We appear to be at a turning point not only for the dollar, but for all commodity markets, including precious metals, as well. The dollar has yet to reflect properly the enormous monetary expansion of recent years, and commodities will be corralled into supplying China’s Asian reformation. Taken together, the effect of a falling dollar and rising commodity prices, including energy, will drive price inflation upwards more violently than currently expected. This article looks at both these issues in turn.

The tenth anniversary of monetary rescue

This month is the tenth anniversary of a sudden increase in reserve balances at the Fed. From August 2008 onwards, the Fed began buying assets from commercial banks, thereby injecting money conjured up out of thin air into the banking system. Before August 2008, total bank reserves rarely exceeded $10bn. 

Since then, bank reserves at the Fed increased to a staggering $2,786.9bn at the peak in January 2014. Between August 2008 and today, true money supply, a reflection of bank lending, has increased by just over ten trillion dollars, the equivalent of 65% of today’s private sector US GDP. It now stands at 100% of private sector GDP, representing an unprecedented growth in monetary inflation for any developed nation in modern times. It is still working its way into rising prices.^[i]

However, an increase in the general level of prices appears to be the last thing on the minds of economists and investors. It is an odd paradox that price inflation is being ignored, spurred perhaps by the deliberate under-recording of it in official statistics. Behind it all appears to be an extreme fear that a global financial and economic meltdown is brewing, which will force foreigners to buy the dollar to cover dollar loans. But as I showed in two recent articles, this is a delusion, with speculators misunderstanding the true position.^[ii] Furthermore, there are about $75 trillion of derivatives covering currency risk, so the idea that the currency world is a simplistic one with future currency risks unanticipated is simply nonsense.

Foreigners are already up to their eyeballs in dollars anyway, having invested an estimated nine trillion dollars in US dollar assets since the Lehman crisis at the last count. Doubtless, portfolio flows have recently added to that in order to take advantage of higher US treasury bond yields than that obtained from German and Japanese sovereign debt. Furthermore, in addition to portfolio and commercial dollar investments, foreigners owned over $4 trillion of liquidity in correspondent banks at the last date of record. It almost certainly over $5 trillion today.^[iii] Furthermore, with the annual budget deficit accelerating into trillion-dollar figures from the next financial year, trade deficits, despite Trump’s tariffs, are also on their way to similar numbers, unless the American consumer suddenly decides to start saving.

That is unlikely. But fear of a financial crisis is not misplaced, but timing and form are the issues. There are two possible paths towards it, or perhaps a hybrid of the two. The Fed may be forced to raise interest rates to curb inflation more rapidly than is currently expected, in which case there will come a point where the interest cost of working capital fatally undermines established business calculations, leading to a conventional credit crisis. Alternatively, events may conspire to drive up stock markets into further overvaluation territory, as was the case in 1928-29, leading to a financial crash that directly undermines the US economy.

Now that the US economy is awash with foreign-owned dollars, foreigners are more likely to turn sellers in a crisis and drive the dollar down than be further buyers over and above dollars accumulated through trade. This is markedly different from US and Japanese corporations covering their exposure to emerging market currencies, as was the case during the Asian crisis in the late 1990s when they drove the dollar and yen up. 

Speculators take the precedent of a rising dollar leading to a new emerging market crisis so seriously that they have become incredibly myopic. They are not thinking through the consequences of a financial crisis for the dollar, otherwise, they would not take out short positions in everything just to go long of it.

It bears repeating that in the event of a financial crisis, central banks have one and only one response. They have a morbid fear of deflation, an ill-defined condition characterized by a fall in the general price level. They believe that a rise in the general price level is healthy and believe they can regulate it by reducing interest rates and injecting more money into the system. In other words, they always stand ready to flood the economy with yet more money.

It is also worth pointing out that every bull market in equities is a wall of worry, and this one has been no different. Even after ten years of recovery from the last crisis, it is still conventional wisdom to worry about the euro and the Eurozone banking system. The imminent collapse of China’s economic miracle under a sea of debt is another often voiced concern. Now we have the collapse of the Turkish lira, the South African Rand, and the cross-infection into other vulnerable currencies. The slowing down of monetary growth accompanied by a flat yield curve in the bond markets is today’s favorite with monetarists, and we have been repeatedly warned about the overhang of unproductive debt. 

These are all issues that central banks can deal with, or do not really matter. Central banks are very good at smothering systemic risk and keeping the game going, as the bears should have learned over the last nine years. Over which time, incidentally, the S&P500 Index has tripled and is still breaking new high ground.

The ending of almost all credit cycles occurs with unbridled optimism, and we are nowhere near that condition. When equity markets peak before the economy, usually due to rising interest rates, optimism is then to be found in the economy itself. If equity markets become wildly over-extended, as was the case in 1928-29 and 1999-2000, that is where the optimism lies and goes no further. In either case, we are emotionally not there yet.

The global economy is probably growing more rapidly than recorded by government statistics. The best indicator we have is the developing shortages of skilled labor. That doesn’t mean that the Fed, for example, will get ahead of the curve and raise interest rates, sufficiently to head off price inflation. The members of its FOMC are equally infected with worries about the future as are the investing public, and, as history has repeatedly shown, they only raise rates reluctantly.

We shall see, but these two separate paths into the immediate future, a wildly over-valued stock market or growing industrial optimism, will both lead to price inflation, measured in unbacked fiat dollars, irrespective of interest rates. 

A credit crisis is triggered not by the overload of debt as commonly thought, but by the rising cost of working capital and is the one risk wholly beyond the control of central banks. It is the principal risk created by the central banks themselves, a consequence of their expansion of money and the reduction of interest rates as a response to the previous crisis. The cycle of interventions has been getting more destabilizing with every cycle, and every cycle ends with an interest-rate driven crisis.

You do not have to be a slick hedge fund manager to understand that based on the massive expansion of the quantity of money over the last ten years, price inflation, not an ill-defined deflationary collapse, is what the future holds. The majority of professional investors are fixated on the latter as the immediate danger, which if anything, goes to show how distorted from reality markets have become.