Some people predict a return to the gold standard with gold priced at $5,000 an ounce or some other elevated price. It seems the people who make these forecasts are not familiar with the history of gold standards.

Take a look at a book like John Kenneth Galbraith’s elegantly written Money: Whence it came, where it went, and you’ll see that the history of gold is full of crushing deflations and depressions. And protest movements that culminate with impassioned pleas of the kind in William Jennings Byran’s 1896 Cross of Gold speech.

True gold standards are rare. Nor do they last long. They are invariably watered down as greater and greater quantities of paper currency are issued for a given stock of gold. As Keynes says, “A regulated nonmetallic standard” slips in unnoticed.

Besides, there is a better way: an elastic currency anchored to a modified price-stability rule. I’ve talked about this before.

Anyway, what got me going on this little rant was a great video clip from David Nicholson’s Wednesday Night Salon, held in the wood-paneled dining room of his Westmount home in Montreal. It shows a debate on the return of the gold standard between Ron Meisels (editor of the Phases and Cycles investment advisory) and Martin Barnes (Managing Editor of The Bank Credit Analyst).

It’s a short piece, just 3 minutes long. But right at the end, Mr. Barnes in his Scottish brogue nails it on the head as to why a return the gold standard “makes no sense.”

Appendix: Buffett and Keynes on gold

Warren Buffet: “It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

John Maynard Keynes: “In truth, the gold standard is already a barbarous relic. All of us, from the Governor of the Bank of England downwards, are now primarily interested in preserving the stability of business, prices, and employment, and are not likely, when the choice is forced on us, deliberately to sacrifice these to outworn dogma ….”

Is now a good time to buy TIPS or RRBs? As Mr. Brewster says such vehicles “can help one’s portfolio keep pace with the cost of living, however….as with any investment, it is important not to overpay for [them] as doing so can offset the benefits of the inflation protection.” And as we shall see below, RRBs don’t appear to be such great bargains right now.

“The best measure by which to judge the value of an RRB [or TIPS] is…the break-even inflation rate (BER),” adds Mr. Brewster. “The BER is the difference between the yield on a nominal Government of Canada bond and the real yield (the yield less inflation) on an equivalent RRB.”

Let’s illustrate with an example. According to Bank of Canada data, the real yield on long-term RRBs is 1.53% as of Jan. 5. The nominal yield on long-term Government of Canada benchmark bonds is 4.08% as of Jan. 5. The difference (4.08%-1.53%) is 2.55% and represents the current BER.

Now, if the actual annual inflation rate until the bonds mature is less than 2.55%, then the nominal bonds will be the better investment. Their real return will be higher than the 1.53% currently paid on the RRB. Conversely, if the annual inflation rate ends up higher than 2.55%, the RRB would be better since its real return would be higher.

So, if you believe long-run inflation will exceed 2.55% per year, you will want to buy RRBs at this time. If not, the nominal bonds would be better to buy.

Will annual inflation be under or over 2.55% over the long run? I personally believe that the Bank of Canada will continue to adhere to its target of 1% to 3% annual inflation. This would make RRBs slightly overvalued relative to the mid-point of the central bank’s target range. So I would not necessarily be a long-term buyer at these prices.

The time to buy RRBs, in my opinion, is when the BER dips toward the lower boundary of the Bank of Canada’s target range. In Chart 1 below showing the BER for the 2021 maturity (provided via Mr. Brewster), you can see that the time to buy RRBs was in late 2008 or early 2009. Back then, fears of deflation were rampant, which dragged the BER down to 1%.

The price of the iShares Canadian DEX Real Return Bond Index ETF (XRB) has accordingly followed the BER higher since the trough a year ago. As you can see in Chart 2 below (Google graph), it has risen from $18 to $20.5, an increase of about 14% (in general, the price of XRB appears to track the BER).

Inflationary fears could still continue to mount as 2010 progresses and thus cause more appreciation in XRB, so I would continue holding the ETF or RRBs if you already own them (disclosure: I own XRB). However, at some point, the central banks will begin to withdraw stimulus from the economy and cap inflationary expectations (and, in turn, price gains in XRB).

Chart 1: Breakeven rate of inflation of 2021 maturity (1991 to 2009)

Chart 2:  Price Trend in iShares Real Return Bond ETF (XRB)

Appendix 1: How Do Real Return Bonds (RRBs) Work?

RRBs are identical to traditional bonds in most ways, except that their cash flows keep pace with the cost of living. Inflation, as measured by the Consumer Price Index (CPI), is represented by the RRB’s Index Ratio, which tracks changes in inflation since the bond’s issuance. To keep pace with inflation, the Real Face Value of the RRB is multiplied by the continuously updated Index Ratio to determine the Nominal (current) Face Value. The semi-annual coupon payments are based on the Nominal Face Value. For example, suppose an investor holds $10,000 Real Face Value of an RRB. If the current Index Ratio is 1.35506, the Nominal Face Value today would be $10,000 x 1.35506 = $13,550.60. If the RRB has a semi-annual coupon rate of 4.25% the coupon payment would be as follows: Nominal Face Value x (Coupon/2) = Interest Paid Out $13,550.60 x (4.25%/2) = $287.95 Note that the coupon rate does not change, but as the Real Face Value is multiplied by the Index Ratio, the coupon payment fluctuates with inflation. At maturity the Nominal Face Value is returned to the bondholder. So both the coupon payments and the principal repayment fluctuate with inflation. While the calculations may appear complicated, what matters most is that inflation protection is achieved.

“Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks — call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot … I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.”

Volker recently gave a speech in China on U.S. economic prospects, which a few media outlets covered. “A long slog, with continuing high levels of unemployment, seems to be in store,” Volker said. He went on to say the anemic pace of the upturn was likely to forestall the surge in inflation that some expect to be triggered by the huge policy stimulus. “This is not an environment in which inflationary pressures are at all likely for some time to come,” he said.

Valuations no longer a prop for the rally

Valuation played a role in boosting stocks over the past three months. In early March, stock prices had become quite cheap, inviting bargain hunters to go shopping. Now, that reason for buying has ebbed with stocks rising to either fully valued or over-valued levels, depending on the valuation yardstick used.

Paul Lim writes in a June 14 New York Times piece, This Rally May Need a New Source of Fuel, that the price-earnings ratio of the S&P 500 based on GAAP earnings currently stands greater than 100. Based on operating earnings, the ratio is near 22, compared to the average of 19 over the past two decades.

But get this: Lim cites a Ned Davis Research study of bear markets since 1929 that found the market’s P/E ratio tends to climb by about 10% in the first three months after bear markets. In the three-month rally from March 9 of 2009, the P/E ratio for the S&P 500 has soared almost 40%.

Chinese stocks for the long run?

Maybe buy-and-hold investing will work if one picks the right country to invest in. The U.S. has two centuries of stocks averaging 9% a year but its brand of capitalism now seems sclerotic, leaving one to wonder if the youthful capitalism of emerging countries is the place to be for the long run. Even noted bear David Rosenberg of Gluskin Sheff + Associates Inc. seems bullish on China, at least in the near term. In his June 15, 2009 commentary, he notes:

“While exports seemed to have suffered a bit of a setback in May (-36.4% YoY versus -22.6% in April), it does look as though the government stimulus is percolating through the Chinese economy much more quickly than it is the case in the industrialized world. Retail sales are up more than 15.0% YoY; turnover in the commercial and residential real estate market has expanded 45.3% and investment spending has accelerated at a 33% YoY pace. No wonder commodity prices are booming again.”

The pullback the buy-the-dippers were waiting for?

Stocks sold off sharply on Monday, June 15 but will any weakness in stocks at this point be seen as a pullback for sidelined investors to jump in? A MarketWatch piece, Funds looking to pullback to get in stocks, thinks the answer to this question is yes. Funds that have been sitting on cash and looking to do a bit of window dressing for the end of the quarter are likely to be buyers, says author Nick Godt. But after June 30, what will the market do without the buy-the-dippers and window dressers?

Getting back to the low “would be consistent with over $5.0 trillion of debt elimination,” says Rosenberg. This is too much for even the U.S. government to absorb, he declares: “A goodly chunk of this excess debt — bringing credit into realignment with the permanently new and lower level of household net worth — is going to have to be paid down (or defaulted on).” Hence, Rosenberg’s bullish stance on government bonds and bearish stance on stocks.

No doubt some of the debt will be extinguished, as it should be. But there is also a denominator in the debt-to-asset ratio. It can move up and take the ratio lower too. Indeed, the previous declines and cyclical lows in the series may mostly reflect, it seems to me, periods of asset inflation brought on by Fed monetary expansion. Something similar could happen again this time around.

Just as I’m not sold on the view we are heading for a raging inflation problem, neither am I personally sold on the debt-deflation thesis. Never underestimate the power of policymakers to pull rabbits out of the air or do whatever it takes to save the system. The bears are right about the system being in need of a great purge but the government is the “house” in this great casino.

This reminds me of the time I was following the macroeconomic commentary of a bank economist during the 1990s. As the economy recovered from the recession earlier in the decade, he kept warning about inflation reappearing. His warnings went on for a couple years – yet inflation remained well behaved. Then came news his reports were no longer available. He had been let go by the bank.

I wonder if the inflationists this time around will similarly discover that their fears were misplaced. In March, the U.S. consumer price index (CPI) fell 0.4% year-over-year, the first decline in half a century. The core CPI was up 1.8% — mostly due to an increase in cigarette prices.

But what really makes one question the inflationary thesis is the amount of slack in the economy. As the Financial Times of London reports, the Congressional Budget Office calculates the “output gap” will be 7% in 2009 and 2010. They don’t expect it to be closed before 2015. Prices don’t normally start going up until the “output gap” is a lot smaller.

Many people, including several well-known investors, have been calling for a bursting of the bubble in U.S. government bonds. I have been looking at going short with the ProShares Ultra-Short 7-10 Year Treasury (PST) or ProShares Ultra-Short 20+ year Treasury (TBT) exchange-traded funds. However, until there is a resurgence of inflationary pressures, the decline could be less dramatic that what might initially be expected.

According to Brusca, optimism is still optional, but with inflation (CPI and PCE core) returning to pre-Lehman trends, Fed policy could get “real different, real fast.” Simply put, if deflation stops looking like a threat, the Fed will start back-tracking, maybe even at WARP speed.

Brusca has his own blog called GPS for Investors at http://robertbrusca.blogspot.com/

If you don’t think I am a total twit, follow my DOUBLE TAKE posts via my NotSOCRATES Twitter site at http://twitter.com/NotSocrates

DOUBLE TAKE: Aside from trying to promote myself while generating Web traffic that helps put bread and butter on my table, this blog aims to stir debate by taking a harder look at current news and events. I obviously enjoy voicing my own opinions, but I am a big boy and I welcome all comments that don’t require R ratings. So let me have it via this blog or send me an email at tom.watson@canadianbusiness.rogers.com. I reserve the right to post email comments without disclosing the sender’s name.

THOMAS WATSON is a Senior Writer and editorial board member at Canadian Business magazine. Since winning a community journalism award as a cub reporter with the Hamilton Spectator in the early ’90s, he has covered business, finance, politics and technology for various news outlets. Prior to joining CB in 2001, he reported on the steel and automotive sectors for the Financial Post. Watson received his first magazine award nomination for exposing a stock manipulation plot aimed at Waterloo, Ont.-based Open Text in 2000, when he was head of investor relations for an international venture capital outfit in the City of London. Watson holds graduate degrees in journalism, international relations and public finance and undergraduate degrees in history and politics.

I hadn’t quite finished deploying my cash balances when he began singing happy days are here again, taking the indexes up 20% in two weeks. He’s snatching away all my buying opportunities. Give that guy a Qualude, already.

Being constitutionally averse to buying while buying panics are in full flight, I am left asking: what, then, can one buy right now? Are there any asset groups with the prospect of good returns  — that haven’t had a sharp run-up and become overbought?

There may actually be one: inverse bonds funds – specifically those tracking government bonds such as the ProShares Ultra-Short 7-10 Year Treasury exchange traded fund.

The prices of inverse government-bond funds should be climbing too because of the inflation expectations unleashed by the Federal Reserve’s unprecedented creation of new money. Then there is the oversupply arising from massive fiscal deficits caused by more than a trillion dollars of government spending on bailouts, fiscal stimulus, and so forth.

But the rally has been delayed by the Federal Reserve announcing plans to buy several hundred billion dollars of long-term U.S. government bonds. In fact, they were set back sharply by the announcement. This was what I was waiting for and now that it’s out in the open, it’s time to look seriously at taking action.

At some point, the Fed will have to stop buying the bonds and their prices – now artificially held near their historic highs – should trend back down to more natural levels. The tsunami of new money should eventually goose the economy. Indeed, it may be like the stuck door that springs open suddenly after much hard pushing. A side-effect will be higher inflationary pressures and expectations. So, the Fed will in time lay off buying government bonds.

The Fed has never increased bank reserves as much as it has in 2008. The previous high, was in 1934 when they rose by 57%. No doubt this stimulus played a role, says Northern Trust economist Paul Kasriel, in boosting real GDP growth from 1934 to 1937 by nearly 10% annually on average. The CPI increased in 1934, 1935, 1936 and 1937 by 3.5%, 2.6%, 1.0% and 3.7%, respectively. After the Fed began priming the pump, inflation did occur in the 1930s.

In 2008, the year-over-year increase in November 2008 in bank reserves was 600%, about ten times the previous all-time high in 1934. “The Fed’s seasonally-adjusted net acquisition of assets – primarily securities, commercial paper and loans to financial institutions – represented 100% of the seasonally-adjusted total borrowing by the U.S. non-financial sector in the third quarter of 2008,” writes Kasriel. In previous post-war recessions, this percentage rarely exceeded 20%. And more purchasing of government debt is likely to come when the Obama administration launches its massive stimulus package in early 2009.

There could be some price deflation in 2009 but if 1934 “is any guide, the Fed, starting in 2010, may have to invest in industrial size vacuum cleaners to start sucking up large quantities of credit that it had previously created!” Kasriel concludes.

Paul Volcker, as you may recall, was Fed chairman from 1979 to 1987 and he was credited with taming the double-digit inflation of the 1970s. He was successful because he was given a free hand. Now it’s time to institutionalize greater independence in the Fed so we can have more Paul Volckers, writes Hutchinson.

That means making the Fed less of a decentralized institution. It also means doing away with the dual mandate to promote both price stability and full employment in favor of a primary focus on price stability.

I would add that price stability should be defined with reference to asset prices as well, not just prices of consumer items. In my opinion, the monetary excess was not just a reflection of political meddling and a dual mandate but also a policy error – i.e. an inappropriate definition of price stability that allowed monetary policy to become too loose.

First, diversifying into foreign markets is less appealing because the Canadian dollar has now lost a great deal of purchasing power and buys much less (hopefully you did your foreign diversification as 2007 came to an end). As well, the risk of incurring currency losses on foreign holdings has risen since the loonie has fallen back closer to the bottom of its historical range and is more likely to go up in years ahead. In short, it’s perhaps time to think about investing more in Canadian stocks.

Second, the drop in the Canadian dollar obviously benefits manufacturing and other non-resource exporters that have long suffered under the loonie’s rise over recent years. This sector of the Canadian economy perhaps deserves more attention, especially if the exporter has a lot of clients in recession-resistant sectors. An example might be SNC-Lavalin Group (SNC.TO), which takes on infrastructure projects for governments around the world.

Third, the drop in the loonie means the dampening effect of a strong currency is gone. Imported inflation will put pressure on the Canadian consumer price index to rise and that means the Bank of Canada will have less leeway to lower interest rates in response to recessionary conditions. Shares in Canadian companies selling mainly to the domestic market may reward investors less than companies selling more to foreign markets.

Leading economic indicators seem to be suggesting as much: in the U.S. for example, the recent decline in the Conference Board’s Index of Leading Economic Indicators is comparable to the decline recorded in the second quarter of 2001, when the U.S. economy was in recession. While the 2001 recession was mild, inflation concerns this time around have delayed the Federal Reserve’s easing of monetary policy.

As the U.S. economy slides further into what should be a deeper recession, stock markets could remain weak. But the economic slowdown will tame inflation and allow the Federal Reserve to cut interest rates to provide the extra stimulus to get the economy and stock market back on an upswing, perhaps more noticeably by the middle of 2009.

But it won’t be bad news across the board for emerging countries. “The emerging market universe will split into the haves and have not’s,” claims Bushell, with the dividing line being current account positions. Those countries with good surpluses and foreign-currency reserves, like China, will continue to enjoy access to access to capital while those with deficits, such as India, Indonesia, Vietnam and Eastern Europe, will face more difficult adjustments.

Bushell thinks the impending global growth scare will “quell the inflationary storm.” But if governments in emerging countries find inflation fighting unpalatable, growth may maintain momentum longer “and deliver a boomerang back to the U.S.” in the form of greater inflationary pressures. The implication from Bushnell’s commentary in Perspective Online would seem to be that the world could face an unpleasant choice between hyperinflation and a 1982-1983 style deep recession to bring inflation under control.

Sure, the U.S. CPI hit an annual growth rate of 5.7% in July. But the main cause of the inflation surge, soaring oil prices, is beating a hasty retreat — as are prices for commodities and foodstuffs (other important contributors). Even rising import prices are going into remission thanks to the recent rise in the U.S. dollar.

Look at how financial markets yawned when the CPI figures came out. Futures on federal fund rates barely moved. Yields on inflation-protected Treasuries (TIPs) fell (the spread of the 10-year TIPs yield over regular 10-year Treasuries yield — a proxy for inflationary expectations — has now collapsed from 2.57% to 2.22% in a little over a month).

Retail sales volumes have been dropping despite the tax rebates issued by the U.S. government. Job losses, falling house prices, and credit rationing are taking their toll. With most rebate cheques already disbursed, retailers are likely to pick up the pace of price discounting in the months ahead, says BMO Financial.

The forces of recession do indeed appear to be in the ascendancy. Japan’s economy contracted at an annual rate of 2.4% in the second quarter, its worst performance in seven years. The eurozone economy shrank in the second quarter, the first contraction since the launch of the euro in 1999. The Reuters-Jefferies CRB index has fallen almost 20 per cent since the peak in July.

The Fed’s latest survey of lending officers shows continuing tightening of credit standards. In the three months ended June 30, total bank credit contracted at an annual rate of 3.7% — the biggest drop in 60 years.

A slowdown in loans coincides with a slowdown in bank deposits — which in turn slows growth in the M2 definition of money supply. M2 had annualized growth of only 2.5% in the three months ended July, compared to 13.2% in the three months ended March, 2008. If inflation is “always and everywhere a monetary phenomenon,” as the great economist Milton Friedman said, then a deceleration in the money supply implies a deceleration in inflation.

In fact, the M2 slowdown implies a drop in economic growth when inflation is taken into consideration. The real money supply (adjusted by consumer price inflation) has contracted at an annual rate of 7.3% in the three months to July 30, “the sharpest three-month contraction since early 1980,” according to Northern Trust.

I wonder if Ms. Cooper and the growing chorus of similar voices are seeing all the warts of the beast they live close to and fewer of the blemishes on the beasts living further afield. While the U.S. certainly has its problems, so do other countries around the world — we perhaps don’t see them as much because of the distance and language barriers.

Take the economic miracle in China. It seems to me to be based in large part upon the suppression of market forces, which is not usually a lasting formula — especially for wrestling hegemony away from the U.S. Like Mother Nature, it’s not nice to fool with market forces. They release a lot of unintended consequences that grow and fester and eventually win out, undermining edifices built without regard for them.

Chinese exports are surging because appreciation in the Yuan has been held far below market levels by printing up scads of Yuan to buy up mountains of U.S. dollars. Supplementing this intervention are currency controls that restrict Yuan convertibility.

Any country can do this sort of thing and put up an impressive run for a time. Japan tried it in the 1980s and early 1990s. But most don’t do it, at least for very long, because it leads to an inflation problem — as highlighted by China’s current annual inflation rate near 8%. And again, this performance would look worse without market interventions: if oil prices in China weren’t subsidized below world levels, the inflation rate could be well into double-digit territory, closer to 15%.

Running the printing presses to suppress currency rates, oil prices, and other things is a recipe for galloping inflation and escalating wages, which, by raising the structure of domestic costs, eventually offsets the competitive edge due to artificially low exchange rates. And currency controls spawn black markets that in time defeat the intent of controls while having other negative side effects.

Besides, there is no need for higher Fed rates if inflation is going to moderate on its own. Some may think negative real interest rates are a stimulative monetary policy bound to accelerate inflation — but policy remains restrictive, according to Sherri Cooper, chief economist at the Bank of Montreal.

That’s because of the credit crunch. As the Fed’s April survey of loan officers showed, there “has been a record level of tightening” in U.S. credit standards. Going by my very rough calculations, this puts the effective Fed rate closer to the 3.75% rate recommended by the Taylor Rule.

Lastly, for inflation to enter a runaway phase, wages need to begin rising too. However, workers don’t have much bargaining power when job losses are piling up. The chances of a wage-price spiral commencing appear to be rather small.

Does this have any significance? One ramification could possibly be the unwinding of the secular growth stories of the emerging countries and a return to economic supremacy of the developed countries. It could also mean the stock markets of the developed countries will be more rewarding places over the next decade or so compared to the stock markets of emerging countries.

The cost-push inflation of developed countries is easier to resolve, I believe. It should ebb as long as central bankers refrain from overly stimulative monetary policy — thereby letting the deflationary forces of the stagflation slow the economy to a non-inflationary path. And this is the course of action that the central banks appear to be following (e.g. a rate hike by the European Central Bank, little increase in the narrowly defined U.S. money supply in 2008, etc).

Demand-pull inflation and wage-price spirals tend to be more stubborn. Taming them usually requires a substantial tightening of monetary policy. A greater setback in growth could be the consequence for emerging economies.

But the required policy restriction will also likely require emerging countries to give up on pegging their exchange rates to the U.S. dollar. That's because higher interest rates attract capital inflows and generate upward pressures on the currency — so if policymakers wish to fight a growing inflation problem, they can't keep their fixed currencies.

A catalyst could come if and when U.S. inflation recedes and the Fed begins easing monetary policy. Emerging countries may not want to follow U.S. interest rates down (as required to maintain their currency pegs) because it pours more fuel on their overheated economies.

All of which raises a few questions. Could emerging countries now be mismanaging their economies to the extent they kill off their vaunted secular growth stories? They wouldn't be the first to botch things: in the 1980s, Japan was said to be on a path to overtake the U.S. but then it fell into a two-decade deflationary period.

Like Japan in its heyday, China and India have been enhancing export competitiveness by maintaining artificially low currency rates. Could their well-publicized growth trajectories similarly prove to be chimeras? And could the U.S. and other developed countries once again emerge on top while providing the better stock markets in which to invest over the next decade or so?

At some point, China, India, and the other emerging countries with managed currencies will find their economies are getting too far out of line and may decide to give up their currency pegs. That means they will have less need to accumulate U.S. dollars. And lower demand for U.S. money could bring the world closer than ever to the long-feared run on the U.S. dollar. Similarly, there will be pressures on U.S. long-term interest rates to rise sharply since foreign countries will have relatively lower U.S. dollar reserves to plow into U.S. treasuries.

Things appear to be different from the 2001-2002 period. It is unlikely the same result — the mildest of recessions — will be the result. This time around the Fed has less freedom of action. The result will likely be a more substantial downturn. The stream of economic reports could be getting a lot uglier from here on in.

But academic studies, notably those from Professor Moshe Milevsky at York University, show that variable rates on mortgages are better over the long run. You will save on interest costs at least 75% of the time, and knock a year off your amortization period.

Besides, variable rates on mortgages are tied to the Bank of Canada’s discount rate (thorough prime-lending rates) and I don’t see the central bank hiking much when inflation is already quite low and the economy could be in recession (GDP growth last quarter was negative). There is thus a good chance variable rates will not be going above fixed rates during this cycle. If they do, it shouldn’t be for very much or very long.

The U.S. was headed for a recession in 2001 but Federal Reserve Chairman Allan Greenspan dodged it with a dramatic reduction in interest rates and the help of a bubble in real estate. My guess this time around is that current Fed Chairman, Ben Bernanke, is willing to allow more of a downturn to emerge.

One sign: Bernanke drained the liquidity created by his rescue of the U.S. financial system to keep high-powered money on an even keel. Another sign: his recent speech about the need to avoid further interest-rate decreases to keep the U.S. dollar from going into a tailspin and fueling inflationary pressures.

Then there is the greater inflation threat in 2008. Prices for commodities and agricultural products are soaring. The consumer price index may still be relatively well behaved but the person in the street is complaining about inflation feeling higher than reported, thanks largely to gasoline and food prices. And investors are less willing to hold bonds as demonstrated by the recent run-up in their yields. The last thing Bernanke wants to see is an inflation psychology take root, where people seek to recoup lost purchasing power through bargaining for higher wages and demanding higher bond yields.

Politically, the timing for a downturn is about the best one can hope for. It’s early in Bernanke’s term and the term of the next President. There will be plenty of time to turn things around and get the show back on the road over the course of their terms.

- gas prices have lagged crude oil prices
- rig count still low in Canada due to cost inflation and strong C$
- U.S. production faces high depletion rates and less accessible gas fields
- Asia and Europe bidding up prices of liquefied natural gas (LNG)
- North American LNG facilities unlikely to come on stream before 2011
- natural gas substitutes (e.g. coal) hitting new price highs
- speculators remain net short natural gas in contrast to crude oil

So let’s stick with the gas stocks and exchange-trade funds (ETFs) mentioned in previous posts. The Claymore Natural Gas Commodity ETF is up about 30% since the Feb. 15/08 post Got GAS. The United States Natural Gas ETF is up a bit more over the same period. Encana shares have gained nearly 50% since the Aug. 20/07 post, Playing the natural gas cycle. But it looks like there is even more price appreciation coming, according to BCA Research.