The Road to Hyperinflation

As most of us who have been watching the financial markets know, yesterday was quite a day. The Federal Reserve announced they would print money to buy Treasuries and mortgage-backed securities.

The Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

The market promptly responded:

1. Gold shot up and stayed up; it is currently trading at $958 at the time of this writing. Silver is rallying as well, trading at $13.48 per ounce at the time of this writing.
2. The US dollar dropped sharply against all other major currencies.
3. Crude oil rallied above $50 per barrel.
4. Treasuries rallied.

From these events, we can deduce two things:

1. The Fed is clearly aggressively pursuing its an inflationary monetary policy. This is further evidence that the Fed can do what it wants; if the Fed is truly determined to inflate, it will be able to do so, regardless of whether or not banks will lend. Monetary policy is a fiat matter.

2. The market is clearly willing to run from the dollar in the face of outright monetization.

As money supply is expanding while demand for US dollars is collapsing, and as dissatisfaction with the political environment in the United States is at a nearly unprecedented level, it is clear the ingredients for hyperinflation are in place. See our previous analysis of hyperinflation for a more detailed explanation.

Moreover, CPI data released yesterday by the Labor Department in the US noted that consumer prices rose for the second consecutive month. Should this trend continue, it sets the stage for a price/wage spiral, whereby higher prices lead to higher wages, which in turn lead to higher prices, and so. Declines in demand due to higher prices may not be sufficient to stop prices from rising further should the Fed continue an inflationary policy.

The New Trading Environment

As we have discussed before, "playing defense" against monetary policy is crucial to wealth preservation in a centrally planned economy. Based on the signals the market and the monetary authorities have recently given us, here are some trading thoughts for the near future:

1. Gold and silver. I've advocated precious metals many times before, and continue to do so, as they are the conventional inflation hedge, and remain the market's monetary commodities of choice.

2. As the Fed is distorting the free market process in the Treasury market through intervention, Treasuries may be difficult to trade without technical analysis.

3. Watch oil. Should it continue to rise, which seems very likely to me, it would be further evidence of an inflationary spiral, as rising oil prices will lead to rising gas prices, which in turn will lead to rising prices, and a demand for rising wages. With that said, I find oil's behavior a bit perplexing, and thus I personally favor precious metals as an inflation hedge. Those with a larger capital base and a need to diversify, though, may seek solace in oil.

4. The stock market remains a trader's environment, even more so than before. Those who can use technical analysis to understand momentum will be best positioned to find profits in the stock market, in my opinion. Fundamental analysis will be less effective, as the Fed's interventionist behavior will make rational analysis difficult and perhaps fruitless.

Disclosure: Long gold and silver.

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The Case for the Australian Dollar as a Long-Term Trade

One of my favorite currencies on a three year outlook is the Australian dollar. There are three reasons for this:

1. In light of the increase in US government spending and the diminishing tax base, I think substantial dollar devaluation is likely over the next 3-4 years. This increases pressure to "decouple" -- specifically for China to discontinue buying US Treasury bonds, and to invest that capital into its own economy, which it has been doing. As China invests more in its own domestic economy, it will boost the economies of geographically related countries that can export necessary commodities to China. That's where Australia comes in.

2. Australia's central bank, the Reserve Bank of Australia, currently has an interest rate target of 3.25%. In a world where zero percent interest rates are becoming the norm, this is quite appealing, and may attract capital that is seeking the security and liquidity of a currency but with an interest rate yield as well. Put another way, the Australian dollar could be the new carry trade.

3. The Australian economy has, at least for now, remained relatively unscathed by the global economic crisis. In Australia, wages are up, business investments are up, retail sales are increasing, the housing sector is expanding, and the country si running a trade surplus.

In light of the aforementioned, the Australian Dollar seems like a viable long-term alternative to the British pound and the US dollar.

Trading the Australian Dollar

Personally I've been riding the recent short-term rally in AUDJPY (Australian dollar against the Japanese yen), though price action is suggesting this rally may be out of steam in the short-term. Patient traders, though, may wish to keep an eye on AUDUSD and look to enter as momentum turns upwards. The chart below illustrates key price points that can serve as areas where prices may consolidate -- and thus where traders can look to enter or exit positions.

Disclosure: Long Australian dollar.

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