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Mary Anne & Pamela Aden

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Inflation Has Returned

Back to the 1970s? That was the title of a recent cover story in The Economist. Some of the similarities between what's happening now and what happened then are worth discussing because they'll affect us all and our way of investing.

Even though there are differences between now and then, the end result was inflation, which we're currently seeing. And while it may not become as extreme as it did in the 1970s, inflation is headed higher.

Even though Greenspan is playing down inflation saying it's unlikely to be a serious concern, the numbers are telling us otherwise. Here's the latest...

Last month import prices soared at an annual rate of 19.2%. Consumer prices had their biggest jump in 14 years this year with the latest rise at 7.2% annualized. This included a 55% surge in energy prices and a nearly 11% gain in food prices (both annualized). Excluding these, the popular core rate was obviously less but since we all eat and drive, the core rate is actually meaningless.

Producer prices reinforced the other inflation figures. They too have soared the most in 14 years over the past year with the latest up at an annual rate of nearly 10%. Energy and food prices surged over 19% and 18% annualized, respectively.

So who says there's no inflation? There is, and it's soaring.

In the 1970s average world inflation soared to 13% and it stayed high for eight years, following a 2-3% rate throughout most of the 1960s. There was international monetary disorder, commodity prices soared, Vietnam and its economic effects were being felt, there was an oil crisis and the oil price soared.

Pressure Is On

Today for the first time since World War II, the Fed has been actively working to push inflation higher with its high-powered pumping of its monetary policy, and other countries have been joining the party. Global monetary policy is the loosest since the 1970s. As The Economist concludes, the good news is that deflation was avoided, but the bad news is that inflation is now coming back stronger than expected.

Inflation has always been caused by excessive monetary expansion, often associated with wars. In the U.S., that's certainly been the case with Iraq, which has become far more expensive than anyone expected.

Whether or not you agree with the war, Iraq has been inflationary, it's helped fuel an oil crisis by fanning insecurity and oil has soared to record highs. Commodities have also risen over 20% during the past year.

So is history destined to repeat? Increasingly, it looks like it could but with a different twist.

Complex War

Even though the transition in Iraq went smoothly, the militants have been stepping up their bombing attacks and Saudi Arabia is becoming a real concern.

Al Qaeda is determined to continue its war there, drive out Westerners, overthrow the monarchy and disrupt the oil sector. And since Saudi Arabia is the world's largest oil producer, this alone could seriously hurt the world economy, producing chaos, soaring oil prices and inflation. Hopefully, it won't happen but Condoleezza Rice considers al Qaeda a serious threat in Saudi Arabia and as we've seen in recent years, anything is possible.

As investors, this means we have to go with the major trends, which are now more important than ever since inflation's picking up. You want to be invested in markets that benefit from inflation like gold and currencies, and avoid investments that do poorly in this environment like stocks and bonds.

Interest Rates at Crossroads

For now, we're watching interest rates closely because they're the key and we'll want to see a final confirmation on this front. As you can see on the right of Chart 1, long-term interest rates have been declining since 1980 and the 80 month moving average identifies this mega trend as the 30 year yield has stayed below it for nearly 20 years.

Since last year, however, long-term rates have been rising and the 30 year yield is now at a crossroads since it's very close to this important moving average at 5.50%. If the yield rises and stays clearly above this level, the mega trend would then turn up, signaling upcoming strong inflation and higher interest rates for years to come.

As you know, gold and bonds are very sensitive to inflation. When inflation moves up, so does gold while bond prices decline. The gold/bonds ratio on the left of Chart 1 is actually an inflation barometer. The trend has been down since 1980 showing that gold was weaker than bonds, confirming inflation wasn't a problem.

But now, this 24 year trend and the moving average is being broken to favor gold over bonds. This marks an important mega trend change and it's telling us gold is going to be stronger than bonds in the years ahead. This in turn reinforces inflation will continue and it's going to be greater than most expect. If that proves to be the case, the 30 year yield will eventually follow and reverse its downtrend too, which would mean the current bear market in bonds will not be a regular one like the ones of the past 20 years, but a major, long lasting one. In that case, gold could soar.

Gold Timing: "A" rise underway

For now, gold has started a renewed intermediate rise we call A, and it could last another month. Chart 2 shows the gold price with our favorite leading indicator. This indicator helps identify intermediate moves in the gold price. The As and Cs coincide with gold rises and the Bs and Ds with gold declines.

A rises tend to consolidate the strength of the prior C rise, which means if gold now stays above $390 and rises to possibly the April highs near $430, it will be a normal A rise.

The point is, don't be disappointed if gold doesn't reach a new high this time around. Once the A rise is over, a B decline will begin. But here again, B declines tend to be moderate, just like A rises are moderate. B declines are still part of the consolidation, which means the $375 low in May is unlikely to be seen again as long as this bull market stays intact. In other words, now and at the end of the upcoming B decline will be the last time to buy gold at a good price.

Then the excitement begins because C rises are the best rise in the cycle when gold rises to new highs. The upcoming C rise could begin in the last quarter of this year.

Meanwhile, the bull market will remain intact as long as gold stays above its rising 65-week moving average now at $381. This applies to the other precious metals as well.

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