Inflation Is Coming! Inflation Is Coming!

By Chris Mayer
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Inflation Is Coming! Inflation Is Coming!

11/15/10 Gaithersburg, Maryland – If Paul Revere were around, maybe he’d get on his horse and start yelling, “Inflation is coming! Inflation is coming!” I think it is coming. In fact, in many ways, it’s already here, just not yet widely recognized. The deflationists still hold sway in the bond market, where investors happily accept puny yields.

The deflationists argue that the dollar will buy more tomorrow than it does today. It is inflation’s opposite. When most people talk about inflation and deflation, this is what they mean. This definition would pain the old economists who were more careful in their use of language.

Be that as it may, deflation today is an argument facing death by a thousand cuts. Every day, evidence rolls showing that the dollar is buying less. Today’s Wall Street Journal points to the whale in the aquarium. One headline reads, “From Cereal to Helicopters, Commodity Costs Exert Pressure.”

The article goes on to point out what is painfully obvious to anyone who follows commodities and companies. The cost of nearly everything is going up. General Mills will boost the price of a quarter of its cereals to reflect rising prices for grains. Kraft is raising prices. Domino’s Pizza hasn’t said it will yet, but it did say the price of cheese is up 29% from a year ago. Profit margins are suffering in the meantime.

There is a long list of companies battling rising costs of the commodities. As the Journal notes: “Corn is up 44%, milk is up 6.5%, hot rolled coil steel is up 4%, copper is up 29% and oil is up 14% from a year ago… Across Corporate America, more companies are wrestling with when and how much to raise prices as raw materials costs climb.”

Still, the Journal’s article had no discernible effect on the optimistic bondholders. (Or should I write “bag holders”? For soon, they will be left holding the bag.) The bond market seemed bored and yields inched up just a touch today, such that the 10-year note recently paid a whopping 2.50%.

By the time the bond market says inflation is here, it will be too late – too late for bondholders. In the meantime, the prices of gold and silver are up too. All of these things point to the obvious: The dollar is buying less.

Why?

Let us the count the ways. There is the US government bleeding red ink and heavily in debt. Both factors portend bad things ahead. How will they square the circle? The easiest – and the most politically expedient – way is to print more money.

There is the jawboning going on between central banks of the world all trying to cheapen their currencies. The rationale is to stimulate exports. But don’t be fooled; the real effect of a cheapened currency is that your dollar will buy less. There are all kinds of fancy names for what the Fed is doing – “quantitative easing” comes to mind. But at bottom, they all mean the Fed will create more money.

I was at Grant’s Fall Conference in NYC recently. Jim Grant, the host and editor of the excellent newsletter Grant’s Interest Rate Observer, said: “Don’t you sometimes get the feeling that the economists are pulling our leg? A bartender would call it watering the whiskey.”

That is a good way to think about it. More dollar-printing simply dilutes the buying power of all dollars. And so we see today the beginnings, the mere sprouts, of a fully-fledged inflation. It can and will get much worse.

Don’t pay attention to that thing called the Consumer Price Index, or CPI. It is running at about 2%. It is an engineered figure and not to be trusted. Oskar Morgenstern, who along with John von Neumann contributed so much to game theory, once described it as a “mere index of doubtful validity,” as Grant relayed.

Nonetheless, on the basis of this suspect fluff, the Fed tells us inflation is under control. In fact, the Fed is complaining that the inflation rate may be too low. As Grant quipped, “That’s like the New York Police Department complaining about the lack of crimes.”

Bernanke would have us believe the Fed can calibrate inflation within tolerances of 100 basis points. But it way overestimates its powers. Once the inflation train gets going, it will be very hard to slow down. One day, the Fed will wish inflation were only 2%.

In the meantime, what to do?

I think we do what we have always done in my investment letter, Capital & Crisis: We try our best to invest intelligently. That includes investing in commodity companies that benefit from a higher inflation rate. Their selling prices will rise faster than their costs.

The price of commodities adjusts quickly to the falling dollar. Wages always lag that. Plus, there are fixed costs that adjust more slowly – such as leases, for example. So there will be a window for commodity companies to make some serious hay.

Investing intelligently also includes investing in good businesses at good prices, especially if they have the opportunity to grow much larger over time.

Chris Mayer
for The Daily Reckoning

__________________
"Patriotism means being loyal to your country all the time and to its government when it deserves it."-- Mark Twain

"Inter arma silent Musae"--when the weapons speak, the muses fall silent.

An't nanum hearm deth, doth hwaet ye willath.

It is forbidden to kill; therefore all murderers are punished
unless they kill in large numbers and to the sound of trumpets. -Voltaire

Economic Left/Right: -3.88
Authoritarian/Libertarian: -4.36

Why Commodities are Rallying as Currencies Decline

By Eric Fry


11/10/10 Laguna Beach, California –



Cotton…silver…palladium…nickel…corn.


What do these things have in common?


Answer: They are not a dollar bill. And neither are they a euro (EUR) or a renminbi (CNY) or a rupee (INR)…or any of the other currencies that central bankers around the world are aggressively debasing.


“It’s not just our own Federal Reserve that wants to destroy its currency,” observes Chris Mayer, editor of Capital & Crisis. “It seems everybody is doing it. As Eric Sprott, a great investor hailing from the Great White North, recently noted in his Markets at a Glance letter:


‘By our count, no less than 23 separate countries have now intervened in the foreign exchange market in some way since Sept. 21, 2010. The goal for all is to increase the supply of their respective paper currencies in order to drive them down in value.’
“Investors, though, aren’t dummies – at least not always. That’s why real assets are rallying.”
The nearby chart tells the tale. Commodities, as an asset class, have become quasi-currencies. From gold to coffee to cattle, commodities of all types have been soaring in price, ever since the Federal Reserve publicly declared its war on deflation. General Bernanke vowed to conduct this war aggressively and to utilize a battlefield tactic he called “quantitative easing.”


The war has been underway for several months, but victory is nowhere in sight. Instead the battlefield is littered with the remains of dollar bills that once seemed so powerful and full of potential.


Seeing the results of this campaign, investors are growing increasingly fearful of taking sides with the US dollar. Instead, they are placing their security in the hands of gold, silver, platinum and numerous other commodities. As such, every major commodity has outperformed the S&P 500’s 8.8% gain for the year to date. Only zinc and cocoa trail behind.


In a world where every major paper currency is suspect, gold is a compelling alternative. But it is not the only alternative. As reliable stores of value, a bale of cotton or a bushel of wheat also seemed preferable to paper currencies.
“And, as if [commodities] needed another reason to rally,” co-editor, Joel Bowman, observed earlier this week, “China is betting on ‘stuff’ over ‘paper.’


“Reports Barron’s: ‘This year, for the first time ever, China has been investing more overseas in assets like iron, oil and copper than it puts into US government bonds.


“‘China in this year’s first half spent $31 billion on hard assets,’ the journal continues, ‘compared with $23 billion on Treasuries and other US government bonds. Experts say China’s investments in each of these asset classes will total about $55 billion for the full year. But even a tie marks a major turnaround from China’s previous practices. For many years, the mainland spent next to nothing on hard assets abroad, while its purchases of US government debt ranged as high as $100 billion a year.’”


Monetary tastes and habits – like culinary tastes and habits – do not change overnight. But once these habits begin to change, they rarely regress to their previous condition. General Bernanke would be unwise to ignore this tendency of human behavior.
McDonald’s opened its first restaurant in China in 1990 – trying to sell hamburgers to rice- and chicken-eaters. Twenty years later, 1,100 McDonald’s restaurants dot the Chinese landscape…and 1,000 more will open by 2014. Tastes rarely change quickly, but when they do change, they usually change forever.


The Chinese, the world’s largest buyers of Treasury debt, are slowly changing their monetary tastes and habits – preferring hard assets over US paper. Likewise, global commodity markets are telling us loud and clear that many, many investors around the world are also changing their monetary tastes and habits – also preferring hard assets over US paper.


But in the midst of these evolving long-term trends, short-term counter-trends sporadically arrive – usually with a surprising fury and intensity. Yesterday was one of those moments. Gold, silver and platinum, along with almost every other major commodity traced out what chartists call an “outside day reversal.” In other words, these commodities advanced strongly early in the trading session to exceed the prior day’s highs, but then reversed later in the trading session to finish the day below the prior day’s lows. And most of these commodities performed this volatile feat on extremely high volume. Net-net, a classic outside day reversal – the kind of pattern that usually signals the end of the rally, at least temporarily.
“This could be a blowoff day for the precious metals,” options pro, Jay Shartsis remarked during yesterday’s trading session. “I note the SLV (IShares Silver Trust) is trading huge volume. It opened at $27.80 and hit $28.30. If it closes near the bottom of the day, a sharp drop seems likely. First hint will be a decline below the opening of $27.80…I am buying puts on Pan American Silver”


Three hours after Jay’s missive, SLV closed the trading session at $26.18, thereby confirming his bearish expectation.


So the red-hot precious metals sector has decided to take a well-deserved breather. In all likelihood this breather will last a while – a few days at least, a few weeks perhaps. But the long-term trend for silver, gold and most other commodities remains unchanged. As long as the Fed and 22 other like-minded central bankers are racing one another to devalue their currencies, commodities will remain “well bid.”


“If you are worried about gold tanking, you shouldn’t be,” says Chris Mayer. “Gold has lots of room to move higher. It is a metal whose value depends on the dilution of paper currencies. As the central banks of the world have expressly told us that they intend to dilute their currencies, you should have few worries about gold’s price…and natural resources should still be a good sandbox to play in to make a lot of money and protect your wealth against inflation.”
Amen.
Eric Fry

__________________
"Patriotism means being loyal to your country all the time and to its government when it deserves it."-- Mark Twain

"Inter arma silent Musae"--when the weapons speak, the muses fall silent.

An't nanum hearm deth, doth hwaet ye willath.

It is forbidden to kill; therefore all murderers are punished
unless they kill in large numbers and to the sound of trumpets. -Voltaire

Economic Left/Right: -3.88
Authoritarian/Libertarian: -4.36

Financial measures that a country introduces have internal and external effects.

An immediate external effect of Quantitative Easing 2 (QE2) was that the price of the Dollar fell by about 3 Cents and that the gold price in return jumped up by about $40/ounce. Yet, this effect was of a temporary nature only. It lasted for a few days. By now, the Dollar is where it was before QE2 relative to the other currencies, and the gold price has also assumed its former value.

This is not too surprising. The market reacts quickly to predictions made by the investors, but corrects itself when these predictions aren't followed up by actions fairly quickly.

It seems that the attention span of the investors is just as short as that of newspaper readers. One day everyone looks at the U.S., and already the very next day, everyone's focus is on Ireland, and whatever happened the day before is old news.

Another immediate external effect of QE2 was that it tanked the prospect that the G20 might come up with a common set of financial policies in Seoul. This effect may be a little longer lived than the policy-driven correction of the financial markets.

The internal effects are maybe a bit more permanent. A deflationary market hurts the producers, because it is difficult to reduce the salaries of your employees without firing them and replacing them by new ones. Thus, the production cost is not reduced, but the price obtained for the goods goes down, which reduces the profit margins.

For this reason, the producers may prefer a bit of inflation, because it is easier to keep the salary increases below the inflation figures, which leads to higher profits ... at least, that's the theory.

Whether it works in practice is hard to predict, because there are other intervening factors. Yet on principle, the concept is sound. The salaries in the U.S. are too high on the global markets, thus they will need to get reduced before goods produced in the U.S. can again be sold profitably on the international markets (the same problem that Europe has). Until such time, it makes more sense to outsource the production to places where the goods can be produced more cheaply, leading to higher unemployment in the U.S. Thus, inflation may have a tendency of reducing unemployment figures.

Also, inflation coupled with a devaluation of the currency leads to an implicit reduction in foreign debt, which the U.S. needs badly. The question is whether the train wreck can still be prevented at all. Huge debt simply is huge debt. There is no way around it.

The Australian Financial Review reports today from New York:

The US economy is still battling deflationary pressures, deepening the Federal Reserve's concern that the United States could face a painful bout of falling prices and wages akin to Japan's in recent decades.

US wholesale or producer prices for finished goods rose a seasonally adjusted 0.4 per cent in October, the Labor Department said. But after stripping out volatile prices for food and energy, prices fell by 0.6 per cent, the largest dip in more than four years.

Economists hd forecase a 0.1 per cent increase in the core figure but slack in the economy and weak end demand is putting pressure on prices and holding back the economic recovery. [...]

Omigod, the US economy is bound for IMMINENT DESTRUCTION!