The Curse (and the Blessing) of Interesting Times

Investors are currently suffering the old curse of living in interesting times. Last week, Fed Chairman Bernanke finally drew a line in the sand under the USD, only to be smacked down in short order by his European counterpart Jean-Claude Trichet, and some piling on s by some of Trichet’s deputies. The sequence of events last week went like this:

1. In the face of an accelerating rise in oil and other commodity prices, the Fed and the Treasury made comments on Thursday that implied that they stood ready to support the USD’s value from falling further. Oil and commodity prices, which are priced globally in USDs,  pulled back noticeably on the news.
2. Trichet, without blinking, called and raised Bernanke one day later, saying that the ECB stood ready to raise its lending rate by another 25 basis points if necessary. The clear implication was that the ECB is not going to submit to the Fed’s Humphrey-Hawkins mandate to support both the domestic economy and USD price stability.The ECB’s only mandate is to ensure price stability, i.e., a stable value for the Euro. The dollar fell anew on Trichet’s comments, while oil and commodity markets surged even higher.
3. There was some market chatter on Friday that hawkish comments about Iran by Israeli Transport Minister Shaul Mofaz were behind the surge in oil prices. Another explanation being bandied about exchange floors yesterday was that a popular ‘convergence trade’ between interest rates in the U.S. and Europe involved mimicking a long USD position by shorting oil futures; when the ECB took the wind out of the USD’s sails, these trades were quickly reversed, causing a pop in the oil price. While either one of these explanations might have been at work on Friday, much of the rise in the price of oil since 2003 has been fundamentally driven in our view.
4. A weaker-than-expected U.S. employment report also appeared to have an effect, as rising unemployment raises expectations for easier Fed monetary policy, and relative to circumstances in the rest of the world–high growth rates especially in emerging economies, and a very hawkish ECB–that can only lead to higher USD inflation globally. It’s our opinion that the parabolic movement in oil and other prices since 2007 is driven in large part by rising inflation expectations due to (a) overly easy monetary policy by the U.S. Federal Reserve and (b) a dearth of sound domestic economic policy in Washington.

As we continue to point out, the correct policy mix for this situation is tighter money in combination with more competitive taxes and regulations, and expanded trade.  Unfortunately, the American ship of state does not currently appear to be headed in that direction. That means that the current pain being felt in parts of the U.S. economy will not recede entirely for some time yet, and that much of the world will continue to struggle with global inflationary pressures and social and political unrest. Not all will suffer however. For example, one interesting piece of news we came across was that the explosion in agricultural prices appears to be easing the conversion of poppy farms to food crops in Afghanistan. This of course will make life marginally more difficult for many heroin addicts, which shows yet again that economics is all about tradeoffs.

Of course, however much we might curse them, times like these bestow blessing as well. Savvy investors have a better chance of finding compellingly priced assets in difficult market environments, where fear rules the day (or the month, or the quarter, or the year(s)). If you have any doubts, the performance of Warren Buffet’s Berkshire Hathaway in the 1970s provides a fine example: