The sell-side analysts and economists are reminding retail investors that
risk assets in the United States have been on quite a tear to the upside recently.
A correction now lasts a matter of days, if not hours before the bulls push
equity prices even higher.
The Federal Reserve is winning the reflation war using cheap money and massive
levels of liquidity to help drive risk assets higher and interest rates artificially
lower. Unfortunately for domestic investors searching for yield, they find
that they are forced to incur higher levels of risk in order to satisfy their
growth and income needs. There are significant risks associated with higher
than average fixed income returns and the cost will be felt should we see
any correction in the future.
However, the Federal Reserve has a history that is littered with dismal results.
The purchasing power of the U.S. Dollar has been reduced by more than 90%
since the Fed's inception in late December of 1913. Since that time, the Federal
Reserve has stolen more "real" wealth from the American people than any other
institution in the history of mankind.
The Federal Reserve has two primary functions. One function is to maintain
price stability or in other words to moderate inflation. Clearly over the
past 100 years their inflation track record has been horrific. However, the
Fed's recent track record regarding the value of the U.S. Dollar Index has
been dismal the past 15 years as shown below.
As can be seen clearly above in the Dollar Index Futures monthly chart, at
present levels the Dollar's overall value has diminished well over 31% since
late 2001. I would also draw readers' attention to the selloff that occurred
from late 2005 until the early part of 2008. The selloff during that period
of time is important to reinforce my next consideration.
Recently the flow of liquidity has primarily been seen in record low interest
rates and a surging U.S. equity market. Nearly every day the Dow Jones Industrial
Average or the S&P 500 Indexes make a new all-time high. The question
that I would like to posit for readers is how long will it be before the so-called
smart money starts looking at the attractiveness of commodities relative to
equities?
If the Federal Reserve continues to print money at this pace, what will ultimately
stop them dead in their tracks? The short answer is energy prices. The easiest
way to stop the Fed's printing press is to see a massive spike in energy prices.
While we often hear that history does not repeat but it often rhymes, consider
the price action in oil futures during the same 2006 - 2008 selloff in the
U.S. Dollar Index.
It is readily apparent that once oil futures were able to push above the $78
/ barrel highs in mid-2006, prices exploded while the U.S. Dollar came under
strong selling pressure. The timing could not be more impeccable for the explosive
nature in the move higher in oil.
Furthermore, if we move forward to present day price action in oil futures
we have a large triangle pattern on the long-term charts. The pattern offers
the inflation versus deflation argument that so many economists and strategists
are plagued by presently in their analysis.
My suggestion is that watching the price of oil futures is likely going to
tell us the intermediate expectation by the market of what lies ahead in the
inflation versus deflation debate. The movement of oil futures prices in the
intermediate term is likely to be based on which direction the triangle pattern
ultimately breaks.
What is obvious about this pattern is that a move that could hurdle $100 /
barrel will open up a strong move toward $112 - $120 / barrel. If we were
to see a move higher in oil futures that could push above the $120 / barrel
price level set back in early 2011 a fierce rally in oil futures could play
out.
A strong rally in oil futures will ultimately put the final nail in the coffin
for U.S. equity markets and the U.S. economy. Gasoline prices would obviously
rocket higher and the U.S. economy would quickly be brought to its knees.
The Federal Reserve would be forced to either print more money and run the
risk of higher oil prices, or do nothing and run the risk that the equity
selloff could intensify.
I want to be clear that I am not calling for a rally in oil futures. Price
action could go either way depending on market conditions, but the real question
is regardless of which way price breaks in the future, how does it help equity
markets? Those evil oil speculators run down by politicians seeking air time
on television and radio could be the final straw for Ben Bernanke and the
Federal Reserve.
Whether the future is full of inflation, deflation, or stagflation I am confident
that energy prices will play a critical role in price discovery for not just
oil and oil distillates, but for the overall domestic economy.
If the Fed does not show constraint at the appropriate time, oil and other
commodity prices are likely to remind Chairman Bernanke that the Federal Reserve's
future track record is likely to be as dire as its historical performance.
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