Contradiction No. 1

Aside from one good year in 2005, the euro has been cleaning the dollar’s clock since bottoming in 2001 just under 84 cents. The price of crude oil is shown on the same chart to highlight the degree of correlation that has developed between these markets in the past five years. At a late November OPEC meeting in Saudi Arabia, Iran and Venezuela pushed for moving away from pricing oil in dollars. Iranian President Mahmoud Ahmadinejad said the falling dollar means oil producers are, in effect, subsidizing the U.S.

“They get our oil and give us a worthless piece of paper,” he said. “We all know that the U.S. dollar has no economic value.”

Iran already prices oil in euros but has to accept the world oil price is first set in dollars, so it’s an empty change. For his part, Venezuelan President Hugo Chavez called for a “revolutionary OPEC” that embodies a socialistic/ populist political stance.

These two leaders — OPEC’s own little lunatic fringe are not among the world’s most respected, but the uncomfortable fact remains the dollar is, to a fairly large extent, a hostage to the price of oil. Other countries are equally dependent on imported oil, though, and while Europe may be getting a break because of the euro’s strength, it’s not a get-out of- jail-free card. Since the end of 2005, the price of oil has risen 56 percent in dollar terms ($61 to $95) while the euro has gained only 24 percent (1.1844 to 1.4631).

The price of oil is not a single cause of inflation in any economy — most economists still think an increase in money supply is necessary to feed inflation — but it is a worrisome contributing factor. But because of the credit crunch, which has many more months to run, the bond market thinks the probability of a Fed rate cut at the Dec. 11 Federal Open Market Committee (FOMC) meeting is 90 percent. This means, unless the yield curve steepens substantially, the market is pricing in a humdinger of a recession, probably in the form of stagflation — drastically slower growth (such as 1 percent vs. the natural rate of 3.5 percent in the U.S.) accompanied by dramatically higher inflation (such as 5 percent compared to the Fed’s desired 2 percent or under). In a normal scenario, a recession would reduce activity and thus the demand for oil. And since the world is not really decoupled from the U.S., demand should fall elsewhere, too.

The market is in the grip of an intolerable inconsistency. It sees inflation rising — a lot — hence the near-doubling of the 2-year/10- year yield spread to 0.825 percent since Sept. 17 (before the Fed started cutting rates). The yield on the 10-year T-note just before Thanksgiving was 4.15 percent, well under the Fed funds rate of 4.5 percent. It’s never a good thing when the 10-year is yielding less than the overnight rate; it means the market is certain recession is coming. Therefore, the Fed should cut rates to boost growth.

At the same time, however, the market finds the Fed’s embrace of the core Personal Consumption Expenditures (PCE) price index unacceptable because everyone is pretty sure consumer behavior is predicated on disposable income, which is affected by the headline Consumer Price Index (CPI), including oil and food.

At last count, the headline CPI is up 3.5 percent, but in practice consumers know it’s up a lot more for some items, such as heating oil. But the bond market believes the Fed will cut rates again at its Dec. 11 meeting. How can the Fed cut rates if inflation is rising? Doesn’t this value growth more than inflation?

Another rate cut means the Fed is honestly afraid of recession. It’s what Mr. Greenspan would do. But this is the Bernanke Fed. Does he have the salt to stand pat, as suggested in the last Fed statement (“the risks are roughly balanced”)? A Fed rate cut in December would be a big blow to Mr. Bernanke’s inflation-fighting credentials.

We can’t have it both ways — denying the existence of rising inflation and pretending rate cuts will not boost it further. A rate cut removes whatever remaining yield advantage the dollar has over the euro the yield spread between the U.S. 10-year note and the German Bund (the equivalent 10-year German treasury note) has already been pared to a mere 10 basis points from more than 200 basis points only two years ago. The loss of yield advantage is severely dollar-negative and, if the euro-dollar-oil connection is valid, it implies even higher oil prices, which in turn feeds inflation (or the perception of impending inflation), and so on. It becomes a vicious circle, which is why periods of stagflation need an external shock to be broken.

These shocks can take the form of a war, a tax cut, government pump-priming, or something from left field we can’t imagine yet — like a meltdown in an emerging market stock market that sends funds fleeing to the safe-haven dollar. It shows the Shanghai Composite Stock Index, which has increased roughly six fold, from 1,000 to 6,000.

This brings us to the second contradiction