Tag Archives: deflation

Global Economic Slack to End Commodity Rally

This year began with a bang. Our forecasting models accurately predicted many of 2016’s early commodity rallies in metals, energies and grains. Our models also expressed the notion that while these rallies would be sharp, there was little evidence to suggest that this was anything more than a temporary spike in a deflating global economy. Therefore, the persistence of these rallies has been the biggest surprise of the year. However, the same factors that have led us to believe that these rallies would be temporary have only increased their alarm. This week, we’ll examine the primary component of our deflationary argument while also shedding some light on an inspired tweak to an existing measure of global economic activity.

Continue reading Global Economic Slack to End Commodity Rally

Weekly Commodity Strategy Review

This was a light week thanks to those who gave their all.  Thank you to those we honor and support and kindness to the families they’ve left behind.

We began with the development of a classic small speculator short trap in the cotton futures market for Equities.com. We’ve been watching it build all week and finally issued an official COT Buy signal in our nightly discretionary email. Free Trial Available

Buying the Cotton Market’s Decline

Thanks in part to the lightened writing duties this week, I was able to step back and survey the markets as a mosaic. I find this exceptionally helpful in determining the big picture themes. In this case, we determined that these 9 charts are screaming DEFLATION. The world’s bankers may be trying talk rates higher but the boots on the ground are still mired in excess capacity and economic slack.

What Inflation?

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Inflation/Deflation Debate Continues

 

Make Sure You Get This One Right
By Niels C. Jensen

“You can’t beat deflation in a credit-based system.”

Robert Prechter

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct – everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those ‘make or break’ decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or ‘quantitative easing’ as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don’t understand the world of finance or you don’t want to understand. Shame on those who fall for cheap tactics.

Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that ‘less bad’ doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

Chart 1: US GDP Growth Volatility

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a ‘buy and hold’ market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people’s problems than your own. A little bit like raising children, I suppose.

Chart 2: P/E Ratios in Various Countries

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), q
uantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

Chart 3: Broad Money versus Narrow Money

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided.

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

Chart 4: Output Gap & Capacity Utilization

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won’t rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 5)?

Chart 5: The Deflationary Spiral

Good question – counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn’t go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest ‘must have’ amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry’s leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. ‘Get long and get loud’ it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple – with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment retur
ns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government’s point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.

 

An Interesting Case for Bonds

                

This is from John Mauldin’s “Outside the Box.” and provides an interesting perspective on U.S. interest rate futures.This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk in investing in futures.


Quarterly Review
and Outlook – First Quarter 2009

by Van Hoisington
and Dr. Lacy Hunt

 


Inflation/Deflation

Over the next decade, the critical element in any investment portfolio
will be the correct call regarding inflation or its antipode, deflation.
Despite near term deflation risks, the overwhelming consensus view is that
“sooner or later” inflation will inevitably return, probably with
great momentum. This inflationist view of the world seems to rely on two
general propositions. First, the unprecedented increases in the Fed’s
balance sheet are, by definition, inflationary. The Fed has to print money
to restore health to the economy, but ultimately this process will result
in a substantially higher general price level. Second, an unparalleled
surge in federal government spending and massive deficits will stimulate
economic activity. This will serve to reinforce the reflationary efforts of
the Fed and lead to inflation.

These propositions are intuitively attractive. However, they are
beguiling and do not stand the test of history or economic theory. As a
consequence, betting on inflation as a portfolio strategy will be as bad a
bet in the next decade as it has been over the disinflationary period of
the past twenty years when Treasury bonds produced a higher total return
than common stocks. This is a reminder that both stock and Treasury bond
returns are sensitive to inflation, albeit with inverse results.

Economic Theory

If inflation and interest rates were to rise in this recession, or in
the early stages of a recovery, the expansion would be cut short and the
economy would either remain in, or relapse into recession. In late stages
of economic downturns, substantial amounts of unutilized labor and other
resources exist. Thus, both factory utilization and unemployment rates lag
other economic indicators. For instance, reflecting this severe recession,
unused labor and other productive resources have increased sharply. The
yearly percentage decline in household employment is the largest since
current data series began in 1949. In March the unemployment rate stood at
8.5%, up from a cyclical low of 4.4%. This is the highest level since the
early 1980s. The labor department’s broader U6 unemployment rate includes
those less active in the labor markets and working part time because full
time work is not available. The U6 rate of 15.6% in March was the highest
in the 15 year history of the series and up from its cyclical low of 7.9%.
The operating rate for all industries and manufacturing both fell to their
lowest levels on record in March. Manufacturing capacity was around 15%
below the sixty year average (Chart 1). Given these conditions, let’s
assume for the moment that inflation rises immediately. With unemployment
widespread, wages would seriously lag inflation. Thus, real household
income would decline and truncate any potential gain in consumer spending.

Manufacturing Capacity Utilization - Monthly

A technically superior and more complete method of capturing the concept
of excess labor and capacity is the Aggregate Supply and Demand Curve
(Chart 2). Inflation will not commence until the Aggregate Demand (AD)
Curve shifts outward sufficiently to reach the part of the Aggregate Supply
(AS) curve that is upward sloping. The AS curve is perfectly elastic or
horizontal when substantial excess capacity exists. Excess capacity causes
firms to cut staff, wages and other costs. Since wage and benefit costs comprise
about 70% of the cost of production, the AS curve will shift outward,
meaning that prices will be lower at every level of AD. Therefore, multiple
outward shifts in the Aggregate Demand curve will be required before the
economy encounters an upward sloping Aggregate Supply Curve thus creating
higher price levels. In our opinion such a process will take well over a
decade.

An Illustration of the Aggregate Supply Curve during a Period of Substantial Unutilized Resources

Record
Expansion of the Fed’s Balance Sheet and M2

In the past year, the Fed’s balance sheet, as measured by the monetary
base, has nearly doubled from $826 billion last March to $1.64 trillion,
and potentially larger increases are indicated for the future. The
increases already posted are far above the range of historical experience.
Many observers believe that this is the equivalent to printing money, and
that it is only a matter of time until significant inflation erupts. They
recall Milton Friedman’s famous quote that “inflation is always and
everywhere a monetary phenomenon.”

These gigantic increases in the monetary base (or the Fed’s balance
sheet) and M2, however, have not led to the creation of fresh credit or
economic growth. The reason is that M2 is not determined by the monetary
base alone, and GDP is not solely determined by M2. M2 is also determined
by factors the Fed does not control. These include the public’s preference
for checking accounts versus their preference for holding currency or time
and saving deposits and the bank’s needs for excess reserves. These
factors, beyond the Fed’s control, determine what is known as the money
multiplier. M2 is equal to the base times the money multiplier. Over the
past year total reserves, now 50% of the monetary base, increased by about
$736 billion, but excess reserves went up by nearly as much, or about $722
billion, causing the money multiplier to fall (Chart 3). Thus, only $14
billion, or a paltry 1.9% of the massive increase of total reserves, was
available to make loans and investments. Not surprisingly, from December to
March, bank loans fell 5.4% annualized. Moreover, in the three months ended
March, bank credit plus commercial paper posted a record decline.

M2 Money Multiplier and Excess Reserves - monthly

If this all sounds complicated you are right, it is. The bottom line,
however, is that it is totally incorrect to assume that the massive
expansion in reserves created by the Fed is inflationary. Economic activity
cannot move forward unless credit expansion follows reserves expansion.
That is not happening. Too much and poorly financed debt has rendered
monetary policy ineffective.

What about the
M2 Surge?

M2 has increased by over a 14% annual rate over the past six months,
which is in the vicinity of past record growth rates. Liquidity creation or
destruction, in the broadest sense, has two components. The first is
influenced by the Fed and its allies in the banking system, and the second
is outside the banking system in what is often referred to as the shadow
banking system. The equation of exchange (GDP equals M2 multiplied by the
velocity of money or V) captures this relationship. The statement that all
the Fed has to do is print money in order to restore prosperity is not
substantiated by history or theory. An increase in the stock of money will
only lead to a higher GDP if V, or velocity, is stable. V should be thought
of conceptually rather than mechanically. If the stock of money is $1
trillion and total spending is $2 trillion, then V is 2. If spending rises
to $3 trillion and M2 is unchanged, velocity then jumps to 3. While V
cannot be observed without utilizing GDP and M, this does not mean that the
properties of V cannot be understood and analyzed.

The historical record indicates that V may be likened to a symbiotic
relationship of two variables. One is financial innovation and the other is
the degree of leverage in the economy. Financial innovation and greater
leverage go hand in hand, and during those times velocity is generally
above its long-term average of 1.67 (Chart 4). Velocity was generally below
this average when there was a reversal of failed financial innovation and
deleveraging occurred. When innovation and increased leveraging transpired
early in the 20th century, velocity was generally above the long-term
average. After 1928 velocity collapsed, and remained below the average
until the early 1950s as the economy deleveraged. From the early 1950s
through 1980 velocity was relatively stable and never far from 1.67 since
leverage was generally stable in an environment of tight financial
regulation. Since 1980, velocity was well above 1.67, reflecting rapid
financial innovation and substantially greater leverage. With those
innovations having failed miserably, and with the burdensome side of
leverage (i.e. falling asset prices and income streams, but debt remaining)
so apparent, velocity is likely to fall well below 1.67 in the years to
come, compared with a still high 1.77 in the fourth quarter of 2008. Thus,
as the shadow banking system continues to collapse, velocity should move
well below its mean, greatly impairing the efficacy of monetary policy.
This means that M2 growth will not necessarily be transferred into higher
GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded
by 15.7%. The same pattern appears likely in Q1 of this year.

Velocity of Money 1900-2008

The highly ingenious monetary policy devices developed by the Bernanke
Fed may prevent the calamitous events associated with the debt deflation of
the Great Depression, but they do not restore the economy to health quickly
or easily. The problem for the Fed is that it does not control velocity or
the money created outside the banking system.

Washington policy makers are now moving to increase regulation of the
banks and nonbank entities as well. This is seen as necessary as a result
of the excessive and unwise innovations of the past ten or more years.
Thus, the lesson of history offers a perverse twist to the conventional
wisdom. Regulation should be the tightest when leverage is increasing
rapidly, but lax in the face of deleveraging.

Are Massive
Budget Deficits Inflationary?

Based on the calculations of the Congressional Budget Office, U.S.
Government Debt will jump to almost 72% of GDP in just four fiscal years.
As such, this debt ratio would advance to the highest level since 1950 (Chart
5). The conventional wisdom is that this will restore prosperity and higher
inflation will return. Contrarily, the historical record indicates that
massive increases in government debt will weaken the private economy,
thereby hindering rather than speeding an economic recovery. This does not
mean that a recovery will not occur, but time rather than government action
will be the curative factor.

Gross Federal Debt Held by Public as a % of GDP

By weakening the private economy, government borrowing is not an
inflationary threat. Much light on this matter can be shed by examining
Japan from 1988 to the 2008 and the U.S. from 1929 to 1941. In the case of
Japan government debt to GDP ratio surged from 50% to almost 170%. So, if
large increases in government debt were the key to economic prosperity,
Japan would be in the greatest boom of all time. Instead, their economy is
in shambles. After two decades of repeated disappointments, Japan is in the
midst of its worst recession since the end of World War II. In the fourth
quarter, their GDP declined almost twice as fast as that of the U.S. or the
EU. The huge increase in Japanese government debt was created when it
provided funds to salvage failing banks, insurance and other companies,
plus transitory tax relief and make-work projects.

In 2008, after two decades of massive debt increases, the Nikkei 225
average was 77% lower than in 1989, and the yield on long Japanese
Government Bonds was less than 1.5% (Chart 6). As the Government Debt to
GDP ratio surged, interest rates and stock prices fell, reflecting the
negative consequences of the transfer of financial resources from the
private to the public sector (Chart 7). Thus, the fiscal largesse did not
restore Japan to prosperity. The deprivation of private sector funds
suggested that these policy actions served to impede, rather than
facilitate, economic activity.

Japan: Gevernment Debt as a % of GDP and Nikkei Stock Average

Japan: Government Debt as a % of GDP and Long Term Government Rates

This recent Japanese experience mirrors U.S. history from 1929 to 1941
when the ratio of U.S. government debt to GDP almost tripled from 16% to
near 50%. As the U.S. debt ratio rose, long Treasury yields moved lower,
indicating that the private sector was hurt, not helped, by the government’s
efforts. The yearly low in long Treasury yields occurred at 1.95% in 1941,
the last year before full WWII mobilization. In 1941, the S&P 500,
despite some massive rallies in the 1930s, was 62% lower than in 1929, and
had been falling since 1936. Thus, two distinct periods separated by
country and considerable time indicate that stock prices respond
unfavorably to massive government deficit spending and bond yields decline.

The U.S. economy finally recovered during WWII. Some attribute this recovery
to a further increase in Federal debt which peaked at almost 109% of GDP.
However, the dynamics during the War were much different than from those of
1929 through 1941 and today. The U.S. ran huge trade surpluses as we
supplied military and other goods to allies, which served to lift the U.S.
economy through a massive multiplier effect. Additionally, 10% of our
population, or 12 million persons, were moved into military services. This
is equivalent to 30 million people today. Also, mandatory rationing of
goods was instituted and people were essentially forced to use an
unprecedented portion of their income to buy U.S. bonds or other saving
instruments. This unparalleled saving permitted the U.S. economy to recover
from the massive debt acquired prior to 1929.

Bonds Still an
Exceptional Value

Since the 1870s, three extended deflations have occurred–two in the
U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to
2008. All these deflations occurred in the aftermath of an extended period
of “extreme over indebtedness,” a term originally used by Irving
Fisher in his famous 1933 article, “The Debt-Deflation Theory of Great
Depressions.” Fisher argued that debt deflation controlled all, or
nearly all, other economic variables. Although not mentioned by Fisher, the
historical record indicates that the risk premium (the difference between
the total return on stocks and Treasury bonds) is also apparently
controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per
annum more than Treasury bonds, but in deflations the risk premium was
negative. In the U.S. from 1874-94 and 1928-41, Treasury bonds returned
0.9% and 7% per annum, respectively, more than common stocks. In Japan’s
recession from 1988-2008, Treasury bond returns exceeded those on common
stocks by an even greater 8.4%. Thus, historically, risk taking has not
been rewarded in deflation. The premier investment asset has been the long
government bond (Table 1).

Risk Premium During Debt Deflations

This table also speaks to the impact of massive government deficit
spending on stock and bond returns. In the U.S. from 1874-94, no
significant fiscal policy response occurred. The negative consequences of
the extreme over indebtedness were allowed to simply burn out over time.
Discretionary monetary policy did not exist then since the U.S. was on the
Gold Standard. The risk premium was not nearly as negative in the late 19th
century as it was in the U.S. from 1928-41 and in Japan from 1988-2008 when
the government debt to GDP ratio more than tripled in both cases. In the
U.S. 1874-94, at least stocks had a positive return of 4.4%. In the U.S.
1928-41 and in Japan in the past twenty years, stocks posted compound
annual returns of negative 2.4% and 2.3%, respectively. Therefore on a
historical basis, U.S. Treasury bonds should maintain its position as the
premier asset class as the U.S. economy struggles with declining asset
prices, overindebtedness, declining income flows and slow growth.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

 

 

 

Dollar’s Strength an Anomaly?

The U.S. Dollar surged through its daily resistance and is well on its way into the overhead weekly resistance between 75.88 and 77.24. Although the rally has been impressive, it’s important to maintain the perspective that the Dollar is in a bear market. Even if we were able to rally another 300 points, that would only bring us back to the 38% retracement level from the ’06 highs.

Of recent interest in the Dollar’s surge are the factors that television commentators claim are fueling it. The major factors receiving notice are, the decline in energy prices and commodities in general, the European Central Bank’s deflationary comments and finally, the worse than expected jobless claims number. The following factors are deflationary and the U.S. equity markets are rejoicing.

I would ask the question, “Have the preceding factors created a bottom in the economic cycle or, are we seeing a more general global slowdown?” I believe that the domestic economic issues have not been addressed and that a globally deflationary environment will create more problems for the U.S. Dollar than it will solve.

First, examine the chart on import prices. The double top may have proven to be the limit. Clearly, it has already begun to turn down. This index includes oil which, when priced separately, is 5% higher than imports in general. Oil is germaine to the topic because the $25+ decline has NOT been priced in and will contribute greatly to the establishment of this chart’s double top.

If, in fact, overall commodity prices are topping out then, this will also reduce demand for U.S. commodity exports. Exports have helped to offset the declining Dollar over the last two years as global demand and globally anomalous weather patterns have made the U.S. the supply center for the world. Dollar strength and, or a global slowdown will curb the primary growth engine for the U.S. economy. What effect will this have on a sluggish employment picture?

Obviously, the unemployment pressure is still to the upside. Will global commodity deflation offset the cost of a declining employment base? According to many pundits, the tax refund checks have gone to cover current expenses, rather than paying down debt. That leaves many people still looking for meaningful employment opportunities. This is most clearly illustrated in this week’s jobless claims.

The past two weeks’ claims have surpassed the historically significant 450,000 threshold. As you can see from the chart, this threshold is frequently accompanied by a recession. Based on the previous factors, I fail to see continued strength in the U.S. Dollar or, the U.S. economy. While the equity markets have broached the 20% bear market threshold and, recently bounced, I still view this as a selling opportunity in both equities and the Dollar.

It appears that this is beginning to be priced into the interest rate markets as well. Inflationary pressures are easing. This is taking the pressure off of the Federal Reserve Board to tighten rates at the next meeting on September 6th. Furthermore, the declining employment picture will add pressure to hold or, LOWER, rates at meetings through the end of the year. This stance is contrary to the hawkish inflationary stance that has been their premise for much of this year. Finally, the combination of a declining equity market in an election year would also add to the shift in the FOMC’s position from hawkish to dovish. The last chart is beginning to tip the market’s hand as it points to lower rates ahead……once again leading to a lower Dollar.