Raining on the Inflation Parade

By: Seth_Barani

The major components of the dollar index are Euro, Yen and Pound. If Euro and Pound are expected to struggle from sovereign debt crises and Yen to be kept weak by BOJ intervention, why will dollar index fall? Predictions of a weak $DXY (under 70) seem to be built on shaky grounds. The present formula to calculate the dollar index is a very poor representation of dollar's purchasing power, since it does not take into account prices of asset-vehicles beyond a few forex currencies some of which are also manipulated by central banks. It is our belief that dollar index does not show the true nature of inflation/deflation.

Answering a single question would enlighten us about inflation/deflation.

Prices of which items are increasing/decreasing on an annual basis for the past few years?

Answer:

---Gold and fellow metals... prices are going up.
---Everything else....prices are coming down to earth (see references).

If you accept an explanation that gold prices are speculatively driven, then the economy is in a deflationary path. Oil prices fell nearly 50% in five years from its peak. Natural gas prices fell from $12 to $4. Housing indicator is in a free fall after a brief interruption from stimulus.

Even the manufacturing activity in China, the major supplier of retail goods in US, is undergoing a slow down. Goldman Sachs, BNP Paribas and others have cut growth forecasts for China by more than 1% which further points to reduced consumption of fuel and raw materials. Some improved manufacturing was reported at Germany but it remains to be seen whether it is real on an annualized basis.

If ever a tiny indicator of inflation was found, Helicopter Ben wouldn't be talking about QE2 and "unusually uncertain" economic times. Instead, he will be blowing a trumpet of success before Congress. A few months of M2 (money supply) expansion claim by the Federal Reserve might be a red herring. It could include refinancing of mortgage obligations. In fact, Freddie Mac data from the office of Chief Economist (see reference) show that while only 49% of 30 year fixed rate mortgages were refinanced in 2002, nearly 83% of 30 year fixed rate mortgages refinanced in year 2009. Therefore, much of the recent M2 expansion ($400 billion, see reference) comes from a short circuit between the banks and the mortgage borrowers but no money has gone into economic activity.

Therefore, based on the above factors, we argue that deflation is the better descriptor of the present state of US economy. And it won't be long before the speculators took profit in gold (presently at $1298) and silver (at $21.40) sending them crashing to ground. The question unanswered so far is, what would one do, holding on to the greenbacks after selling gold/silver? Where is the next bubble? Certainly won't be Treasury bills. There is little difference between Treasury bills and dollar bills except for liquidity purposes. Both are IOUs. Both fetch similar interests (esp if you plug in the dollars in FDIC insured deposits). We believe the money might move into emerging markets and developing countries. India may be a large beneficiary of capital inflows. USDINR (presently at 46.10) might be a good short now as rupee could strengthen.

References:

Food Prices -

http://www.pbs.org/nbr/site/onair/transcripts/tomatoes_blamed_for_brusing_produce_prices_100715/

Housing Prices -

http://www.cbsnews.com/stories/2010/07/26/national/main6715016.shtml

Oil Prices -

http://blogs.marketwatch.com/fundmastery/2010/09/21/why-are-oil-prices-falling/

Coal and Natural gas Prices -

http://www.commodityonline.com/news/Coal-ETFs-hit-by-falling-natural-gas-prices-31563-3-1.html

Wheat Prices -

http://www.commodityblog.com/commodity-prices-wheat/decreasing-us-wheat-exports-cause-slump-of-prices

Federal Reserve data on M2:

http://www.federalreserve.gov/releases/h6/current/

Freddie Mac data on annualized refinance data:

http://www.freddiemac.com/news/finance/refi_archives.htm

Author Seth Barani is a PhD in physics and is a freelance capital market researcher and trader. He can be reached at s.barani@gmail.com.

© 2010 Copyright Seth Barani - All Rights Reserved
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