The inflation trade is back with a vengeance

The market is still worried about how the Paulson/Frank bailout plan will actually work and how it will affect the economy. I'm still wondering myself, and it's hard to find anything to cheer about, except that one way or another the government is going to be socializing the costs of the housing crisis. This will take pressure off of the financial sector and should lead to an unclogging of the financial system over time. The great unknown is just how bad this precedent will be for the future of our free market system, as the government plays an ever-greater role in financial markets.

Meanwhile, the concerns about inflation have really heated up in the past two trading days. A weaker dollar, soaring gold and oil prices, and rising breakeven spreads on TIPS are all signs that the market is getting more worried now about inflation. The Fed has been plenty easy, in my view (though other supply siders, most notably Art Laffer would disagree), and they still are, so it's no surprise to see this.

The actions in dollar, gold and oil all suggest that the problem we're facing is not one of a shortage of dollars. Dollars are plentiful and cheap, why else would the value of the dollar be declining against these three key benchmarks?

If there is plenty of money in the system, then it's likely that the economy won't be as bad as many people seem to fear. Inflation is not good for an economy, since it leads to malinvestments (like the housing boom) that then need to be worked off and result in lost productivity. But we're not in a hyperinflation were everything is paralyzed. So I'm still optimistic that we're going to avoid an economic collapse or a deflation as some are predicting. The surprise will likely be that the economy continues to grow, albeit modestly, and inflation continues to be a problem. Should this be the case, look for Treasury yields to rise significantly, and all other yields to rise by much less.