The Untold Inflation Story: Investor Risks and Opportunities

Inflation in England surged to 3.7% in December 2010, almost double the Bank of England’s target rate of two-percent inflation. And what will England’s central bank do about rapid inflation? It will need to raise interest rates above its current posted bank rate of half-of-one-percent.

In Canada, where the central bank actually raised interest rates twice last year, inflation sits at exactly two percent—the Bank of Canada’s target rate. If the inflation rate rises in Canada to 2.5% or three percent, I believe the central bank there will move quickly to raise interest rates again.

Coming back to the United States…

The posted inflation rate for December 2010 was 1.5%. Well below the Fed’s target of two percent. Why the concern if inflation is only 1.5%? There is plenty of concern about inflation and very few analysts (other than me) are concerned about it.

Food prices are rising throughout the world; inflationary. The price of oil is getting close to $100.00 U.S. a barrel again; inflationary. Large American companies are posting their best profits in years; inflationary. The stock market has been rising for 22 months; inflationary. Most importantly, all the liquidity in the financial system created by the government to stop the credit crisis from worsening, to put an end to the worse recession since the Great Depression, is inflationary.

Inflation in the U.S. will follow the path of inflation in the U.K. and move higher over 2011. But, unlike the Bank of England, I believe the Federal Reserve will move very quickly to raise interest rates as inflation rises.

The risks to investors are plentiful. Throughout history, rising inflation has meant rising interest rates. Rising interest rates result in lower stock prices and lower bond prices (the later of which is already happening).

The major benefit for investors of rising inflation is rising gold prices. Seasonally, January to March of each year are the worst months for gold bullion prices. Hopefully, my readers are using this opportunity to buy more gold-related investments.

Michael’s Personal Notes:

This morning, the yield on the 90-day U.S. T-bills is up to 0.155%. Not a big deal, but let’s look at it a little closer.

When the credit crisis arrived in 2008, there was a run to the safety of short-term U.S. Treasuries, which sent down yields sharply. A Federal Funds Rate of zero has also been keeping short-term bond yields down.

I expect to see the standard 90-day U.S. T-bill soon hit a yield of 0.16%. At that point, the yield on 90-day U.S. T-bill will be at its highest level since August of 2009. Hence, it is not just long-term rates that are rising; pressure is slowly mounting on short-term rates as well.

Yesterday, in an interview on Bloomberg’s InBusiness, a former U.S. Treasury official who has moved on to work for Pimco, Neel Kashkari, said that the U.S. may face a debt crisis and foreign buyers of U.S. Treasuries may look elsewhere without action by the government to limit spending. This is basically the tune I have been singing for months.

Each day, I end with the same question in my mind: how can interest rates not rise?

Where the Market Stands:

The Dow Jones Industrial Average opens this fine morning up 2.1% for the year and only 175 points away from Dow Jones 12,000.

The amount of bullishness among investors and advisors continues to amaze me. But who can blame them? Almost everything we read tells us the economy is improving and corporate earnings are strong, why wouldn’t the stock market rise? Listen to CNBC late in the day and you can’t help but feel bullish.

But, in my 30 years of following and analyzing the stock market, I’ve never seen the market deliver what is expected of it. At the depth of the crisis, when it looked like there was no end in sight to the spiraling downward trend of the U.S. economy, the stock market started to rise, and it has risen for 22 months.

Now that investors and advisors think that the worst of the recession is behind us, and that the market will move higher, a contrarian like me can’t help but turn bearish.

The bear market rally in stocks that started in March of 2009 is alive and well. I expect more immediate-term gains by the market, but short- to long-term, I’m turning bearish.

What He Said:

“I see the coming recession being deep and difficult, because U.S. consumers do not have the savings to spend their way out of the recession. The same thing happened in Japan. The Japan example proved that, when consumer confidence is shattered, even zero percent interest won’t spur consumer spending. The same thing could happen here.” Michael Lombardi in PROFIT CONFIDENTIAL, August 23, 2006. Michael started talking about and predicting the financial catastrophe we started experiencing in 2008 long before anyone else.