The Most Important Economic Phenomenon and How to Play It

• By George Kleinman

The most important economic phenomenon lying ahead of us, which we must understand as traders and/or investors, is the inflation-versus-deflation battle.

Below I discuss this most important of all financial phenomena, one poorly understood by the public at large, as we lead into specific ways to position ourselves in the marketplace.

Inflation-or-deflation is a phenomenon not just of money supply, but of money in circulation.

When Federal Reserve Chairman Ben Bernanke was interviewed recently by Congressman Ron Paul (R-TX), one of the smartest guys in Congress, he didn't give the full answer.

Here's an excerpt from that interview (with some additional comments Rep. Paul then gave to correspondent Neil Cavuto):

Ron Paul: So it seems to me that you're in the midst of massive inflation, but I guess you have a different definition. When you double the money supply, that's not inflation itself? Or are you looking at only prices?

Ben Bernanke: "Inflation" is the change in the price of the consumer price level, which is very stable right now, and the various measure of money, as you know, in the broad measures of money, the measures that cut the measures of money in circulation like M1 and M2 are not growing quickly.

Neil Cavuto: So, Congressman, he more or less said your inflation concern was misplaced. What do you make of that?

Ron Paul: Yeah, that's what he said. But when it comes, people will realize they should have been more concerned. Just like he was totally unconcerned about the crisis building. Remember the many years and months before the crisis hit he reassured everybody that there were no problems. So I don't know why we should be reassured by him now saying, "Don't worry about inflation."

But I was trying to make the point that the definitions are different. If you increase the supply of money, that is inflation. It causes harm, even if you don't have your rise in prices yet. But we do have rising prices in medical care and there is a lot of inflation out there.

Neil Cavuto: And you've been arguing that a lot of this federal printing of money led by the Fed and all these rescues and bailouts where we are pulling money out of our you know what, I mean, that's going to be eventually inflationary. Now, to be fair to you, you've been saying this long before even our economists started picking up on this. What is your worry now? How pronounced is this threat? How soon is this threat?

Ron Paul: Well, I don't think you can predict, that's one thing, Austrian economics teaches you that you can predict trends, but not timing and yet, it will come because the money supply has been increased. ...

Neil Cavuto: He said he's going to be ready for that, Congressman, and that the Fed is already ready to act when it happens.

Ron Paul: Yeah, sure.

Neil Cavuto: But you argue once you see it, it's too late to address it.

Ron Paul: Yeah, he also said that he will never monetize the debt. Well, he has no choice. If he doesn't monetize the debt, interest rates are going to skyrocket and that he doesn't want and the financial markets don't want that. So he would be fired rather quickly by the president if he allowed, if he said, if he lived up to saying, "I'm not going to monetize any debt."

Certainly Bernanke didn't create the mess we're in now; his predecessor as Fed chairman Alan Greenspan and President Bush did with help from the publicm, and now Obama and the Congress are pouring salt in the wound.

The policies the Fed has pursued under Bernanke's leadership have arguably avoided a depression, but the fact remains these policies will likely lead to accelerating inflation in the future.

But why are there few signs of inflation at this time?

Before inflation shows up as a result of the inflated money supply, the massive equity loss in real estate, lost wages, etc.--deflationary events--has to be absorbed. The government can increase money supply, but if people are unwilling to spend it, and save or pay off debts instead, deflation can occur because the money in circulation can drop even while the money supply is increasing.

In other words, the global economy has been deflating, and when this process is complete the opposite will take place. With the unprecedented expansion of the money supply, there will inevitably come a time when the velocity of money will come back and cause greatly accelerated inflation.

And, despite what Austrian economics tells us, I believe there is a way to predict the timing. The markets will tell us when this transition is taking place, and most likely the markets will anticipate this change.

Which markets? Certainly gold and long-term Treasury bonds as well as a host of commodities.

Here are specific plays that make sense to me for the longer term.

The charts below are weekly charts, meaning each bar represents one week's price action. The blue line on each chart is the 52-week exponential moving average (EMA), a one-year moving average that represents the major trend.

If the market is trading above the blue line, the assumption is the longer-term trend is up; if it's trading below, this indicates the longer-term trend is down.

Buy Gold on Strength

Weekly Gold, 2007-Present



Source: Commodity.com

Despite all the deflation, gold turned above its 52-week EMA in January and has remained above since then. The pattern could be described as sideways, which is truly a sign of strength in the face of International Monetary Fund gold sales and the deleveraging of the economy.

The near-term trend could remain sideways, however a breakout to the upside, above the $990 level indicated on the chart, would constitute a very bullish development, a sign the inflation is coming, and project much higher gold prices.

Buy the Canadian Dollar

Weekly Canadian Dollar, 2007-Present



Source: Commodity.com

This year the Canadian dollar has already reversed trend from down to up, as indicated on the chart above. The current level, 92 to 93, appears to be a pivot point. If the loonie can remain above the 92.5 level over the coming month or so, my projections are much higher levels, above par to the dollar, like it was trading during 2007.

Sell Treasury Bonds

Weekly Treasury Bond Futures, 2007-Present



Source: Commodity.com

Higher inflation leads to higher interest rates, and long-term Treasury bonds will break down as interest rates go much higher.

Higher interest rates theoretically should support the dollar, but the dollar will weaken in relation to the "commodity currencies," notably the Canadian and Australian dollars, although it might appreciate versus the Japanese yen and the euro.

Note how the 30-year bond futures broke below the 52-week EMA in May.

Buy Select Commodities

Weekly Cotton, 2007-Present



Source: Commodity.com

When gold breaks to the upside, the Canadian dollar breaks to the upside, and Treasury bonds head south, all the pieces of the puzzle will be in place for more inflation.

The place to be in this case will be commodities in general, those commodities that China imports in particular--cotton (depicted in the chart above; note how cotton broke above its 52-week last month), soybeans, copper, coffee and sugar.

These are all markets I trade and we follow with specific recommendations for my subscription-based trading service Futures Market Forecaster.