Betting on Inflation

Posted on: by .

The UK just reported DEFLATION (-.1% for September) for the first time since 1960. Deflation is a huge concern for the Fed. We have seen a strong rally in the dollar and a huge drop in commodities. What many fail to realize is there is a link between the dollar and commodities. It is time to start thinking of putting on positions to bet on a rise in inflation.

Betting on Inflation

In traditional economic environments we tend to look at commodities individually, looking at oil prices during the driving season, heating oil during the winter, gold vs. silver spread, corn during food shortages, orange juice during frosts, etc. We look at how environment, trade, and localized conditions impact these commodities on an individual basis.

The dollar however has a broader role to play with commodities. A vast majority of commodities are not only priced and traded in U.S. dollars in the financial futures markets, but also in the spot and international trade markets. The Petro-dollar relationship has handcuffed oil to the dollar, forbid the U.S. from exporting oil, and has tied us to a long-term and committed relationship to Saudi Arabia and OPEC (which has included military actions in the Middle East).

Courtesy of FRED

Dollar Factor

When the dollar increases against foreign currencies it creates deflationary pressure on import prices and commodities. The Fed has even mentioned their concern about deflationary pressure as their monetary policies are trying to create modest inflation with a target of 2% or is it 2.5% (CPI, PPI, PCE). We have seen oil prices fall and that has translated to a decline at the gas pumps. Broader commodity prices have declined, especially in the metals markets.

Courtesy of FRED

A big part of the dollar rally and the commodity decline, which has brought forth general deflationary pressures, was when the Fed took the first “Hawkish” steps and ended QE3. (Note: the Fed continues to buy government bonds and MBS, so QE hasn’t really totally ended). The announcement set an expectation that the Fed was going to start raising rates, reducing the money supply, and shrinking their $4+ trillion balance sheet.

You could say the dollar rally was front running the expectations that Fed rate hikes and tightening would soon follow the end of QE3. Expectations were for the first quarter of 2015, then in June, then September, now October or perhaps December. But as the expected Fed Rate hikes are getting pushed off meeting to meeting, the dollar rally is stalling.

Now with the concern of a global economic slow-down, recent weak job numbers, and an earnings season that is forecasting a slowdown in top-line revenue – the perception is shifting that the Fed might NOT hike rates in 2015 or even early 2016.

If the general perception changes from one of expecting a Hawkish Fed in the coming year to one of a cautious and Dovish Fed, then the dollar will sell off and that will send commodity prices higher and drive inflation higher.

We must remember the Fed is very concerned about deflation and any rate hike that will fuel a stronger dollar will also fuel more pressure on commodity prices and more deflationary pressure. This is another reason why the Fed will be reluctant to raise rates.

There is a growing possibility the Fed may not just pause on hiking rates, but actually reverse course and become more accommodative and ramp up another QE or similar program. That could devalue the dollar more rapidly and also fuel commodity prices higher.

Deflation NOT a concern?

It’s certainly a balancing act, the Fed fears Deflation but they also don’t want to fuel hyper-inflation. They may just be stuck, in which they can’t raise rates but they also can’t become too accommodative.

Personally I think broad deflationary concerns are not warranted. True the oil is down and so are gas prices, which has created what seems to be deflationary pressure and the dollar rally is a big part of that. But if we look at the M1 and M2 money supply and then compare it to the non-existent velocity of money, there seems to be a very real and concern that inflation could rocket out of control. The non-existent velocity looks like a loaded spring of potential energy that we can’t see. Imagine if velocity picks up on the trillions of newly created money supply? We could see double digit inflation upon us in no time.

Courtesy of FRED

The Money Dam

Historically you never see double digit inflation until it is upon you. It comes fast and hard. Those that say, “Where is this inflation you are concerned about?” – It reminds me of a town down river of a huge dam saying – “Where is this big flood you are concerned about?” It is easy to take those towns folk and point to the old dam that could break at any time and the trillions of gallons of water that could wash away their town. It is a little harder with inflation, but you can point to the increase in M1 and M2 money supply (trillions since the crisis) and then point to the dam, which is the velocity of money – which is showing you the money is NOT moving, it is building behind the dam. When the dam breaks, the flood of water and money is upon you fast. Ask anyone that has lived through a FLASH flood, you don’t see it coming and you don’t expect it. Ask anyone that has lived through a double-digit or hyperinflation environment, they just don’t see it coming.

Courtesy of FRED

When does the dam break?

I don’t think it is a question of if, but a question of when. We have had years of money flooding behind the dam and building. The strong dollar is creating what seems concerning deflationary pressure, but once you realize it is not the laws of commodity supply and demand, but rather the dollar appreciation you realize the deflationary pressure is really based on the dollar.

The Fed is not going to hike rates anytime soon, but they may also keep the myth alive that they will. I am not sure if they are willing – yet – to take a more accommodative action. Regardless the dollar rally and inflation dam is only getting bigger.

Frankly I don’t know how much bigger or how much longer the inflation dam will hold. I could easily hold through the beginning of 2016 and even into the election cycle. If we are to ONLY consider Fed policy and positioning, without any outside forces at play.

However, there are many outside catalyst that can break the dam:

  • BRICS and/or China take on a more aggressive currency stance and protect the Yuan.
  • China is already selling treasuries, as are other nations. If they become more aggressive in selling U.S. treasuries.
  • Oil repricing – if OPEC decides to reprice oil out of dollars and breaking the Petro-dollar agreement. This could be a factor if Congress lifts the oil-export ban, if U.S. expands oil production, oil trade deals with Mexico/Canada, and/or China takes a larger role in oil imports with the Middle East.
  • Trade Agreements – trade agreements can fuel protectionism and tariffs, which can fuel currency volatility that drives up inflation.

All if it comes down to the pressures that could fuel a broader and more aggressive currency war.

Position now

Now is a time to start positioning yourself long in commodities and reducing your dollar exposure. A broad based commodity position via funds or ETFs is a simple way to take a commodity position. I would also look at increased gold and silver holdings at these levels.

We might not see the dollar weaken yet or commodities rally, but you don’t want to be chasing it when you it starts ramping.

The equity markets broadly look to see more volatility, so getting generally long equities needs to be hedged. Certainly if the Fed remains accommodative we could see the equity markets continue to rally this year and I think that is a real possibility – remember if the dollar declines that could fuel stock prices to rise further on inflationary pressure.

The housing market could also get a boost if the dollar declines and the Fed remains accommodative. It could bring a flood of foreign money into the U.S. markets.

Assets rise when the dollar declines and right now commodities are getting into or are already undervalued compared to other asset classes. Some economists are looking at 2017-2018 before we see real inflation pressure, but don’t wait now. I would start taking on some positions now. Even if it is only 10% of your portfolio, get something on today.

Support & Resistance

INDU 16,800 – 17,400
This is a range I think we could be in during earnings season and prior to the Fed’s October FOMC meeting. I would look at 17,000 as a straddle strike.

NDX 4300 – 4400
This is the general range, but we could see a jolt move to 4500 or 4200 based on any over-weight earnings surprises. Expect volatility until the Fed sets the tone.

SPX 1980 – 2060
This is a broad range, with weak earnings we could see moves lower and if the Fed seems like they will not raise rates we could get jolts higher. 2020 seems to be a short-term resistance level.

RUT 1140 – 1180
The Russell is showing some weakness and if we can’t get up to 1180 soon and on some strength, we could be revisiting the 1140 level prior to the FOMC meeting later this month.

The more dovish the perception of the Fed is the more we can rally, the more hawkish (rate hikes) the more this market will come under pressure.

The UK reported DEFLATION and that is a bogey man the Fed does NOT want to see. A Deflationary print in their CPI, PPI, or PCE indicators will certainly confirm the Fed will NOT raise rates and could even fuel more talk of accommodation.

That would fuel inflation pressures, dollar weakness, and commodity rally.

Comments are closed.