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The Deflationary Undertow Before The Inflationary Wave

Published: February 16, 2012
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By Gonzalo Lira

War between Israel and Iran now seems inevitable. Leon Panetta claimed that it would be this coming spring—and I see no reason to doubt him.

How an Israeli-Iranian war will play out—that is, whether it will draw in more geopolitical actors (such as the U.S.), or if it will be a series of limited attacks, counter-attacks, and then stalemate—is impossible to predict. War tends to take on a life of its own.

But we can predict how it will affect the global markets.

A very reasonable assumption is that oil supplies, especially to Europe, will be severely curtailed. Aside from the fact that one fifth of the world’s oil production passes through the Straight of Hormuz—ground zero of a war with Iran—the rest of the world and especially Europe depends on Iranian oil. As discussed in the SPG Scenario of this past June (“An Israeli-Iranian War?”), close to 10% of the eurozone’s oil comes from Iran—and the countries most particularly dependent on Iranian oil are precisely those most in trouble right now: The so-called PIIGS.

So oil prices will inevitably rise. And so—just like 1979, after the overthrow of the Shah of Iran and the subsequent Oil Shock—the world’s economies will experience another likely oil shock which will send up the price of oil, hurting the world economies rather badly—

—and driving up inflation.

Dollar inflation and euro inflation is in the offing, in the weeks and months following a war with Iran. The assets that will rise drastically in price will be precious metals, especially silver; agricultural commodities; and oil—obviously. The assets that will collapse in price will be sovereign bonds, corporate bonds, and equities, in that order. In the Scenario, I discussed which countries will hurt the most, so I won’t bother repeating what I wrote there.

However, notice I say that inflation will rise “in the weeks and month following a war with Iran”: A war with Iran which disrupts oil supplies will—inevitably—lead to an inflationary wave.

But before that inflationary wave hits—that is, in the days and hours following the beginning of the war—we will experience a deflationary undertow.

This deflationary undertow will present some interesting opportunities.

If and when there is a curtailment of Iranian oil due to a war in the region, inflationary expectations and a regular ol’ short-squeeze—paradoxically—would force both the dollar and the euro up, as traders and speculators sell off assets and positions and go to cash in those two currencies, in order to cover their exposure.

That is, as the markets digest the news of war with Iran and the subsequent disruption of the global oil supply, there would be a rush to cash before a reallocation of capital in the global markets.

This is the deflationary undertow that we can expect immediately following war breaking out with Iran.

How severe will this deflationary undertow be? It will depend on how expectant the world markets are.

The more build-up to the war in the mainstream media, the lesser the deflationary undertow. If a majority of market participants come to the conclusion that war with Iran is inevitable, and thus reallocate their capital before the war, then market panic following the outbreak of hostilities will be at a minimum: Therefore, the less severe and strenuous the reallocation of capital following the beginning of the war. Oil prices would of course go up—but there wouldn’t be a generalized market disruption and panic.

This, of course, is predicated on their being a steady drum beat to war.

If a war with Iran is sudden and unexpected, the market reaction would accordingly be more violent—more short-term deflationary.

As an example of this deflationary undertow, consider the period June–December of 2008, with respect to gold: Gold peaked at $930 on June 30, just before the Global Financial Crisis, only to fall all the way down to just below $730 on September 11, when the financial panic was at its peak. Then gold rose once more to over $900 by September 25—only to collapse to just below $700 on October 11: A yo-yoing of 23% up, and then 22% down, in exactly one month.

Why such huge swings? Uncertainty.

There is no question that there will be a deflationary undertow immediately following the start of war with Iran. This would mean a fall in the prices of precious metals and all other commodities (except of course oil), before the markets realized that rises in the price of oil mean widespread inflation of both the dollar and the euro, and thus a rebound and rise in the prices of precious metals.

The real question is, Will this deflationary undertow before the inflationary wave hits be severe? Or minor? Or barely a blip, before we shoot the inflationary moon?

It will depend on how prepared market participants are. The more priced-in the expectations of war, the less potent the deflationary undertow.

So watch the mainstream media, and keep an ear on the zeitgeist. The more mainstream discussion about the inevitability of war, the less the deflationary undertow.

Keep in mind: I am not arguing that a war with Iran would be deflationary—not at all. War with Iran, and the curtailment of global oil supplies, would be radically inflationary. I am saying that the immediate, near term effect of a war with Iran could potentially be severely deflationary, if global markets are caught flat footed.

This deflationary spasm of a few days (a couple of weeks at most) before inflationary expectations set in and drive precious metals and commodity prices a lot higher could be the perfect buying opportunity—if you’re prepared.

This piece is adapted from one that appeared at my Strategic Planning Group, and is part of a longer discussion of a possible Israeli-Iranian war. If you’re interested, check out SPG’s preview page, to see what it’s about.

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