Thursday, February 16, 2012

The Deflationary Undertow Before The Inflationary Wave

Ride the wave, or drown. 

War between Israel and Iran now seems inevitable. Leon Panetta claimed that it would be this coming spring—and I see no reason to doubt him.

How an Israeli-Iranian war will play out—that is, whether it will draw in more geopolitical actors (such as the U.S.), or if it will be a series of limited attacks, counter-attacks, and then stalemate—is impossible to predict. War tends to take on a life of its own.

But we can predict how it will affect the global markets.

A very reasonable assumption is that oil supplies, especially to Europe, will be severely curtailed. Aside from the fact that one fifth of the world’s oil production passes through the Straight of Hormuz—ground zero of a war with Iran—the rest of the world and especially Europe depends on Iranian oil. As discussed in the SPG Scenario of this past June (“An Israeli-Iranian War?”), close to 10% of the eurozone’s oil comes from Iran—and the countries most particularly dependent on Iranian oil are precisely those most in trouble right now: The so-called PIIGS.

So oil prices will inevitably rise. And so—just like 1979, after the overthrow of the Shah of Iran and the subsequent Oil Shock—the world’s economies will experience another likely oil shock which will send up the price of oil, hurting the world economies rather badly—

—and driving up inflation.

Dollar inflation and euro inflation is in the offing, in the weeks and months following a war with Iran. The assets that will rise drastically in price will be precious metals, especially silver; agricultural commodities; and oil—obviously. The assets that will collapse in price will be sovereign bonds, corporate bonds, and equities, in that order. In the Scenario, I discussed which countries will hurt the most, so I won’t bother repeating what I wrote there.

However, notice I say that inflation will rise “in the weeks and month following a war with Iran”: A war with Iran which disrupts oil supplies will—inevitably—lead to an inflationary wave.

But before that inflationary wave hits—that is, in the days and hours following the beginning of the war—we will experience a deflationary undertow.

This deflationary undertow will present some interesting opportunities.

If and when there is a curtailment of Iranian oil due to a war in the region, inflationary expectations and a regular ol’ short-squeeze—paradoxically—would force both the dollar and the euro up, as traders and speculators sell off assets and positions and go to cash in those two currencies, in order to cover their exposure.

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