the massive easing that has taken place over the past two years. There are a large number of firms which have got a very big mess in their hands, with no visibility about how to get rid of it. The status of consumer credit, as well as industrial loans, do not provide any reason for optimism at this stage. It is easy to get distracted by noting improvement in sectors which were never the cause of the crash in the first place.

A few days ago the Treasury auctioned about $7 billion in five-year inflation-indexed securities (TIPS), and demand was robust. The bid-to-cover ratio according to Bloomberg was 3.10, the highest since October 1997, signaling that investor appetite for government paper is far from being exhausted. Indeed, since TIPS ensure against inflation, they are probably even better than gold as a hedge against future volatility at this stage. If you don’t believe that the government is going to supply the dollar massively in excess of demand in order to meet its future obligations, and are confident that the exchange rate risk is manageable, TIPS provide a credible opportunity to hedge against volatility and uncertainty in the markets.

Meanwhile, even as TIPS meet robust demand, the ten-year government note fell, in spite of the somewhat gloomy outlook for the stock market. As it is prone to happen, every once a while, sellers like to dump U.S. assets in bulk, including, bonds, stocks, and currency, in response to the occasional fear that a resurgence of the crisis is around the corner.

Notwithstanding the ever-present worry that the Chinese and the Russians, even the oil giants of the Gulf region may begin to run away from the dollar in panic at any moment, the dollar seems to be doing reasonably well against its peers, given how severe the deterioration of the U.S. finances are.

Let’s put the picture into perspective: the American government is now counting in trillions, not in billions as it used to do in the past, when discussing the financing of its grand schemes. The nation is busy with pursuits in Afghanistan, a nation-building effort in Iraq, and a war against an elusive, shadowy entity called “terror”. Unemployment is at ten percent and rising. Once the envy of the world, the American finance complex is totally disgraced at home and abroad, as the once unflinching defenders of unbridled capitalism more and more embrace the various discredited mechanisms of socialism in fear of complete economic collapse.

We have always been of the opinion that this recession will be w-shaped, with two dips as the effects of the economic stimulus packages recede, and investors and authorities alike come to the realization that we had been riding an air bubble all along this fake bull market. The non-farm payrolls data of last week only confirmed the suspicions of bears. The unemployment rate went up by another 0.1 percent, and the monthly payroll cuts exceeded the August number by 60000.

Still, we caution against taking the shocking headline number too seriously however. The BLS has a habit of performing erroneous calculations in the month of August as youngsters leave the labor force to go back to school, and this distortion often causes swings and errors in the interpretation non-farm payrolls report in this season.

As world markets continue to rally in the face of tax cuts, stimulus packages, monetary easing, various new social programs aimed at protecting the middle class from the impact of the economic downturn, there are indications that the recent revival in economic activity is going to bring about some positive surprises on a wide scale. Both investor and consumer sentiment are indicative of a slight but steady revival of confidence, and if that attitude is sustained, financial speculation and reckless credit expansion by governments may well extend this rally into the winter season.

Perhaps the most important signs of revival are coming from Asia. Japan has reasons to be optimistic that its new government will finally be willing to tackle the pressing issues of the past decades with some credibility and determination. The emerging behemoth, China, has not felt the impact of this crisis as strongly as other nations have, and with a bit of luck they may eventually come out as a stronger, more balanced economy once the crisis dissipates. The resurgence in the U.S. means that the Indian IT sector is finally seeing some revival in demand. In Europe the social programs in place have mitigated the impact of the economic collapse to some extent, and the more balanced economy of the continent may be better placed in a revival led by Asia, as exports pick up, and commodity demand increases.

The Lehman Collapse on September 14th 2008 was the earthquake that quickly set off a number of powerful chain reactions across markets and the real economy, and contributed to the grim situation that the U.S. is faced with at the moment. Still, few would suggest that the crisis began with the Lehman bankruptcy. The Lehman Event was only the point where the markets suddenly realized how unrealistically high the expectations were, and as such, it is just one of the symptoms of the crisis, not one of its causes.

People pore over the details of the Lehman Bankruptcy to find lessons and create maxims that can be applied to the future. Yet the real significance of the Lehman collapse was not in the fact that it happened, but that it happened so late. If Henry Paulson and Ben Bernanke had decided to bail out one more firm, instead of one less, today we would not be discussing this collapse. Instead they decided that Lehman was too much, and the result is the turmoil that ensued. Lehman, in that sense, was an unlucky representative of the recklessness in the finance sector, since it is hard to argue that Merrill Lynch, Citigroup (C), or AIG were any more sensible or prudent in the way that they managed their risk.

Not quite strangulation, of course, but given that banks are already cowed to contracting credit to all but the most creditworthy among their customers, it is clear that the new proposals of the G-20 finance ministers are not exactly that much of a change for the industry.

In fact, it is just preaching to the pious in this case, as banks in Europe and the U.S. still hold very large amounts of their assets in highly liquid assets, or directly at the central bank in order to ensure survival in case that turmoil returns.

Sunday’s elections in Japan have resulted in a fundamental shift in the composition of the Japanese House of Representatives, with the decades old Liberal Democratic Party reduced to a minority, and the untested, barely ten-years old Democratic Party of Japan elevated to a position of total dominance with control of both houses of the Japanese Diet. Although Japan had a brief experience with a non-LDP government in 1993, at that time the LDP was far more powerful, and the opposition fragmented and weak in terms of seats occupied. For the first time since the end of the Second World War, the corrupt, bureaucratic, inert, and inefficient defenders of the status-quo are giving way to a new, and untested government. Clearly this is a historic result for Japan, and it will have major consequences for the world of economics as well.

The head of DPJ, Yukio Hatoyama, is almost certain to be the next prime minister of Japan. He comes from one of the important political dynasties of the country, and like many other leaders of the DPJ, is a former member of the LDP. Before Mr. Hatoyama left LDP in 1993 to join the cause of the reformists, he was a member of the powerful Tanaka faction headed by the powerful, corrupt, and jailed upstart Kakuei Tanaka. The previous leader of DPJ between 2006 and 2009, Ichiro Ozawa, has recently been forced to leave the party leadership due to a corruption scandal, and if he had not made the unfortunate mistake, he would have been the prime minister today. True to the ninja tradition, and in line with the ancient customs of LDP, Mr. Ozawa is notorious for the many backroom deals he concluded, and the numerous intrigues he spun throughout his long career as a Japanese politician.

In July exports fell by a 23% annual rate in China. In six out of the past seven months prices have been falling. Unrest in Tibet and the Eastern Xinjiang Province continues to bring widespread international condemnation of Chinese policy. Economic growth is expected to slow to eight percent this year, even by the unreliable statistics of a closed, controlled society like China.

Fortunately (or not quite so, depending on your point of view), the Chinese have read well on their American textbooks of air economics, and bubble growth strategies, and do not shrink from applying the lessons learnt. In a bid to outdo the living masters of the art, Mr. Greenspan and Ben Bernanke, they are inflating money supply and bank lending at a rate which puts even the most ardent supporters of quantitative easing to shame. In the past six months alone, Chinese banks, under government dictate, have expanded credit by a massive $1.1 trillion. Non-performing loans? Asset bubbles? Inefficiency? Such worries are only for the faint of heart, the monetary authorities of China argue, as they join the global rodeo-ride on the ocean waves of liquidity.

The flow of funds data released a while ago by the Federal Reserve summarizes the purported recovery of this year in a succinct, and striking fashion. During the first quarter of this year, domestic financial debt in the U.S. grew by around 4 percent in annualized terms, while both the household and corporate sector obligations shrank. The growth in debt was entirely the result of massive government spending on both the state and federal levels. Both the speed of expansion in government debt, and the speed of contraction on the private sector exceed the levels of the previous recession in 2001 by a large margin.

So the question is, will this massive government intervention allow the private sector the breathing space it needs in order to shrink its balance sheet, regain its health and resume its role as the driver of economic growth? The answer would be yes, in the absence of any unpredictable shocks external to the economic picture.

As speculation over the future of the recent formidable risk rally intensifies, signs that the market has overextended itself are accumulating. The clearly unfavorable fundamental environment aside, technical valuations, and the VIX are both signaling that the market has gone too far, too fast, with little concrete proof of a real economic recovery. We believe that the exuberance evident in the inflated prices of both the stock and forex market create ideal conditions for a reality check in the coming months. In addition, the kind of economic shock that we had in the past two years would require a double bottom to end, even in the unlikely case of a complete recovery.

All along the course of this rally, the troubles of the financial sector, and the sufferings of the consumer have been continuing, if not worsening in severity. The problematic assets held by financial institutions are not being purged due to the vigorous attempts of the government at painting an illusory picture of fundamental health in the financial sector. The main purpose of these attempts is preventing further asset depreciation, including stock market crashes, which hit the consumer hard, and have political consequences. Apart from rising consumer bankruptcies, and continuing foreclosure activity in the residential real estate sector, banks are also troubled by the turmoil in the commercial real estate market where prices have fallen by more than thirty percent since August 2007, and still do not give any sign of bottoming. Commercial real estate projects initiated in the boom years of the U.S. economy were by no means stress-tested to survive in today’s brutal reality. More and more bankruptcies in this field are probable, since refinancing opportunities remain limited. Although the government will surely intervene in this field, the most that it can hope is stemming price depreciation. And that certainly isn’t enough to save the economy from a protracted period of stagnation.

The S&P 500 has been rallying vigorously all these past months, and there is little doubt that what we have seen so far this year is encouraging for optimists. The markets are responding strongly to the bullish momentum created by government stimulus, bailouts, the various incentive programs and the global cooperation aimed at creating a coordinated response to the economic crisis. Oil has recently touched $70 per barrel, while gold is lingering at a level close to $1000 for many months now.

What causes the recent rally is well-understood. Inventory liquidation, government spending, debt creation, and many other practices aimed at inflating the economy, and discouraging people from saving have created considerable enthusiasm in the markets for a sustained and credible rebound. The markets can sustain themselves even in the absence of favorable data, if optimism about the immediate future can somehow be maintained. The years following the 1929 stock market collapse, and our own debacle which followed the turmoil of 2007, have provided enough examples of euphoric vacillations which have been invalidated in the ongoing scheme of events. There was certainly no shortage of fairy tales throughout this crisis, and we would be surprised if analysts and commentators were to abandon bullishness right in the middle of another bonanza of good news.

An economic recovery cannot occur without a significant rebound in global trade. Global trade cannot be revived without a recovery. The difficulty in this relationship goes far beyond semantics. Governments have been pumping gigantic amounts of money to revive global economic activity, and businesses are responding as liquidated inventories need to be restocked, and industries must restart producing some goods. But how long can they keep producing if trade itself cannot be revived somehow? And can government intervention, and similar artificial means substitute for the absence of real private demand in an economy? These are the questions that the drivers of the supposed bull market, and heralds of the new age of economic resurgence must answer.

Last year’s collapse in shipping and trade volumes was nothing short of catastrophic. Machines that were hauling tens of thousands of tons of cargo were suddenly kept busy with hundreds. Shipping rates suffered falls close to an unlikely hundred percent in some cases. This year has seen trade volumes hold their ground a lot better, and overall activity by value has not changed much between January and today. Government intervention in export credit and insurance business ensured that the sudden shock of September-December did not translate to a global meltdown of the financial system, and that much is good and desirable. However, while the symptoms of the global economic malaise were thus successfully dealt with, the dynamics that created the large shock for trade have not been addressed, and they must remain a major source of concern for bulls and politicians alike.

This is the question asked by many traders who want to tie the purported beginning of the bull market to some real fundamental improvement in the economy.

As the economy moves out of the slump, it is argued, the Fed will be forced to admit that it cannot keep rates at where they are for long without kindling the risk of rampant inflation.

On July 21, Chairman of the Federal Reserve, Ben Bernanke, is scheduled to deliver his semi-annual report on monetary policy and the state of the U.S. economy before Congress. During the report, Mr. Bernanke will surely face questions about the the ultimate liquidation of the large sums of debt the Fed has accumulated on behalf of the American government during the past year. Should we expect anything substantial from this event?

The value of his testimonies become most evident in light of his previous predictions and analyses. After all, this semi-annual meeting with the Congress was where he declared his conviction that the total cost of the subprime crisis would not exceed $100 billion. Today he’s facing the representatives of the American people in order to explain, in part, how he will deflate the $1 trillion dollar balance sheet with which he has been trying to tackle the issues arising from the complications of the same subprime problem.

Last week’s release of non-farm payrolls data was a reality check for the bulls. Expectations of a V-shaped recovery following the severe collapse of the past year were sullied by the larger than anticipated job losses, and the release of the relatively more positive ISM data did not do much to cheer up the markets either.

At this stage, it is important to keep these developments in context. This recession has been ongoing for more than a year and a half by now, and we must expect some rebound to occur sooner or later, as inventory liquidations, capacity reductions and labor discharges create a bearish extreme in the economy. It is only natural that such a severe contraction will be followed by a period of readjustment, during which positive growth should not be surprising. The question that must be asked is, will this period of shallow growth, or contraction translate to new job openings, greater capital spending, business investment, and confidence for the private sector? We can be reasonably confident that it will not. And there are many interesting details in the recent release that reinforce this conviction.

Commodities have been staging a strong rally for the past few months, fueled by the expectation that government stimulus packages, extensive bailouts, and hundreds of billions of funds slated by the IMF for the rescue of troubled emerging markets should sooner or later end the headlong collapse of global economic activity. The rally has been particularly striking in copper where the glut was partially eliminated by a bout of Chinese purchases aimed at bailing out the domestic producers. Similarly, oil has made a remarkable comeback, and zinc, lead, aluminum, and tin have all risen comfortably above the lows of December 2008.

The uptrend in prices is confirmed by shipping prices, global demand forecasts, and port congestion data, but the picture here is diverse. Even as oil is rallying, Saudi crude exports to the U.S. have fallen to the lowest level since 1988, according to the U.S. Department of Energy. The International Grains Council is predicting a fall of 10 million MT in wheat demand for this year over 2008, while iron and steel demand in China remains firm, no doubt bolstered by the credit bonanza, and government spending outlook.

In many ways, the U.S. recession of 2008-2009 resembles Japan’s own economic debacle in the 90s and beyond. An overly confident national mood, appreciating asset prices, coupled with a ballooning real estate market and a heavily indebted corporate sector were the triggers of the long slump and the decades long bear market in Japan in the 90s. A look at the long-term chart of the Nikkei is a good indication of how bad it could get for the world and the US in the coming years. Rallies that lasted for years, declarations of bull markets did not manage to color the pale picture of the underlying bear market which has been ongoing for about two decades.

Is Japan in any better shape in this crisis? Yes and no. Japan’s corporate culture, and its sense of invincibility had a severe beating and a reality check once the bubble of the 80s burst. But as usual in a capitalist system, this has also allowed Japanese firms to adopt some aspects of the ruthless Western style of management, ensuring a more dynamic environment where the principle of survival of the fittest is applied with greater vigor.

One important difference between a bull and a bear market lies in volatility. Rising markets are often accompanied by falling volatility, while bear markets are coupled to rising volatility in most cases.

The cause of this is not hard to determine: in a bull market traders feel more confident about holding an asset in the face of adverse shocks, as confidence in the economy itself reduces the amount of emotional buying and selling.