Right now our economy is a clash of two forces, the deflationary housing depression, and the inflationary weakening dollar.

Both have a massive domino effect on other parts of the economy, but if there’s one thing both these forces agree on, it’s that Americans are spending less on discretionary goods and services.

As a result, we’re stuck in a negative feedback loop in the economy right now.  The dollar continues to tank against the world’s other major currencies, crossing the $1.60 per Euro level yesterday.

The euro was lower against the U.S. dollar in European trading Wednesday, a day after it breached US$1.60 to a record high.

In late-morning trading, the 15-nation currency bought US$1.5968, below the high of US$1.6018 it reached Tuesday after a pair of European Central Bank governors suggested that interest rates would go higher if inflation was not stemmed.

Markets have hoped that the bank would lower rates much like the U.S. Federal Reserve Bank, Bank of England and Bank of Canada have done.

The euro hit its last record of $1.5982 Thursday, but dropped back after a Wall Street rally generated optimism that the worst of the U.S. credit crunch may be over. The euro was rejuvenated this week when Bank of America’s first-quarter earnings fell short of expectations.

More concerns about the U.S. economy’s health came Tuesday after the National Association of Realtors reported that sales of existing single-family homes and condominiums dropped by 2 percent in March, the seventh such drop in the past eight months.

As the dollar weakens and loses value, investors put their money in other investments, namely commodities.  That’s what’s cause world food and oil prices to skyrocket over the last 12 months, and in particular the last 4 months.  More investors invest, demand for that commodity rises, and a bubble is created.  That commodity USED to be real estate.  Now it’s oil.

Oil has nearly doubled in price over the last 12 months.  Why is that?  Reuters has a good primer on commodity speculation.

DOLLAR WEAKNESS

The fall in the value of the dollar against other major currencies has helped drive buying across commodities as investors view dollar assets as relatively cheap.

It has also reduced the purchasing power of OPEC’s revenues and increased the purchasing power of some non-dollar consumers.

OPEC oil ministers have noted that although prices are rising to record nominal levels, inflation and the dollar have softened the impact.

Some analysts say investors have been using oil as a hedge against the weaker dollar.

And again, this leads to a negative feedback loop:  the weaker dollar leads to higher oil, leading to further slowdown in the US economy, leading to…a weaker dollar.

FUNDS

Since the Federal Reserve cut U.S. interest rates in mid-August and central banks pumped billions of dollars into financial markets to ease a credit crunch, oil and gold have risen.

Investment flows from pension and hedge funds into commodities including oil have boomed, as has speculative trading. At the same time, the credit crunch has brought some other markets, such as the U.S. asset-backed commercial paper market, to a virtual standstill.

Some of that money has found its way into energy and commodities, analysts say.

There’s no credit crunch in the oil market.  If you’re willing to put your money into oil, somebody will take it. Liquidity puns aside, oil is easy to get into and get out of, as it’s widely accepted as having value, being oil and all.  Hedge funds are moving into oil, oil goes up as demand increases (which if it keeps doing that is good for the hedge fund and its investors.)

And bad for the rest of us.

DEMAND

While previous price spikes have been triggered by supply disruptions, demand from top consumers the United States and China is a main driver of the current rally.

Global demand growth has slowed after a surge in 2004 but is still rising and higher prices have so far had a limited effect on economic growth.

Analysts say the world is coping with high nominal prices because, adjusted for exchange rates and inflation, they have been until now lower than during previous price spikes and some economies have become less energy intensive.

This is always the true culprit according to the Church of the Free Market, but oil has never been a free market.  Demand hasn’t doubled for oil in the last 12 months, but the price certainly has.  Oil prices have increased almost sixfold since January 2002…the last recession we were in.

Recessions historically mean lowered demand, so lower prices…but this isn’t an ordinary recession.  Not by a long shot.

OPEC SUPPLY RESTRAINT

The Organization of the Petroleum Exporting Countries, source of more than a third of the world’s oil, started to reduce oil output in late 2006 to stem a fall in prices.

Fewer OPEC barrels entering the market helped propel the rally and consumer nations led by the International Energy Agency have urged OPEC to pump more oil.

At its meetings since December, OPEC has agreed to leave output unchanged, saying there is enough crude in the market. It next meets formally on September 9.

Few in the group believe there is much it can do to tame a market it says defies logic.

Energy companies blame China.  China blames OPEC.  OPEC blames speculators and the dollar, and of course energy companies.  Of course OPEC isn’t going to increase production, they’re making a mint.  And because so many of the currencies in the Middle East are pegged to the dollar, inflation is killing them.  They need the money, and so they’re getting it the old fashioned way:  Charge more.

NIGERIA

Supply of crude from Nigeria, the world’s eighth-largest oil exporter, has been cut since February 2006 because of militant attacks on the country’s oil industry.

Oil companies and trading sources have detailed about 500,000 bpd of shut Nigerian production due to militant attacks and sabotage.

IRAN

Oil consumers are concerned about supply disruption from Iran, the world’s fourth-biggest exporter, which is locked in a dispute with the West over its nuclear programme.

Western governments suspect Iran is using its civilian nuclear programme as a cover to develop nuclear weapons. Iran denies this, saying it wants nuclear power to make electricity.

IRAQ

Iraq is struggling to get its oil industry back on its feet after decades of wars, sanctions and underinvestment.

Exports of Kirkuk crude from the country’s north are stabilising as the system recovers from technical problems that had mostly idled the pipeline since the U.S.-led invasion of Iraq in March 2003.

And you can thank US foreign policy for this.  Since the Iraq war drumbeat began, the price of oil has gone from $20-$30 a barrel to almost $120.  This isn’t a coincidence.  The failed Warren Terrah has played a major role in the downfall of the US economy.  Some have profited immensely.  Most of us are now far worse off.

Finally, there’s the refiners.

REFINERY BOTTLENECKS

Refiners in the United States, the world’s top gas guzzler, struggled with unexpected outages which have drained inventories.

It’s funny how companies making as much as $40 billion in yearly profits have so many “unexpected outages” and infrastructure problems.  Refiners say there’s no profit in refining gas these days because of their high overhead and oil prices.  Yet somebody’s walking away with these billions, and the price increases are always somebody else’s fault.  The finger pointing circle jerk continues on a daily basis, and Congress does nothing.

Meanwhile the price of oil in 2008 is increasing at $1.50 a week.  If this keeps up, oil will be approaching $175 a barrel by the next President takes office a tripling of oil in 24 months.  Gasoline prices will be well above $5 a gallon, diesel would be close to $6 a gallon.  How much damage will be done to the economy with gas prices that high?

The fact of the matter is the negative feedback loop of a weak dollar leading to higher oil and a further weakening dollar shows no real signs of abating.  If anything the pace of the process has increased rapidly in 2008.

Many economists speculate oil will top out sooner rather than later because the Fed is almost out of rate to cut.  It can’t keep up these 75 basis point rate cuts anymore.  But the damage has already been done, the loop has been set up and as OPEC ministers keep pointing out, oil no longer follows logical rules.  It’s out of control right now, along with several other commodities.

Something has to give in the war between inflation and deflation right now.  My belief is that inflation will blink first because of the reason above, the Fed is rapidly running out of rate to cut.

The result will most likely be a commodity crash.  We almost saw that last month, where oil and other commodities dropped 10% in one week.  But that was a release of pressure, not a bubble crash.  Commodities have continued to rocket back up, especially oil.

That will be the next bubble to burst, and it will signal the beginning of massive deflation in this economy.

One of the results of that will be a huge wave of corporate bankruptcies.

The looming wave of bankruptcies is unlikely to be kind to bondholders. And they have only themselves to blame.

Rather than receiving the historical average recovery of 42 cents on the dollar in a default, owners of a third of high- yield, high-risk bonds rated B+ or lower may get no more than 10 cents, according to New York-based Fitch Ratings. About 22 percent are likely to get 11 cents to 30 cents.

Bond investors from Pacific Investment Management Co. to Capital Research & Management Co. may pay the price for allowing themselves to be subordinated by junk-rated companies that borrowed a record $2.2 trillion of bank loans in the past three years. Unsecured creditors of Fedders Corp. and Buffets Inc. have lost almost all their money as lenders lay claim to the companies’ assets. Standard & Poor’s says Burlington Coat Factory Warehouse Corp. and Univision Communications Inc. bondholders may meet a similar fate in a default.

“There’ve been some disappointments,” Paul Scanlon, team leader for U.S. high yield and bank debt at Putnam Investments, said in a telephone interview from his Boston office. Putnam manages $66 billion in fixed-income, including bonds of Univision. “As people look back over the last 24 months, there are many transactions in portfolios that people have hoped the outcome might have proceeded differently than it has.”

I bet.  Ten cents on the dollar on $2.2 trillion in corporate bank loans is, well, a $2 trillion loss for the banks.  These companies are going to go under and take jobs and money with them into a black hole.  Inflation is rocking America right now, but trust me when I say deflation is a whole lot scarier.  Gas prices are bad, yes.  But what if, say, a quarter of the gas stations in your area went out of business as a result of lowered demand?  If the oil bubble burst, prices would come down certainly, but the damage would be done.

As the losses for the financials approach $300 billion, I still keep running across articles and interviews of financial gurus who keep saying that the worst is over and that recovery is right around the corner.  My response is “wishful thinking, friend.”

We’ll be hearing that next year too.  Folks, trillions in losses are on the way, a full order of magnitude or more than what the industry has taken already.  The dollar is in freefall, the commodity bubble is looming like a poisonous cyst, the housing market is plummeting and the real problems are still off in the distance.

Things are bad now.  They will be a whole lot worse shortly.

Be prepared.

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