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Inflation Deflation Chaotic Mix

By Chris Laird      Printer Friendly Version
May 14 2008 10:27AM

Seeing the gold market correct, and oil in a speculation mania, and other commodities with speculation, then combining weakening US consumer demand, one wonders what the heck is going on. The markets are in a chaotic battle between inflation and deflation forces.

The USD is rising, from a bottom around 70. It fell for years since 02. At this 70ish number on the USDX (US dollar index heavily Euro weighted) the USD rebounded. The EU is screaming the Euro is too strong. Germany is the only one who is not screaming. Even so, the EU has a much better trade balance situation (on the whole) than the US.

There are signs that the out of control US trade deficits are cooling. US exports are up significantly with the new cheap dollar. Imports are dropping a bit.

China, India, Japan are feeling some heat from a slowing US consumer…

But, we see inflation gathering steam in the EU, Asia and the Middle East especially, and the US. Energy and food prices are forcing those countries to start addressing inflation pressures. The EU holds interest rates steady due to inflation concerns. The strong Euro certainly has helped Europe to escape the 10% inflation besetting the Middle East and Asia. But the EU still has uncomfortable inflation, and the Germans won’t tolerate inflation.

But on the deflation side, a maxed out US consumer is shifting from a bedraggled housing market to using credit cards to cover expenses. The housing market shows little sign of improving. Morgan stated that the US recession is only beginning. EU housing markets are in trouble now.

When the entire world economy, that was predicated on ever more borrowing from mid 1990 on to now, turns to a tight credit market, you can be sure that many conflicting signals appear.

A very serious world grain shortage is spreading. This is causing serious food inflation, is driving world inflation, and the poorest 1 billion people in Asia who live on (Imagine this!) $2 a day or less and who were paying half or more of their income on rice or bread, now cannot afford to feed themselves. This fact has China, Egypt, India, much of Asia, and poorer South American countries in a quasi panic.

Rising diesel and fertilizer prices are forcing farmers to cut planted acres, cut / cull livestock herds, just when the world needs more, not less food. It is said that, unless the world has record grain harvests in 08, there will be real world famine in 09. So far, what we have seen is some scattered food riots that are scaring the hell out of nations with big poor populations…

There is a report that 25% of the world wheat crop is at serious risk of a new virulent wheat rust that chokes the wheat before it comes to head. (Mid East to Asia). The US has its own concerns over a wheat rust spreading through the Mid West. So, what are the chances of a record grain harvest in 08?

Just to give an idea of the concern about food, China just spent a $400 a ton premium on fertilizer that used to cost $170 a ton Jan 08. It was a huge order. Reason? They are afraid that if they don’t have great harvests this year, tens of millions may starve in 09. It is a grim situation. Other poor countries in Africa, Asia, South America, are also very concerned about grain shortages.

Oil is at record prices (nominally). US economic activity is slowing because of that, not to mention the big drag the housing bubble is putting on things.

There is huge inflation in energy and foods, and other essentials, while in the non essentials there is price weakness. It’s a combination of inflation and deflation. The biggest deflation is in the financial/housing markets being forced to deleverage. There is also some big credit contraction in the Western consumer sector.

In short, there is a conflicting set of signals, some very deflationary, but big inflation in essentials such as food and energy.

Gold is in the midst of a correction from its highs around $1020. It’s now down $150 from that level at $870 ish. I would think gold would be near a bottom. At some point, the inflation in essentials such as food and energy should bring gold back up with it.

Some other markets, such as oil should be due for a correction, as there is likely a $30+ speculation premium. But, as speculation goes, it’s hard to call a top. I would think that oil at $150 would be ripe for a nice correction. There is some significant new refining capacity coming online later this year. Refining bottlenecks are a key driver to higher gas and oil prices.

In all of this, a big speculative involvement in oil, grains, and commodities should be ripe for a fall. Nevertheless, there is so much money searching for a home and going into essentials such as food and energy commodities, since equity markets are stagnant at best, and in Asia, downright in crash territory.

Just a lot of mixed signals out there. It’s not a surprise because the entire world economy is now shifting from an unprecedented Western credit bubble and consumer bubble to a new phase – something else than that, anyway. We can for sure at least say that the world economy after 1995 to 2007 has definitely entered a big phase change. It’s chaotic too.

One thing I would say in this situation is that technical indicators are not as reliable. It’s more important to track the food crisis, the oil bubble, the shift in the USD, and the political instability that will be caused by food riots in 09, than to worry as much about technical indicators that are more of a study of the past markets. When there are big shifts, one has to do more fundamental market analysis. That is our focus. IE very little technical analysis, and more searches for changing market trends.

A number of weeks ago, we predicted the USD had bottomed for subscribers. That has happened. It is possible, that after falling for 5 or 6 years after 2002, the USD is forming a base.

It will be important to see the Fed’s stance on future inflation in the US to determine if that is the case. One thing that is of concern is rising world inflation and probably slowing economic growth.

We would expect that gold and precious metals will form a base well within the long term trend from Aug 06 to the present that extrapolates to around $800. That should be a rough base. At some point, inflation and stagflation should propel gold and precious metals higher. This does depend significantly on developments in the credit crisis, good or bad.

There is a caveat with oil. Oil has a lot of speculation, and if oil falls, gold may fall more with it. Even so, oil would settle, perhaps near $90 or $100 like it did the last time it corrected after hitting $120. The ever present risks of new negative credit market developments would be gold bullish. There is also a caveat that if financial markets sell off, gold would sell off as well during the fall. But gold has show resilience shortly afterward.

It could be said that central banker’s credit crisis battle is inflationary, and that is finding its way into speculation in essentials such as energy and food, and some general commodities.

I would expect gold to remain in its overall up channel, with a range from $750 roughly to $900, even if there was a bunch of oil correcting or world stock sell offs. If oil goes to $150 and or we do not see world stock sell offs, gold can re attain $1000 + this year.

A rising USD would take some of the pressure off rising commodity prices. In fact, it might just be the catalyst for a break in oil and other commodity speculation, and subsequent corrections.

Nevertheless, inflation worldwide is very much in force, and stagflation will ultimately be prevalent, not only in the US but elsewhere. Longer term, that is quite gold friendly.

In the mean time, we await gold to find a bottom. I personally am not worried about the gold and precious metal correction. I view it as a chance to buy some bullion coins. I know that metal stock fans have a tough time riding this volatility. It’s just part of the game, if you like metal stocks.

The Prudent Squirrel newsletter is our financial and gold commentary. Subscribers get 44 newsletters a year on Sundays, and also mid week email alerts as needed. We alerted our subscribers April 20 that the USD was bottoming. The USD has strengthened significantly since. The alerts include quick notification of important financial news developments by email. Subscribers tell us that the alerts alone are worth subscribing for.

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Christopher Laird



Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter and alerts, are general market commentary only. They are not intended as specific advice. You should talk to your own investment professionals for specific advice.

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