Mark Axelowitz, director of wealth management at Morgan Stanley Smith Barney, and adviser to very high net worth individuals, was recently on CNBC's Fast Money program discussing trends that he has noticed among ultra high net worth individuals (see CNBC article).

Source: CNBC Video
Just as many investors are jumping back into stocks, essentially afraid that they may have missed the recent rising market, ultra high new worth individuals are more cautious, and appear to be worried about inflation, the dollar, and of course, taxes. This macro-economic perspective has kept the rich from chasing the recent rally, and instead has them investing heavily in fixed income instead of equities as they shy away from diving into the market with both feet. The rich stay rich for a reason. Maybe it is time to pay attention.

As pointed out in a recent Financial Times opinion piece by Nassim Nicholas Taleb and Mark Spitznagel (see FT article, concepts also expressed in a recent CNBC interview), the core economic problem that we are facing "is that our economic system is laden with debt." In fact, as pointed out by the authors, the debt load is about triple the amount relative to the GDP levels of the 1980s. Given that Tabel and his colleague have been betting on debt-induced hyperflation becoming the next black swan event (see previous post), and making them even more coin in the process, it might be easy to dismiss this as someone simply talking their book - which is probably somewhat the case. Yet the levels of the deficit spending and debt are unprecedented, and scary. Of course, what is possibly even more shocking is how making these levels know and pointing out their consequences is still looked at as a revelation, or at least finally drawing serious concern. It is simply no longer enough to point out the irony of using debt to solve a problem caused by too much debt. That train has already left the station. The focus is finally shifting to those trying to slow down the train before we all get run over.

As pointed out in the FT article, Taleb and Spitznagel believe the only solution to the debt problem is to immediately convert debt to equity. After all, companies in bankruptcy do this all the time - then again, I am not sure what that says about a country and its credit rating [Note: As a follow-up, see the recent Felix Salmon Reuters blog post about the unsustainability of debt-to-equity conversion]. To bolster their case, the authors given three reasons for their concern and reasoning. First, debt and leverage cause the system to become fragile - i.e., there is less room for error. Second, globalization has caused the system to be more complex, which in turn has caused business parameters to be more volatile. Third, and somewhat novel in perspective, is that debt is "highly treacherous." Loans hide volatility since they do not really vary outside of default. Such risk is hidden even more in highly complex derivative products, such as swaps and CDOs.

So what additional steps can governments do to reverse the trends? Tabel and Spitznagel list two options: deflate debt or inflate assets (once again, the authors are betting on the later). What have governments done? Deficit-based stimulus spending. And they are considering more (see previous post). Besides adding more debt, stimulus spending is likely to over- or undershoot since it is difficult to get just right in size and timing. This of course leaves economies vulnerable to inflation, and in some cases creates hyperinflation. Therefore, unless the levels of consumer and government debt are dealt with, and we consider other approaches for dealing with current problems, we are likely to experience another black swan - even one that is large and can be seen flying right towards us.

36 South Investment Managers, the hedge fund managers who made 234 percent betting on "black swan" events in 2008, are now placing their bets on hyperinflation (see Bloomberg article). The new fund, called the Excelsior Fund, is targeting returns that will be five times the average inflation rate for the France, Germany, Japan, U.K., and U.S. economies. The Excelsior Fund will make its bets on inflation by buying long-dated options that are currently cheap (i.e., typically deep-out-of-the-money options). The fund will be using the options to look for increases in commodities and equity prices, along with increases in bond yields and currency volatility. Given that the options are deep-out-of-the-money, the fund will be very high risk, but carry the potential for very high returns.

In Barrons recent cover story (see Barrons article), roundtable members were once again interviewed about their thoughts on the economy, the markets, and select stocks. While there was varying opinion about the short-term outlook, many believe that the market has gotten ahead of itself, with some expressing longer-term concerns - even if the a short-term rally continues. As a hedge against the recent government spending spree and potential coming hyperinflation, some have stressed their continued interest in gold (one analysts with a $850/ounce entry point). The short-term stimulus / long-term worry perspective was articulated by Felix Zulauf, stating that:

"The U.S. economy will look a little better in the next two to three quarters, due to inventory restocking and fiscal stimulus. But the improvement won't continue after mid-2010, when the economy turns bumpy again."

Zulauf goes on to state that:

"The market undershot into March, and will probably overshoot in the first half of next year. The first rally is just about done. The market might climb into July, but it will correct in the fall, with stocks retracing maybe 50% of the recent advance. That will provide an opportunity to buy for a rally next spring or summer. That's the whole mini-bull market. Economic conditions won't support more than that."

Fred Hickey goes on to mention that while there are similarities to the 1930s, the current situation is different in that by adding liquidity, we may be recreating the very problem we were trying to solve. As mentioned by Hickey:

"The situation is reminiscent of the past 14 years, when the Fed primed the pump and created bubbles everywhere."

In a different Barrons article (see second article), Michael Darda, chief economist at MKM Partners, is more optimistic short and long-term, and expects the market to bottom this summer. As evidence, Darda points to the money base, measuring currency-in-circulation, bank reserves, and vault cash (see second Barrons article). The money base is now near a record high of around 2.9 times the stock market's value, a value that is slightly below a higher value in February (right before stocks took off), but below the average of 1.5 over the last 20 years. As Darda points out, the value was below 0.9 times as the stock market peaked in 2007. And while rising yields on the 10-year Treasuries have reduced refinancing, and threaten to lower home prices, Darda points out that what is important is the spread of the yield curve. The current slope is signaling strength, and not giving an inverted slope recession prediction.

But Darda does concede that while futures are pricing in a 50 bps increase in short-term rates by the end of the year, he expects unemployment levels and politics will keep the Fed from raising rates - in what could be a choice of risking a "repeat of the 1970s than a repeat of 1937-1938." This perspective of short-term moves followed by long-term concerns is in line with Arthur Laffer's recent higher inflation / higher interest rates op-ed piece in the WSJ (see previous post). In the article, Laffer highlighted that in:

"shorter time frames, the expansion of money the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Of course, over the long-term, such effects are much more negative, not only for the economy, but the market as well. Therefore, while good economist seem to vary somewhat on the short-term outlook of the economy and market (not unexpected), most agree that the longer-term consequences of the 2008 credit crisis and subsequent spending will provide a challenging environment at best going forward, especially long-term. As mentioned before (see previous post), plan accordingly.

There is an excellent opinion article in the Wall Street Journal today by Arthur Laffer (see WSJ article). In the article, Laffer discusses the increase in the monetary base, and how in the past 95% of the monetary base was composed of currency-in-circulation. Even with the recent unprecedented increase, cash-in-circulation has risen only 10%, now making up less than 50% of the monetary base, whereas bank reserves have increased nearly 20-fold. Granted, an increase in bank reserves was needed as a result of the liquidity issues of 2008 in order to make it possible for banks to begin lending again, but the balance has shifted too far. Laffer points out that banks will no doubt continue to make loans until they are once again reserved constrained. Currently, as banks make more loans and put more money into the system, the growth rate of M1 (currency in circulation, demand deposits, and travelers checks - see wikipedia article) is now around 15%. This of course will result in higher inflation and higher interest rates. As mentioned by Laffer,

"In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold."

Does this market situation seem familiar? Unless the Fed acts to reduce the monetary base, which appears unlikely anytime soon given that there is no easy approach or outcome (see the Laffer article), it appears likely that the Fed will continue to lose control over rates (see previous post), and the markets will continue to tip towards inflation (see additional previous post). Plan accordingly.

Once again we have a weak dollar helping to push the price of crude oil even higher (see Bloomberg article, see first WSJ article on crude, second WSJ article on the dollar). In the CNBC video below, the technical analysts Nicole Elliott is absolutely beside herself, and even giddy at times, regarding the absurdity of the move in 2-year U.S. Treasuries. She eventually comes to the conclusion that the central banks have lost all control of the setting of interest rates, not to mention the long bond and interbank loans which have been outside of their control for a while.

Source: CNBC Video
Yet the 44.4 basis point move between June 5-8, along with the recent move in the Fed funds rates, are being dismissed by some firms that trade directly with the Fed, implying that it is simply speculators that are driving rates up (see Bloomberg article). Many dealers go on to predict that the Fed will hold tight well into 2010. Maybe so, but does it matter? While the Fed has recently retreated from seeking debt-issuing power to help control inflation (see Bloomberg article), the markets certainly are nervous about what they are seeing, regardless of the policy and wishes of the Fed. The TIPS market has also been active (see previous post).

Of course, what many traders are seeing and are nervous about begins with the unprecedented amounts of cash that is flowing into the world economies, much of which will eventually trigger higher inflation, higher taxes, and lower profit margins. To make matters worse, there is a feeling that much of the spending and printing is not necessary, and even worse, that no one at the Fed is really even minding the store. For instance, in the YouTube video below, one politician questions the Inspector General of the Federal Reserve. During the questioning, the Inspector General seems to have no idea where the trillion-plus dollars the Fed has put into the system actually ended up, or who received the money. There also seems to be no postmortem or investigation on the impact of not bailing out Lehman Brothers, or auditing of any off-balance sheet transactions.


Source: YouTube
Given the market reactions, the inflation-driven moves are beginning to appear a little more obvious (see excellent Michael Pento greenfaucet post), even if the size and timing are still under debate. Yet the moves can happen quickly. Just ask those trading the 2-year Treasury, or those who were looking to lock-in to a 30-year mortgage under 5 percent just a few weeks ago. This certainly seems encouraging for commodities long-term, and even short-term, regardless of the current rallies. Just think if demand actually catches up?

Universa Investments L.P., run by Mark Spitznagel (with no ownership, but a significant investment from Black Swan author Nassim Taleb), is opening a new inflation fund, named the "Black Swan Protection Protocol - Inflation" fund (see WSJ article). While worries that inflation will be caused by increased deficit spending are nothing new (see recent blog post), the fund is making bets on what is expect will be hyperinflation - similar to, and possibly worse, than what was observed in the 1970s. Investments in the aptly named fund will include options tied to what are believed will be volatile commodities, such as corn, crude oil, and copper, in addition to associated stocks, such as the gold miners and oil drillers. The inflation fund is also making negative bets on Treasury bonds in expectation of higher yields and lower bond prices. While most investors believe that the economy will have to deal with inflation at some point, the timing is still a matter of debate. Given the use of options in the fund, which in the past tended to be deep-out-of-the-money puts when looking for a sell-off, it would seem that Spitznagel and Taleb are looking for a much quicker and, in this case, higher move to the upside for assets tied to inflation.

In the wake of the 2008 financial meltdown, it was easy to look the other way as governments and regulators considered nearly every course of action for keeping the engines of the economy from totally falling off the tracks, let alone from moving too fast in the wrong direction. But now, after massive stimulus spending, failures, and private-company ownership stakes, governments are dealing with numerous unintended consequences, forcing them to perform a difficult balancing act between immediate stimulus and long-term growth and stability.

This is now becoming evident in the Treasury market, where rising interest rates are putting pressure on the Fed's plan to bring down borrowing costs and help revive the housing market (see Bloomberg article). Mortgage rates, which have been increasing recently (see Bloomberg article and Reuters article), are now reaching high enough levels (if 5.25% is high) where they are beginning to decrease the number of new refinancing, not to mention making new home purchases more expensive and less attractive. While the increasing yield curve has been good for the net interest margins of the banks, the higher rates are coming at a bad time. It was recently reported that the number of homeowners who are getting behind on their mortgages is increasing, causing a spike in foreclosures (see NY Times article). Also, while the median price of a new home was up 3.7 percent in April, the general longer-term trend is still down, and will require a few more positive months to confirm a reversal. Sales of new homes also rose less than expected in April, with a downward revision of the March figures adding additional concern. Durable goods orders did see their largest gain in 16 months in April, but the March number was revised down sharply, causing concern for the accuracy of the current April reading.

Commodities and commodity-related stocks, on the other hand, have been rallying, with gold marching towards $1,000 an ounce, and oil rising above $65 a barrel (see WSJ article), up nearly 50 percent over the last five weeks (see Reuters article). The moves have come in part due to the falling greenback, with the dollar index down 10 percent over the last 3-months. Higher commodity prices have helped resource-rich emerging markets, lifting specific international indexes and causing a rally in emerging market bonds as the higher prices reflect an improved outlook concerning these nations ability to repay their debts (see Bloomberg article). Yet domestically, rising crude oil prices may slow down consumer spending as U.S. consumers find they once again have less disposal income (see Reuters article). Further increases in commodity prices, especially crude oil, will certainly draw concern from the Federal Reserve as it wrestles with the balancing act of growth and inflation, and subsequent worries about stagflation, making it difficult to raise rates. Capacity utilization is still low enough to make one believe that broad-based inflation is at least a year away, yet higher gasoline prices will influence consumer spending - which is vital to GDP and growth - with higher market rates adding extra pressure on spending.

In the area of "the news is good since it was not as bad as expected" camp, reported revisions highlight that GDP only contracted 5.7 percent in Q1, less than expected and previously reported, while corporate profits after taxes increased by 12.9 percent after falling 28.4 percent in Q4 (see WSJ article). Yet, not everything is rosy. Within the last few days, Tiffany posted a 64 percent drop in Q1 earnings, as margins slumped (see WSJ article). Cintas, the uniform maker, gave a weak Q4 outlook, saying that it also expects to have another round of layoffs, bringing its total workforce reduction to 12 percent over the past year (see WSJ article), and signaling further expected weakness in the broader labor market. As for technology, Dell warned that the PC market has not yet hit bottom (see WSJ article). Isolated, insignificant, and cheery-picked? Possibly. But certainly cause for concern.

All of this leaves the Fed and the Treasury with a difficult balancing act going forward. Fortunately for the Fed, or maybe unfortunately depending on your perspective, they may be off the hook, as investors and the markets take action themselves, and in the process drive up Treasury yields on debt and inflation fears (see Financial Post article). As equities enter the summer and currently appear to be stuck in a range as traders collectively make a market, the Fed may also find that it too could benefit from a little monetary consolidation. Unfortunately, the dollar, Treasuries, and commodity prices seem to have a mind of their own, with traders spotting the handwriting on the wall, and taking matters into their own hands. Quite possibility, the inflation train may have already left the station. Maybe the most the Fed can hope for is to make sure it simply arrives later than expected. Even those that feel inflation is a distant reality, see it as a reality, nonetheless. As investors and traders, we can prepare, and maybe make a little money along the way. Gold and commodity traders, as well as those shorting the dollar, are off to a good start.

Even while equities were rallying over the last few months, some well-known hedge funds were increasing their exposure to gold (see WSJ article). Some of those buying gold, gold futures, and shares of gold producing companies include Greenlight Capital, Paulson and Company, Eton Park Capital Management, and Blue Ridge Capital Holdings, among others. Yet, instead of providing a hedge against a market correction, the move appears to be motivated more by a worry of excess spending and borrowing by the government, resulting in an eventual spike in inflation, and rally in gold prices. While the recent market run has scared some away from the trade, many others are staying long, and even adding to positions, with current gold-related hedge fund investments coming in on average around 5 percent of assets. With gold still holding above $900 an ounce, there is some worry that a crowded trade will keep the shiny metal from moving much higher in the short-term. Nonetheless, for those with a longer investment horizon, there is still an expectation that the excessive printing of money will eventually cause the chickens to come home to roost, validating those who continue to stay long gold.

The flood of borrowing in the U.S. is eventually going to force us to pay the piper, with some arguing that the bill may come sooner than later. Others have argued for continued deflation over the next 12-18 months (see previous post). Fortunately, or unfortunately, depending on your perspective, the move from deflation to inflation might not be as sharp as expected (see Bloomberg article). As it turns out, rising home vacancies across the U.S. are depressing rents, the largest item in the consumer price index released by the labor department. Home and apartment rents, as well as owners' equivalent rent, make up 30 percent of the CPI. As of the third quarter of 2008, the number of empty homes stood at 19 million, signaling that deflation may be here to stay for a while - or at least worries of inflation can wait until 2010, at the earliest. While not a perfect scenario, an environment with lower inflation will allow the Fed some extra time before it needs to start raising rates, thereby giving lower rates more time to do their magic without the threat of stagflation.

As the country and the financial markets struggle to both understand and swallow the need for a $700 billion bailout of the financial system, the impact of using taxpayer money to fund such a bailout could have repercussions beyond the credit markets. The money will have to come from somewhere, i.e., taxes and/or deficit spending. As such, the potential flooding of the economy with money, and a further possible lowering of interest rates, could create increases in inflation. While this will affect nearly all areas of the economy, it could once again provide a catalyst for raising energy and commodity prices. In fact, just recently Barclays predicted that commodities will in fact revive their sharp and historic correction over the summer, and are simply in a normal correction stage rather than a change in demand (see Bloomberg article). If it is true that demand will stay strong, or at least will not collapse due to a global slowdown, any increase in deficit spending, lowering of interest rates, and further devaluation of the dollar could certainly be bullish for commodity prices. But of course, this depends on the strength of the global economy, which will depend to some degree on the handling of the credit crisis - in yet another illustration of the myth of decoupling.

There is an interesting article from Bloomberg that discusses how TIPS (Treasury Inflation Protected Securities) are not living up to their goal of protecting against inflation. The principal for TIPS increase with increases in the CPI, yet many bond holders do not feel that the CPI is properly tracking inflation, in particular the large price increases in gasoline and soft commodities, such as corn. Even as prices have increased over the last 18 months, yields on TIPS relative to Treasuries have essentially stayed the same.

As an alternative, some investors are using swaptions, which when purchased give the buyer the right to purchase a swap. Swaptions are essentially options on interest-rate swaps. Inflation swaps allow one party to pay a fixed rate in exchange for the inflation rate. Lately, swaptions have been better at gaining value when the expectations of future inflation increase, even if the CPI is not keeping up. As an example, in April and May one-year inflation swaptions returned about 0.3%, compared with a 2% loss by TIPS of all maturities. Nonetheless, even while reacting to inflation better, some investors still prefer TIPS since they are backed by the government, unlike derivatives that depend on the credit quality of the issuing firm.

Watching the post-Fed announcement finance shows (both before and after the market close), along with a read of the print media on the Fed's move, brings up a number of observations regarding the recent decision. The most interesting observation is how the market participants and pundits really, and I mean really, wanted a halt in interest rates, now or in the future, along with at least a neutral bias. Of course, the market did not get what it wanted. Or did it?

As the statement was released, every word was parsed to find its hidden meaning, or at least to see what was different from the last statement (more about this is a moment). What may be even more interesting is how all the hand wringing may have just been wasted energy, as the contents of the Fed report almost seemed to not matter. The majority of the pundits immediately talked about how the Fed has signaled a pause, some before they even read a word themselves. Even headlines from the major print media and other publications are using this and similar language - the Fed is pausing.

Below is the exact statement as released by the Fed:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 2-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Atlanta, and San Francisco.

If you are having trouble figuring out what is different from the last meeting, have no fear - you are not alone. To make things easier, the WSJ has done all the heavy lifting for you, creating a parsing graphic - essentially taking the parsing of the statement to comical proportions. Even worse is how the pundits read into the statement what they want. My hope is that unlike the rest of us (myself included), the Fed spends more time worrying about the implications of their moves, and less about how the statement will be interpreted. Given the general nature of the statement, I suspect that this is not the case.

So let me join in the fun, and confusion.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Interpretation: Therefore, we plan to pause. Well, maybe not. In fact, you could argue for just the opposite.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

Interpretation: Inflation is a mixed bag. Core is better, and the committee expects inflation to moderate in coming quarters. Nonetheless, energy and other commodity prices have increased, and there is still uncertainty. So what is the read? Since inflation is not as much of a problem (core), and commodity prices are moving just as they were during recent cutting, we can keep on lowering rates. Therefore, do we plan to pause? Well, again, maybe not. Like before, we could argue that they will stay the course, continuing to cut.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Interpretation: The key for the pundits is the first line. Easing to date is working, has helped to moderate growth, and should continue to do so. Gone from the previous statement is the phrase "downside risk to growth remains." Different to be sure, but is "help to promote moderate growth over time" a big enough change to infer a pause? Some mention that the second line also supports the pause, but isn't this line simply the Fed's mandate? Others supporting the impact of the second line mention how "act as needed" has now replaced "act in a timely manner." Seems a stretch to me. So now, while not timely, the Fed will monitor developments and act as needed, either to increase growth or decrease inflation. Again, isn't this just their mandate?

In the end, the market is hanging on the "substantial easing" paragraph, assuming that a pause is in the cards. This may very well be the case, but I am not sure this is what the Fed is signaling, or intended to signal. Furthermore, I am not even sure this is what the market is now signaling. A Fed pause would imply a stronger dollar, lower commodity prices, lower prices for the related agriculture plays (like the fertilizer companies), and a general market rally. We really got little of this after the announcement on Wednesday. Maybe future market action will give more clarity.

[Update: Clarity - indeed. Nice rally Thursday. Since a number of resistance levels are being tested, the next few days/weeks will be interesting. The strong dollar, and its effects, played out today.]

Of course, maybe we are missing the point entirely. Debating the impact of the statement on the markets may be like debating a lagging indicator - it is what it is. Maybe it makes more sense to talk about how the market action today, and over the next two months, will impact what the Fed does at their next meeting. It is certainly starting to look more and more like the markets move and control the Fed, and not necessarily the other way around. With unclear statements, the Fed may be simply hedging its bets. The current market action may be just a clue for what will drive the next decision. Of course, when that decision is made, and the statement is released to the market, we will once again need to roll out the parsing machine and let the silliness continue.

While seeming to follow, instead of lead, the Fed is contributing to the problem and giving the market the power. Like a spoiled child, the market did not get what it wants, and as a result, is not going to play nice. Trying to convince us that the Fed is done easing, regardless of whether that is actually the case or not, is not going to change the behavior. What the market needs is closure.

Recently it has been discussed how the traditional 7-8 multiple of crude oil to natural gas has broken down - or at least how natural gas has not caught up as crude continues its march well beyond $100 a barrel. It was further speculated that this may be a buying signal for natural gas and natural gas stocks - even with the recent run up in prices. As it turns out, commodities and bond yields, which have also more or less moved in tandem over the years, have also been gaping apart - with the gap holding for a significant period (approximately the last 5 years), and with the spread between the two continuing to increase. Why do they typically move together? Simple. When commodity prices rise, inflation begins creeping into the system. Anytime inflation increases, bond investors will demand higher yields, causing commodity and bond yields to move together. A simple sector shift from bonds to commodities puts selling pressure on existing bonds, further driving up yields.

So the trade seems easy - short commodities and bonds (driving yields up). Simple, right? Well, maybe not. Others examining the divergence list potential problems with this logic. First, things have changed. Commodities are now believed to have less influence on inflation (not that demand doesn't cause inflation, but that demand is not necessarily scaled back due to price increase). Regardless of prices, people need energy and raw materials. Second, we are in a commodity bubble. Bubbles burst, but we don't know why or when. To the first point, we often hear the refrain: "it is different this time." No, it is not - or at least, usually, it is not. Things may be a little different, and timing may be off, but long-term trends tend to have a way of popping back up and reminding us of efficiencies, and of our own stupidity and greed. As for the second comment - I agree. Even if we know a bubble exist, we don't really know when it will pop. Furthermore, when it does pop, it usually takes longer than we expect. What shall we do? We probably need to sit back and wait for more clarity, at least before taking both sides of the trade looking for convergence. Once the commodity boom stalls and takes a breather in its historically long cyclic move, investors will have less profits to redeploy (such as in the bond market), at which point the selling and stalled buying pressure on bonds should start driving the yields back up. For those that do take both sides of the trade, let us just hope that the old axiom of Wall Street - that our capital last long enough to allow the market to see how smart we are - gives us a reason to laugh and gloat, instead of a reason to cry.

China had another stellar period of growth as its GDP rose 10.6% in the first quarter. Unfortunately, consumer prices in China climbed 8.3% in March, driven by the usual suspects. The government did not hesitate, immediately raising reserve requirements to 16%, taking additional currency out of the system. Analysts at Goldman Sachs believe it will not be enough, and that China's central bank will need to further raise interest rates and implement even higher reserve requirements. In the mean time, higher currency gains are expected as rates increase. Whether the Chinese central bank can raise rates faster than the currency is appreciating is still to be seen.

Forbes is speculating how the "euro experiment" may come to a soon end. The problem is that each of the euro-based countries has its own unique monetary problems. Apparently there is growing tension in countries with inflationary pressures (such as Germany, Austria, and the Netherlands), and countries with growth pressures (such as France, Italy, and Spain). If countries start to break from the euro, the spiral unwinding could be hard to stop. To take advantage of a break from the euro, the author suggest shorting the euro and buying the dollar, or possibly selling investments in Italy and Spain, while buying fixed-income assets in Germany.

Not much of a surprise, but inflation is reaching high levels all across the globe. We are well aware of increases in commodity prices, as a result of higher agriculture products to make alternative energy, and higher energy and raw material costs due to increase global growth. What often gets overlooked is how the weakening dollar is also having an impact on inflation, and not just in the U.S. Since many countries link their currencies to the U.S. dollar, these countries and their economies are forced to feel the impact of U.S. Federal Reserve rate cuts, even if their economies are not slowing. Of course, lower rates and a cheaper currency are just the opposite of what these counties may need when faced with inflationary pressures.

U.S News and World Report has an interview with Jon Auerbach discussing potential new BRIC-type countries. Nigeria is mentioned as being an important market given its lead in banking in Africa. Zimbabwe, discussed in an earlier post regarding their inflationary problems, may also present opportunity depending on upcoming election results, and their ability to contain and control hyperinflation. Opportunities exists in Kenya as well, after resolving many of the problems that occurred early in the year.

Zimbabwe's inflation tops an "official" level of 24,000%, below the original 150,000% estimate. I am sure that the Zimbabwe central bank is not celebrating that the estimate came in "low".