Monday, August 25, 2008 - Vol. 10, No. 202 Today's comment is by Jack Crooks, Editor of World Currency Options and The Money Trader.  The vast majority of consumers see "inflation" as what we're paying for groceries, gas, a Starbucks coffee, and electricity. Yes, it's true that rising prices for these necessities has been the poster child for inflation lately. But there's much more to inflation than just forking over more at the gas station or coffeehouse. When it comes to Europe, wage push inflation plays a crucial role. Producers Pass the Inflation Buck to You - the Consumer Producer prices are simply the costs required to produce goods and services. Naturally, when producers have to pay higher costs to produce goods, they'll demand higher prices for the goods they're selling. In other words, they pass their higher costs to you, the buyer. Rising commodity prices tend to be a big reason why producers' costs rise. More money spent in production means smaller profit margins at current prices. If a producer wants to make up for shrinking profit margins but can't control his input costs, then he must pass on these costs in the form of higher prices. Excess money creation is what drives this type of inflation, affording higher prices. No doubt, this is exactly why rising energy costs have been such a huge driver of the inflationary environment we've trudged through over the last several months. The debate is heating up among whether this global inflationary period is coming to an end. I tend to believe it is. But, more importantly, economic growth and available credit across the globe is rolling over at the same time surging commodities have left inflation concerns on everyone's mind. For this reason central bank policy makers are struggling. The cost of energy has buoyed the cost for producers, consumers, and everyone in between. But what happens when this pressure eases for a considerable stretch of time? Inflation Is a Little Bit Different on the Other Side of the Pond They don't serve ice cubes in their drinks. They can drive on the left-hand side of the road. And inflation is also a little bit different in Europe. Despite this fact, inflation analysis in these respective regions often focuses on generalities and overlooks one particular difference. Let me explain... Let's focus only on two countries and two central banks: The Federal Reserve and the European Central Bank. If you haven't been hiding under a rock for the last year, then you probably have some kind of idea how their respective policies vary. The Federal Reserve has knocked off more than 3% from its benchmark interest rate in the last year. In that same time, the European Central Bank has mostly stood its ground, mixing in one rate hike of 25 basis points that brought its benchmark up to 4.25%. And if you've been following my currency articles lately, you also probably know that this monetary policy discrepancy has been a boon to the euro, and a detriment to the buck. For many months, even years now, the relative performance of each currency has been primarily based upon expectations for this rate differential to change. As you might imagine, inflation expectations play an enormous role in monetary policy expectations. Even though inflation has received plenty of attention over the last several months, many analysts have neglected an important difference between European inflation and U.S. inflation. Now's the time to pay closer attention. What All the Analysts Have Missed Over the Last Few Months In the last few weeks, commodity prices (particularly crude oil) have cracked. With that abrupt downturn also came a reprieve in inflation expectations. And that's got many accepting the potential for a lasting shift towards even lower prices and less inflation pressure. With that in mind, the dollar has managed to rally on two simple facts: 1. The U.S. Federal Reserve has already lopped off a considerable portion of its benchmark interest rate. So they're now ahead of the rate-cut curve, which has helped maintain some growth in the U.S. relative to Europe. 2. The European Central Bank will be forced to bailout their deteriorating economy by cutting their benchmark interest rate. Up until this point, the European Central Bank had a good reason to keep fighting inflation. But with commodity prices easing up, now may be the time for ECB policy makers to take action. Here's why they've struggled... Why Hasn't the ECB Joined the Worldwide Rate Cutting Party Yet? With many threats to global growth and concerns over several Eurozone member countries, many have been surprised the ECB has gone so long without letting up on the interest rate front. After all... The Federal Reserve has made several moves to lower rates The Bank of Canada has followed suit The Bank of England has gotten the ball rolling So has the Reserve Bank of New Zealand The Reserve Bank of Australia is likely next If you're wondering why the ECB hasn't budged, look no further than labor unions. Simply put: Wage contracts put in place via labor unions have employees' wages moving higher in lock-step with inflation. There's really no thought to profitability (the point when workers typically consider demanding higher wages). In other words, rising headline inflation fuels this wage-spiral. And this wage-spiral spurs greater headline inflation. And it continues on like this. That's something Ben Bernanke hasn't had to deal with. You see, the Fed has been able to react to weakening growth by cutting interest rates. The plan: As growth moderates, or rolls over, inflation is likely to follow. But that assumption is more difficult to make when you've got rising wages keeping prices unnaturally high. The ECB hasn't yet been able to make that assumption. Its interest rates remain high. But here's what you should expect... When the ECB finally decides to cut rates, they will do so substantially and they will do so quickly. It will be their way of reloading. Because we know, with the labor unions continually eroding profit margins and forcing prices higher, the ECB will need some fire power for their next inflation shoot-out. If they cut back rates now, they'll be able to hike rates and combat inflation when the time comes again. All you need to do is be prepared to act accordingly. JACK CROOKS, Editor of World Currency Options and The Money Trader EDITOR'S NOTE: Jack is already preparing his loyal subscribers for when the ECB will be forced to cut rates. When ECB President Trichet tips his hand, Jack's readers will be ready to pounce on the next winning trade. Could Jack's strategy work for you? Find out today - before another profit opportunity passes you by.

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Wealth:

Time to Start Bargain Hunting: Where I'm Looking After witnessing a major rally following the Bear Stearns Cos. bailout in mid-March, investment grade corporate credit spreads have risen to multi-decade highs this summer. If you're a long-term investor, I would consider nibbling at these levels because interest rates for many bonds in the non-financial sector now pay attractive inflation adjusted yields. But I'd avoid most financial company debt instruments because these securities will remain distressed much longer amid ongoing balance sheet erosion and high risk premiums to fund borrowing obligations. The corporate debt market now yields an effective 3.11% above risk-free Treasury bonds compared to 3.05% at their pre-Bear Stearns' peak in March, according to Merrill Lynch. The Dow Jones Corporate Bond Index now yields an effective rate of 6.04% or a 2.20% above ten year Treasury bonds. That's also at a multi-year high. One of the cheapest ways to invest in investment-grade corporate debt is to buy low-cost exchange traded funds (ETFs). These products are listed in the United States and offer daily liquidity. You can also find similar products traded in Frankfurt, Germany and denominated in euro. Another segment of the credit markets also offering high value is the mortgage-backed securities market or the MBS sector. The investment-grade corporate debt market and mortgage-backed securities are cheap. These products provide a low correlation to common stocks AND they pay attractive inflation adjusted yields. Plus, non-financial corporate bonds offer strong balance sheet management. In fact, I prefer to own the corporate debt of, say, Coca-Cola or Exxon-Mobil Co. than the U.S. federal government or the state of California. These and other S&P 500 Index non-financial companies have far healthier balance sheets. As the U.S. and global economy continues to slow this year, inflationary pressures should also cool. This should open the door to higher bond prices, especially in the high grade investment sector and mortgage-backed securities. But I would still avoid junk bonds or high yield debt because the corporate default rate for risky issuers continues to rise and won't peak over the next 12-18 months. ERIC ROSEMAN, Investment Director

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