By Puru Saxena
For Daily Reckoning UK
Jan 4, 2007

Are the bond investors being fooled into believing that inflation isn't a problem? Or are the equity punters wrong about the coming interest-rate cuts and a soft landing in the United States? Perhaps, the commodities camp is stupid and we are in fact witnessing a gigantic bubble in natural resources.

Amidst all these diverse views, my own money lies in the inflationary camp (commodities and emerging-market equities) and I suspect that the bond-investors will be the ones who get badly hurt. After all, central banks around the world continue to churn out a ridiculous amount of paper, otherwise known as money. Inflation (money-supply and credit growth) is spiralling out of control and all this excess liquidity is causing prices to rise all around us, thereby diminishing the purchasing power of our savings.

So far, central banks (through their propaganda and skewed inflation figures) have managed to keep the public's inflationary fears under check. However, once the masses wake up to the inflation menace, there will be a stampede out of "paper" causing interest-rates to soar and the bond-market will sink like a rock. The same drama unfolded during the 1970's, and I suspect history will repeat itself over the coming years.

Those who believe in a deflationary collapse don't understand the monetary system. Today, central banks have the freedom, the ability and the motive to print an endless amount of money, which will avoid any deflationary bust-ups at least in the immediate future. A more likely outcome is that thanks to the money- printing prowess of Mr Bernanke and his counterparts elsewhere in the world, the purchasing power of all the "paper" currencies will continue to fall against tangible assets and eventually the entire monetary- system may come into question.

You must understand that banks are in the business of lending money and inflation benefits them immensely. The higher the rate of inflation (money-supply and credit growth), the bigger their profits from collecting interest on the issued loans. Moreover, inflation also keeps a segment of the public happy (at least those who have the ability to invest) as their assets continue to rise, thereby giving the illusion of prosperity.

So, the hidden agenda of the central banks and politicians is to create and encourage inflation, whilst telling the public that they are in fact fighting inflation! I may add that during highly inflationary times, it is always the majority of the public that suffers badly, as their savings, incomes and pensions continue to erode in value. So, in order to protect your wealth, you must avoid the "safe haven" of cash and invest in assets that are likely to benefit from the ongoing monetary insanity.

These days, the consensus view is that the interest-rate in the United States will fall over the coming months as the Federal Reserve steps in to support the US economy. In my view, the Fed Funds rate may actually rise around April-May next year.

Firstly, despite the hikes since 2004, the Fed Funds rate is still close to the bottom of its 30-year range. So, the notion that the interest-rate is "too high" is totally absurd. In fact, I would argue that given the degree of inflation we have seen in the United States since 2001, the Fed Funds rate is shockingly low!

More importantly, if my assessment about the markets is correct, commodities (especially gold and silver) will advance over the coming months and test their highs recorded earlier this year in May and the US dollar will decline to its low recorded in December 2004. Such an outcome will cause inflationary fears to return with a vengeance and the Federal Reserve will raise its interest-rate.

The prime objective of any central bank is to protect its merchandise (the currency it issues) and the Federal Reserve will do everything in its power to prevent a total collapse of the US dollar. In theory, a higher yield is supposed to make a currency more attractive, so the Federal Reserve is likely to increase the interest- rate at the cost of the US economy. Such an unexpected move will probably send the financial and property markets into yet another painful correction phase during the next summer.

On a brighter note, we still have a good stretch ahead of us and I expect the markets to remain strong until towards the end of the first quarter next year. At this stage, our managed accounts are fully invested in the commodities complex and emerging-markets. However, depending on the market conditions prevalent early next year, we will start to lock-in our gains by going into money-market funds and bonds for a few months.

Monetary conditions play a crucial role when it comes to investing so let's examine the international reserves. Despite the highly advertised monetary tightening, our world is awash in liquidity. Non-gold international reserves held by foreign central banks have soared to a new record high of $4.75 trillion, representing a rise of 14.5% over the past year. Emerging nations hold a record $3.37 trillion (21% growth over the past year) of those reserves.

On the other hand, the developed central banks hold a near-record $1.38 trillion, a miniscule 1.5% growth-rate over the past year. It is clear to me that the developing nations are now financing the industrialized nations and all this liquidity will provide a cushion and reduce the impact of any major financial crisis. Moreover, the money supply is growing at a furious pace in most nations and this should also prevent a prolonged weakness in asset-prices at least in the immediate future.

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