Will inflation fears send oil to $250?
In case you're wondering why interest rates are climbing along with the price of filling up your gas tank, the answer is simple: fear of inflation. The U.S. has pumped so much money into the economy -- including $12.8 trillion to bail out banks and others along with cutting the Fed Funds rate to almost zero -- that people around the world are beginning to question the strength of the dollar.
This fear creates a trading opportunity, the same one that drove oil up to $147 a barrel last July. And now Gazprom's CEO is forecasting oil will hit $250 -- more than three times its current $71. That's a prediction from which traders are profiting. How so? Traders bet on a drop in the dollar and a rise in oil; they do this by selling the dollar short and buying oil futures.
Since oil is traded in dollars, the weaker it gets, the more dollars it costs to buy a barrel of oil. There is a feeling of momentum about this trend -- that means traders are piling into the trade because their peers are making money off of it. Despite a three percent demand decline forecast for 2009, $3.8 billion has flowed into oil and gas exchange traded funds so far in 2009, almost three times the $1.4 billion in the first half of 2008.
And the worse it gets for consumers, the more the traders profit. How so? I paid $1.66 a gallon for mid-grade in January and now I am lucky to get $2.62 -- 58 percent more. Moreover, the yields on 10-year Treasury notes have spiked from March's 2.5 percent to yesterday's 3.862 percent.
Since such rates are used to set the price of money for mortgages, credit cards, auto loans and the like, the rising rates nip hopes for economic recovery in the bud. Rates are rising, in part, because traders are betting against the dollar.
This leaves a bit of dilemma for the Fed which has already expanded its balance sheet from $800 billion to over $2 trillion since the financial crisis began. (The $1.2 trillion in new assets has been the toxic waste it's been buying to rescue Wall Street.) If the Fed buys up more toxic waste, it pumps more dollars into the market which further raises inflation fears and helps those traders I mentioned.
This is good for the economic recovery only if it actually sends those yields back into the 2.5 percent range. If it boosts yields as more traders pile on to the short-dollar/long-oil trade, then it will be the worst of all possible worlds. Inflation fears rise, spiking interest rates choke off economic recovery, and real prices spike for consumers.
In this scenario, the only ones getting rich are the traders. Meet the new boss, same as the old boss.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.