History - The Great Teacher

The Daily Reckoning PRESENTS: We are now living in an inflationary war cycle. Over the coming decade, Puru Saxena expects massive inflation (money-supply growth) and worsening geopolitical conflicts. During such a hostile environment, commodities (especially gold and silver) are likely to outperform every other asset-class…


At present, there is a lot of noise about a “commodities bubble.” The majority of “experts” are convinced that commodity prices have risen too much and they’ll collapse. On the other hand, stocks and bonds are being touted as bargains – or as the foolproof road to riches and financial freedom! These days, the mainstream media is awash with analysts who are claiming that commodities will suffer due to rising interest rates. Frankly, I find their argument totally absurd.

History has shown that commodity prices are positively correlated to the direction of interest rates. On the other hand, financial assets such as stocks and bonds are negatively correlated to interest rates.

During the 1970’s, interest rates soared and this period coincided with a gigantic bull-market in commodities. Despite sky-high interest rates, all the commodities went up several-fold! It is interesting to note that the 1970’s saw a vicious bear market in stocks and bonds. Back then, the United States underwent a huge recession and Britain had to be bailed out by the IMF. Interest rates peaked in the early 1980’s and this coincided with the end of the commodities boom. In the following two decades, both interest rates and commodities declined whilst stocks and bonds witnessed a huge boom.

There is no doubt that the previous commodities boom took place amidst rising interest rates and a severe recession. So, next time when the “experts” claim that commodities are about to collapse because of rising interest rates and a slowing economy, perhaps you can direct them to a good history teacher!

I’ll let you in on a secret, which is essential to your success as an investor. You must understand that the central banks don’t raise interest rates to fight inflation. After all, the modern-day central banking system is inflation! Central banks raise or lower interest rates in order to manage the public’s inflation fears or expectations. During such times when the public wakes up to the inflation problem and starts losing faith in the world’s paper currencies (present scenario), central banks raise interest rates to show that they’re fighting inflation. Interest rates are pulled up in an effort to restore confidence in the world’s currencies as a higher yield makes currencies more attractive. On the other hand, when the public’s inflation fears are under control and confidence in the monetary system is high, central banks lower interest rates to create even more inflation!

During cycles of monetary easing, the rate of inflation (money-supply and credit growth) accelerates, thereby creating an economic boom. During periods of monetary tightening (such as now), the rate of inflation (money-supply and credit growth) slows down temporarily, causing financial accidents in a highly leveraged global economy. Make no mistake though, the response or cure offered by the central banks to every financial accident is always more inflation and credit.

At present, every central bank has assumed the role of an “inflation-fighter!” Interest rates are being increased in the majority of countries under the pretence of controlling inflation. However, it is worth noting that despite rising interest rates, our world is still awash in liquidity. Recently, the non-gold foreign exchange reserves held by the central banks rose to a record $4.4 trillion U.S., up nearly 10% year-on-year! Emerging nations held a record $3.07 trillion U.S. and the developed nations held a near-record $1.33 trillion U.S.

Opinion is divided as to whether interest rates will continue to rise. The majority seems to think that the Federal Reserve won’t raise interest rates much further for the fear of seriously hurting the housing boom. However, I feel that the U.S. interest rates will have to continue to rise or else the U.S. dollar may stage a dramatic decline. Given a choice between protecting either the housing boom or an outright collapse in the U.S. dollar, I can assure you that the Federal Reserve will choose the latter. The truth is that the Federal Reserve exports U.S. dollars to the entire world and it’ll do everything in its power to delay the destruction of its merchandise. In summary, I concede that the Federal Reserve may pause during the second half of this year to offer some respite before the U.S. mid-term election in November. However, the major trend is now up and interest rates may well be in double-digits within five years.

If my above assessment is correct, you can bet your bottom dollar that stocks, bonds and property are going to come under serious pressure. Already, the real-estate market in the United States is showing signs of a slowdown as the establishment tries to engineer a soft landing. In my opinion, we now amidst a global housing bubble, which will eventually deflate due to rising borrowing costs. It is interesting to note that the bond yields fell between 1981 and 2003. As the cost of borrowing declined, housing as well as bond prices went through the roof! However, in June 2003, bond-yields bottomed out and have been rising ever since. Over the past three years, the cost of borrowing has become more expensive and we’re beginning to see its impact on the slowing real-estate markets worldwide. The U.S. 10-year Treasury yield has now broken out of its 20-year downtrend and this is an ominous development. This breakout points to much higher interest rates in the future, so I’d have to advise you to sell your leveraged properties and bonds without further delay. The great bull market in bonds ended in June 2003 and this is not a good time to be invested in fixed-income assets.

In the past, I’ve stated that in a highly inflationary environment, stocks, commodities and real estate can all rise at the same time. Basically, an over-supply of paper money causes its purchasing power to diminish. I still maintain that over the coming decade, even if all assets (with the exception of bonds) continue to rise, I expect commodities to outperform all other asset classes on a relative basis.


Puru Saxena
for The Daily Reckoning
July 19, 2006

Editor’s Note: Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication available at www.purusaxena.com

An investment adviser based in Hong Kong, Saxena is a regular guest on CNN, BBC World, CNBC, Bloomberg TV & Radio, NDTV, RTHK Radio 3, and he also writes for several newspapers and financial journals.

The above is an excerpt from Money Matters, a monthly economic publication, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly reports, subscribers also benefit from timely and concise “E-mail Updates,” which are sent out when an important development in the capital markets warrants immediate attention. Click here to subscribe:

Money Matters

Israeli troops crossed the border into Lebanon yesterday.

Markets typically react to “geopolitical risk,” sometimes exaggerating the danger…sometimes brushing it off. Yesterday, investors judged the war in Lebanon only a minor threat. Gold fell $22 to $629. And oil sold off, to just over $75.

Now, markets, like democracies, can never really be wrong; there is no higher authority. If they say oil is worth $75 a barrel and no more, then that is what it is worth.

But, the burden of today’s little reflection is that investors could, and should, change their minds. Not that we have any idea what the future will bring. The gods still keep their secrets. But the past blabs: oil and war is a dangerous mixture.

Investors are aware, of course, that war affects oil. It was war in the Levant that drove up the price of oil in the ’70s and caused the worst world economic slowdown since the ’30s. Every hint of war since has caused the oil market to shudder.

However, what is under-appreciated, in our view, is how oil affects war. With the advent of mechanized warfare, oil – not superior generalship or better weapons – has been decisive. In World War I, Germany could not win because oil had already become the key ingredient of modern warfare and it didn’t have any. In World War II, oil was even more important. The Allied war effort was fueled by abundant stocks of Texas crude, while the Axis powers were always running out of gas at critical moments. The Germans were beaten in the desert of North Africa largely because Rommel’s tanks went dry. And at the battle of the Bulge, again, the poor Krauts were undone by lack of vernacular as well as lack of combustible. Posing as an American soldier – a Wehrmacht trooper asked for “benzene” instead of “gas.”

In both Europe and Asia, Axis strategies slipped up on oil. The Huns made for the oilfields of Rumania. The Japanese had a go at Pearl Harbor. Not that Hawaii was an oil producer. The Nippon high command attacked the American base after Japan had been cutoff from supplies of Texas oil. At that point, it saw no choice but to try to cripple the U.S. fleet, so that it couldn’t interdict oil supplies to Japan from other countries! In both cases, Asia and Eurasia, the oil-centered strategy proved fatal; it shifted the focus of the campaign from destroying the enemy to protecting fuel lines. Hitler moved forces from the crucial attack on Moscow to the south, in order to secure his oil supplies. Tojo stretched out his army throughout the South Pacific in order to protect his “Southern Resource Area.”

We don’t know how much oil-centric thinking entered the minds of America’s strategic planners for the war in Iraq, or if they did any serious thinking at all. In Robert MacNamara’s memoir of his time as head of the U.S. Defense Department during the Vietnam War, the “brightest and best” apparently spent a lot of time trying to figure out how to win the war, but somehow forgot to think about why they were fighting in the first place. In any event the war was lost…and it made no difference.

Still, we can’t help but notice the way the world has turned since 1945. The Texas oil fields peaked out 30 years ago. The North Sea rigs hit maximum production two years ago. Now, it is the Anglo-American empire that fears for its oil supplies and bends its wars to fit its energy needs.

America today, like Japan and Germany in the 1930s, buys most of its oil on the open market. And like the Axis powers in the ’30s, most of the world’s oil comes from places that it cannot control, without stretching its military forces beyond their abilities – the Middle East, Russia, Venezuela. Looking backwards, it is easy to see that the Germans and Japanese would have been better off building up their economies, rather than their military forces. They could have stayed out of imperial politics and bought the oil they needed. Would the same course be best for the United States too?

More news from our pundit of world currency…


Chuck Butler reporting from the EverBank trading desk:

“I fully expect the Reserve Bank of Australia to raise rates at their next meeting in August. Once we get past this risk-aversion phase we’re in right now, I can see the dollar getting hit on all sides.”

Chuck has more on interest rates in today’s Daily Pfennig


Back to Bill Bonner, across the pond…

*** Oprah denies she’s gay. Pamela Anderson is getting married. The Israelis are on the ground in Lebanon. Who has any time or attention left to think? Not us. We’ve been wondering about Oprah for a long time. And Pam Anderson. We’re so happy for her.

*** The war in Lebanon might be worth thinking about. Not the war itself…after so many years of wars, terrorist attacks, walls, bombings, peace talks, and truces, who can still care what happens? No, what interests us is the explosive mixture of oil and war. And what the market is saying about it, which is not much.

The market is probably right, in the sense that the war is not likely to have much effect on the actual quantity of available oil. But we think it fails to entirely appreciate the risk. The financial importance of any move, after all, is determined by multiplying the likelihood of it times the consequences. The likelihood of an oil shortage may be slight. But the consequences may be so catastrophic that investors should be taking precautions. They should be buying gold, and hoping the price drops below $600 again, so they can buy more.

A lack of oil distorts a military power’s strategy…and probably dooms it to defeat. What was a barrel of oil worth to Hirohito in 1944? Or to Rommel in 1943? Almost an infinite amount.

What will a barrel of oil really be worth to America in 2006…2007…or 2008? We don’t know, but a higher price will have extremely prejudicial consequences for the economy.  When Americans buy oil, they take dollars out of their pockets and send them to oil producers. As the price rises, they are left with fewer dollars to buy anything else.

Already, reports of weakness in the consumer economy are drifting into camp like soldiers after a major defeat – wounded, hungry and discouraged. House prices are slipping on both coasts. Today’s news brings a report from Philadelphia, South Jersey and Delaware: house prices are going down in the mid-Atlantic region. Yesterday’s news told us of falling prices even in San Diego. And “Orange County foreclosures rising sharply,” adds a headline today.

Retailers’ stocks are in decline. “Target lowering sales forecast,” says the Wall Street Journal. Builders are collapsing. Auto sales are falling. Employment growth is softening. And real consumer spending is slowing.

And here comes news that the federal deficit is shrinking. Good news for the long run, but bad news for here and now. With consumers forced to come to their senses, the only reckless spendthrift left may be the U.S. government.

We have no way of reading tomorrow’s headlines, but we think we know what some might tell us: people in the summer of 2006 failed to appreciate the risks of oil and war.

*** Your editor normally wears a tie to work. He does so out of habit…and because, along with his age, it gives him a slight distinction. New employees often mistake him for someone of authority.

But he is sans cravat today. “Record Heat on Buses, Tube” is one of today’s top headlines in London. To us, veterans of the Maryland Tidewater, it seems rather pleasant and comfortable. We walked home from work yesterday, about an hour and a half, without breaking a sweat. But the English aren’t used to heat.

Men have taken off their jackets and ties. Women have stripped down, too. You used to have to pay good money to see them in such a state of undress. But that was a long time ago…and far, far away.

The Daily Reckoning