Thursday, October 18, 2007

"I am a bit suspicious as to why Secretary Paulson is orchestrating an 80 billion dollar fund to alleviate credit concerns. My suspicion lies in the fact that the Fed is running out of bullets when it comes to fighting inflation.

I think Secretary Paulson is desperately trying to alleviate the immediate fallout from a rate hike. Yes, a rate hike.

Inflation is waiting in the shadows and will soon jump out and scare the pants off us.

When taking a sample of prices of products going into the pipeline we come up with a very interesting picture. Food and energy seem to be an underlying culprit.

On the commodity front, high commodity prices over the summer have yet to be priced into the CPI. Commodities, measured by the 19-commodity Reuters/Jefferies CRB Index, rose 8.1 percent in September, the biggest monthly gain in 32 years. Wheat prices have soared 61 percent this year and reached a record $9.6175 Sept. 28 on shrinking inventories. The kicker in the Grain prices is that they are inflated because of demand issues and not because the crop was abnormally small, something that can't be fixed with the next growing season.

I am not going to even go into oil; it's expensive. On the currency front, fourteen of the seventeen currencies from Asia's largest economies appreciated against the US dollar in the past year, with India's rupee having the third-best performance at 16 percent, behind the Australian and New Zealand dollar. Currencies like the Chinese Yuan will have a hard time remaining low with the Chinese CPI hitting 6.5% from the beginning of the year through August.

We are beginning to see these same inflationary pressures show up in the EU. Annual CPI in the Euro-region economy held at 2.1 percent in September, above the ECB's ceiling for a second month. Again, Food and Energy are their biggest concerns.

The situation the Fed will face is best described as being between a rock and a hard place. If they raise rates they could lock up liquidity for short term paper and simultaneously collapse the Yen against the Dollar taking a lot of the carry trade off the table.

One the other hand if the Fed just leaves rates as they are and hope inflation just floats on by, which it won't, we could easily find our economy in stagflation.

I can't see a lot of growth with the cost of living increasing at any greater pace than currently.
Therefore, I think ETFs like the Dow Diamond (DIA), who have a high correlation to Dollar/Yen currency rates and also have developed a high correlation to cheap money, will see the brunt of the ripple effect of higher interest rates and slower growth rates.

During the months of July and August, we witnessed the Dow make about an 11% correction within those respective months and simultaneously saw the Yen/Dollar rate make about a 9% correction. Both of which have recovered since, but that was without inflation."

- Patrick Shilling - Seeking Alpha 10/18/07

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