Deflation and the Dollar, Round 2?

The oil inventory numbers came out yesterday and there was an increase of roughly 5 million barrels, 1 million more than the American Petroleum Institute's (API) estimates. Consequently, the price plunged nearly 6% in its largest drop in nearly 3 months. But is this the whole story?

Not exactly. Right now, there seems to be a lot going on with oil which could cause its price to drop even further. According to the Wall Street Journal, commodity speculators including hedge and pension funds, as well as ETF investors, were responsible for the wild oil price fluctuations, driving the price to a high of $145 barrel in July 2008. So we can be pretty sure that this price drop was not solely due to simple supply and demand. Let's take a look at what's really going on.

There are a few reasons why oil prices may be heading lower in the foreseeable future:

The Commodity Futures Trading Commission (CFTC) is considering instituting position limits for speculators in the energy markets. In fact, there is a global push for regulation to reduce price volatility. Whether or not these regulations will go through or even have the intended effect is up for debate. While this may be a seemingly popular move, it could have a dilatory effect on other areas of the economy.

On Monday, stocks in China sold off roughly 5% on speculation that the Chinese government will reduce the economic stimulus they had been providing as there is now talk of a Chinese Bubble about to burst. Should this occur, it could be a sign that their growth may be slowing thereby reducing their need for oil. If their growth numbers are directly tied to government spending, then it stands to reason that when the government reduces spending their growth will slow as well. Although I'm not really sure that anyone actually believes the numbers they report anyway.

So what does this mean for the global economy going forward? Well a few things. Recently, there has been a positive correlation between the US stocks and oil, as seen in the chart below.

So if you believe in these short-term correlations, it stands to reason that if oil is going to go down, US stocks will go down as well. And if US stocks go down, we can expect the US dollar to go up in value as the investors and speculators will move back to the safety of the US dollar. 

So in this instance, I would be a seller of oil (USO) and the US market indices (SPY, DIA, QQQQ) and a buyer of the US dollar (UUP).

Because one of two things is most likely to happen; either these correlations break down or government regulation/intervention unintentionally causes even more deflation than had originally been planned. 

And this is why government controls on free market economies can have unintended consequences which can be more damaging then helpful. If the US government truly wanted to reduce commodity speculation, they would increase interest rates to stave off inflation and keep speculators from having to seek out ways to protect themselves from the government's destruction of the US dollar. By keeping rates extraordinarily low for far too long, we are going to be moving in and out of bubbles for some time to come. 

Let's just hope that it doesn't blow up in their face.