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How Safe Are We in Our Anti-inflation Bets?

Amidst the G-20 summit vociferous chorus of contradicting viewpoints and arguments on how to save the global economy, a pragmatic investor is more concerned about safety of his holdings rather than outcome of heating up currency wars and trade protectionism. Few doubt that the US Fed’s $600 bn liquidity expansion program is pro-inflationary. Yet many US investors are in denial that hard assets more or less accurately track the volume of dollars in circulation quoting current deflationary environment and risk aversion benefitting value of the greenback. Luckily, the markets aren’t that blunt and straightforward in their everchanging sentiment, so we are granted an opportunity to drill down the params of yet another downward correction to find our if this time it is going to last. Again and again, more and more signs and factors witness short life of the commodity bear.

Safe haven advocates are forced to be more and more creative to prompt an average investor to resume buying into the US dollar and "riskless” securities such as the US banking stocks, whose flawlessly staged rally on Wednesday amazed many miracle believers. The Achilles’ heel of the riskier frontier universe is, doubtlessly, the euro. The more Irish scenario resembles one of Greece dated back in May, the higher chances for the dollar bulls to upset numerous critics of the QE2.

Let us investigate, however, if the local dollar strength and rally in commodities are mutually exclusive. Solution of this problem can properly address majority of the current market’s "unusual uncertainties”. The greatest disinsentive for the commodity bulls at the earlier stages of current financial crisis was the paradigm of "when the US sneezes the rest of the world catches cold”. Another word, commodities are known to be highly cyclical investment media, and it would have been totally reckless to plunge into it amidst global recession. Nowadays, as fewer economists speak of any uniform economic trend around the globe, commodities (with gold being a recognized poster child) more and more play a purely anti-inflationary, rather than a "bet on growth”, role. Let us illustrate this thesis.

Above presented is the correlation chart between the Dollar Index and the Gold Spot. Beginning end of September’10, when markets entered so-called "money-printing rally”, the correlation became negative. It means during the dollar strength periods gold performed more and more independently. This phenomenon appears even more evident if we look at the Dollar Index/WTI correlation chart:

Contrary to what many think, crude has rarely been a pure "economy growth” story. Finally, investigating the Dollar Index/Spot Copper correlation graph, we really don’t have to sleep on it:

Largely thanks to the China’s buying spree, copper looks a totally independent trend-setter. One can be relatively safe buying into the red metal on dips, irrespective of how strong current dollar and "risk aversion” sentiment. Many think, that since copper has been purely a "China story”, one should be advised instead to track China’s economic growth, retail sales and ad hoc demand forecast, in order to keep benefiting from copper appreciation. Our further research strongly points that such an approach would be too simplistic:

Although correlation between the performance of copper and Chinese retail sales, illustrated above, remains positive, it has been substantially easing. Unfortunately, since we don’t have a graphical tool quantifying inflationary expectations at our disposal, our study cannot be considered complete. Nevertheless, many factors strongly hint that most commodities are neither the "cyclical recovery” nor a "China’s sentiment” plays, but largely the anti-inflationary media.

Disclosure: Long DBA, TBT