Commodities, Inflation, and the Coming Crack-Up Boom
Inflation (growth in the supply of money) is by far the most important driver of the current long-term bull market in commodities. Specifically, rapid growth in the GLOBAL supply of money has resulted in the devaluation of currencies relative to commodities. Other asset classes, including equities and real estate, have also benefited from the inflation, but commodities have been the biggest beneficiaries because they commenced the current cycle at very under-valued levels relative to just about everything else. On the other hand, US equities commenced the current cycle at very over-valued levels relative to just about everything else and have therefore benefited from the inflation to a much lesser extent. In general terms, inflation is creating a rolling boom/bust cycle with relative scarcity and valuation determining the asset classes that benefit the most during a particular cycle.
Another important factor has been the failure of bond yields to respond in the usual way to the obvious evidence of currency depreciation. What we've had, in effect, is the combination of persistently high inflation (money-supply growth and the associated fall in the purchasing power of money) and persistently low inflation expectations. In other words, despite the bountiful evidence that most currencies are depreciating at rapid rates, confidence in the currencies and the central banks that sponsor them has stayed at a reasonably high level. This has led to gold, the confidence barometer, putting in a sub-par performance relative to most other metals. It has also set the stage for dramatic out-performance by gold over the coming several years because we can be sure of two things: First, that the inflation will continue (there will be interruptions from time to time, but governments and their central banks have gone so far down the inflation path that turning back is no longer an option); and second, that the inflation will EVENTUALLY cause monetary confidence to collapse. A collapse in monetary confidence resulting from an extended period of high inflation is what Ludwig von Mises referred to as a "crack-up boom".
Inflation affects currency purchasing power in a non-uniform and non-linear manner, resulting, early in the inflation cycle, in the consequences of excessive money-supply growth being evident in only a few sectors of the economy and in the general appearance of purchasing power stability. The widespread belief is thus fostered that a high rate of money-supply growth isn't really a problem in the "modern economy". As described by von Mises (www.mises.org/humanaction/chap17sec8.asp):
"This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.
But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them."
The world appears to be moving inexorably toward a collapse in monetary confidence, or "crack-up boom". However, while we can be reasonably certain about the eventual outcome we cannot be certain about the timing. Our guess is that the collapse won't occur until next decade, but it could begin at any time and with little warning because things tend to go 'haywire' all of a sudden when confidence in a currency reaches the tipping point (the point when the masses finally wake up). In the current environment it is therefore important to maintain a substantial core position in gold-related investments at all times.
Current Market Situation
There are often links between different markets, but these links usually aren't as strong as they've been over the past year. The following chart, for instance, shows that over the past 12 months the CRB Index and the euro have effectively been 'joined at the hip'.
The close relationship between the CRB Index and the euro reflected on the following chart suggests that the next significant downturn in the euro will be accompanied by a significant downturn in commodity prices. Or, putting it another way, when the US$ eventually commences a rally worthy of the name it will likely be accompanied by weakness in commodity prices. This, in turn, means that when the euro embarks on its next downward trend the commodity currencies such as the AUD and the CAD are likely to do the same.
Further to the above and as is currently the case with most markets, the short-term 'key' for the commodity market is the US$. To be more specific, the commodity market is likely to remain buoyant as long as the Dollar Index continues its downward drift; and to sink once the dollar begins to trend upward.
We continue to believe that the US$ is close to a bottom, but there is nothing in the dollar's price action or in the performances of inter-related markets to indicate that a bottom is already in place.
16 October 2007
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