This short paper was written back in July of 2016.
My Theory – Reflation Thesis – July 2016
Generals always fight the last war and economists always fight the last depression.
Commodities bottom in a repetitive manner. Rising commodity prices will foreshadow the reflation of the global economy.
When commodities bottom the gold market bottoms first. It also peaks first. This is likely due to gold forecasting inflation and deflation.
Crude oil and copper tend to bottom simultaneously as economic activity picks up. Since 1986 (when oil futures first started trading), only once this relationship did not hold and that was with gold topping last in 2011.
On the charts below the green lines mark major bottoms and the red lines mark major tops.
Economic Expansion, Core Inflation, Unemployment and Wage Growth
Ned Davis Research has discovered that the economy is in expansion when the S&P500 is 3.6% above the 5 month smoothed trend. As of Friday July 8, 2016 the S&P500 is 6.1% above the 5 month moving average. If the stock market is a leading indicator of growth, expansion supports the reflation thesis.
The above chart from US Global shows that the oil price tracks World GDP. The price of oil hit a low in February of 2016 and has been trending higher, supporting the reflation of global growth thesis.
Further evidence is found in the chart from Wells Fargo below. Commodity prices rise when US unemployment is below 6%. Currently US unemployment is around 5%.
Wage growth is now advancing at the fastest rate since the 2008-2009 financial crisis. Deflation is behind us, not ahead. This expansion of US wage growth will filter into the inflation calculation and increase US consumer spending.
This why all commodities have rallied this year.
The US Dollar Effect
Crude oil has not always traded inversely with the USD. This relationship began when the Euro came into existence. In the future I suspect crude oil will rally with the dollar.
The red box shows when the dollar and oil declined together, the green boxes are periods when oil and the dollar rallied together and yellow when they were inversely correlated, pre-Euro. With the potential end of the Euro, oil will likely become less of an anti-dollar trade and begin to trade on economic activity.