By Jephraim P GundzikRising inflation and falling home prices are likely to push the US economy into recession by the second half of 2007. Gathering economic weakness, combined with negative real yields on US Treasury securities and growing political pressure to weaken the dollar will lead to significant dollar depreciation against most currencies.Economic growth in Asia, Europe and Latin America will also weaken in 2007. Slowing global economic growth will be very bad news for equity markets around the world. Dollar depreciation and rising international energy and grain prices will be good news for precious metals.Impact of instability on commodity pricesWhile global geopolitical instability has ratcheted higher every year since the terrorist attacks on the US in September 2001, global asset markets have hardly responded. In 2006, many of the world’s stock markets, including America’s, reached record highs. As geopolitical instability increases further in 2007 the probability of major disruptions in energy supplies will grow.Instability in the Middle East and Africa is very likely to increase in 2007. Intensification of Iraq’s civil war, conflict between Washington and Tehran, escalating war between the Israelis and Palestinians, and growing domestic pressure on Lebanon’s US-backed government will heighten instability in the Middle East. This instability will help fuel growing unrest in Sudan, Chad, Congo and Somalia, provoking significant military conflicts in Africa. Afghanistan’s insurgency is also expected to become more violent, prompting the gradual withdrawal of NATO forces.Unprecedented global geopolitical instability will have its most obvious impact on international commodity prices. More frequent energy supply disruptions in the Middle East and Africa, combined with accelerating natural oil production declines in the world’s largest oil fields, will keep crude oil and natural gas prices buoyant. Slower than anticipated global economic growth will not push oil prices lower in 2007.Production discipline – much greater than generally understood – among the world’s major oil exporters will ensure oil supply growth remains below demand growth. The continued rise of global energy prices in 2007, paired with growing demand for renewable energy, will produce further strong increases in international grain prices. In 2006, corn and wheat prices in the US jumped by 70% and 60% respectively. Much of this jump occurred between September and December.Rapid growth of ethanol production capacity worldwide has contributed to this leap in corn and wheat prices. Prices for soybeans and other oilseeds have also begun to head higher on the back of rapidly growing global demand for biodiesel fuel. The substantial increase in petroleum-related energy prices since 2001 is only one factor behind growing demand for biofuels. Increasingly stringent environmental regulations, energy security concerns and targeted levels for alternative energy use in many countries is also driving demand for biofuels.Inflation and recessionThe growing use of corn, wheat, soybeans and other grains to produce biofuels is expected to nearly double prices for these commodities in 2007. In addition to grain-related foods, prices for other food staples that are grain-dependent, including meat and milk products, will also head higher in 2007. The result will be much higher than expected US inflation. Consumer price inflation (CPI) in the US is already significantly higher than CPI in Germany, Switzerland, the UK and Japan. In 2007, US inflation will accelerate, widening the inflation gap between it and other countries.By every measure, inflation in the US has clearly accelerated since 2004. In 2005, the Federal Reserve’s preferred measure of inflation, the personal consumption expenditure (PCE) deflator exceeded 2% for the first time since 1995. The core PCE has continued to accelerate in 2006, and will likely top 2.5% by the end of the year. This is significant because the Fed’s stated aim is to keep core PCE between 1.5% and 2%. The steady acceleration of core PCE shows that inflation from rising energy prices has penetrated the broader US economy.Despite the obvious acceleration of inflation, the Federal Reserve shifted monetary policy into neutral in late summer. The Fed has justified more accommodative monetary policy in the face of rising inflation by suggesting that slowing US economic growth will eventually mitigate inflation. This is a huge gamble because US inflation is being pushed higher by supply-driven energy price shocks rather than demand. In 2007, continued energy supply shocks are likely to feed a grain supply shock, stoking a sharp increase in food price inflation and further acceleration of core PCE.The stated logic behind the Fed’s monetary policy change is spurious, to say the least. A 12-year-old child could grasp the idea that energy supply problems are pushing US inflation higher and that these supply problems are likely to intensify in 2007. This suggests that another explanation must be behind the Fed’s shift to more accommodative monetary policy. The most likely seems to be growing concern among Fed policymakers over increasing systemic problems for the US financial system arising from the collapse of the US housing market.Between 2001 and 2005, very low interest rates in the US, combined with the proliferation of non-traditional mortgage products and easy credit access, allowed many American households to convert substantial home price gains into income gains through cash-out mortgage refinancing.refinancing accounted for about 50% of all mortgage refinancing between 2001 and 2004. In 2005, cash-out mortgage refinancing accounted for 73% of all mortgage refinancing. In the first half of 2006, cash-out refinancing accounted for a staggering 87% of all refinancing.Home price appreciation in the US slowed sharply in the first half of 2006. In the third quarter of 2006, home prices began to fall steeply. According to data from the US Census Bureau, new home prices dropped nearly 10% in September 2006 from the same period in 2005. This marks the sharpest fall in US home prices in 35 years. Rising inventories of unsold homes have been pushing home prices lower.Recently, America’s largest home builders and home sellers have begun trying to convince investors and home buyers that the housing market has stabilized. Falling long-term interest rates have reduced mortgage rates, encouraging a very small number of buyers to return to the market. However, the housing sector’s weak pulse is very likely to vanish again in early 2007 as confusion over Federal Reserve policy mounts, the pace of inflation quickens and financial markets in the US swoon.America’s economic fairytale has turned into a nightmare and very few investors realize it. In addition to producing a sudden and sharp decline in household income by eliminating the prospect of new mortgage refinancing for many Americans, declining prices for new and existing homes will have a strong negative impact on the US financial system, severely restraining credit growth. Falling home prices, especially in what were once the hottest housing and mortgage markets in the US, have caused mortgage default rates and foreclosures to surge higher.The combination of rising defaults, foreclosures and falling collateral values is beginning to weaken the balance sheets of mortgage lenders, including several of America’s largest banks. Growing weakness in the banking sector is very alarming. Banking sector and economic crises in many countries over the past 25 years can be traced to overly enthusiastic credit growth used to finance either capital investment or real estate speculation, or both. Japan offers a stunning example of what can happen after a real estate bubble bursts.The Federal Reserve appears determined to let financial markets “self-correct” in order to adjust interest rates to changing expectations for economic growth and inflation. Self-correction is a defining feature of financial markets. However, with the Fed rudderless, it is very unlikely that this self-correction will occur in an orderly and gradual manner. Rather, such self-correction will be sudden and sharp.Dollar devaluationGrowing concern at the Federal Reserve over the impact of rapidly rising mortgage defaults and foreclosures on the US banking system will prevent it from tightening monetary policy in 2007. Inflation in the US is already substantially higher than inflation in Europe and Japan. Rising energy prices joined by rising food prices will have a greater impact on inflation in the US than in Europe and Japan because dollar depreciation is expected to partially offset rising dollar-based commodity prices in 2007.In addition, inflation will rise from a much lower base in Europe and Japan than in the US. As a result, US inflation will be much higher than inflation in most other countries in 2007. More importantly, real yields on US Treasury securities, which are only marginally positive now, are expected to become negative in 2007 as US inflation climbs higher and the Fed begins to cut interest rates.At the same time, real yields on European and Japanese government bonds, which are already higher than real yields in the US, are expected to move higher. The growing real yield gap between the US and other countries will place enormous downward pressure on the dollar. Waning Fed credibility and increasing political pressure in the US for dollar depreciation will speed the dollar’s decline.Democrats will take control of the US Congress in January 2007. Democrats have a strong history of economic intervention and are very likely to use trade and exchange rate policy changes in an attempt to reinvigorate rapidly slowing US economic growth. Asia’s economic giants, Japan and China, are likely to take the brunt of any economic policy changes engineered in the US Congress.Legislation in the US aimed at prying open export markets in Japan and China is likely to inflame already substantial trade tensions, especially between Washington and Beijing. Meanwhile, the implicit change in US exchange rate policy that will precede such legislation will increase downward pressure on the value of the dollar against all major currencies, particularly the yen.The dollar is likely to depreciate by at least 20% against the yen, the Swiss franc, the euro and the pound in 2007. The dollar will also depreciate against the currencies of emerging market commodity exporters. Finally, Beijing will probably allow the yuan to appreciate about 10% against the dollar. Rather than political pressure from Washington, continued high energy prices and soaring grain prices will motivate the revaluation of the yuan.Sliding stock marketsEconomic growth in China is likely to slip towards 6% in 2007. Beijing’s enormous fiscal latitude will ensure that ramped up fiscal spending will partially offset significant weakness in China’s US-oriented export sector. Accelerated yuan revaluation against the dollar will help offset the inflationary impact of rising energy and grain prices. Economic growth in Japan will probably fall below 1.5% in 2007 due to export sector weakness. In addition to importing all of its energy needs, Japan relies on imports of US corn for sustaining domestic meat production. This reliance on energy and grain imports will encourage the Bank of Japan to push the yen higher against the dollar to contain inflation.Economic growth in Korea should slow towards 1% in 2007. Growing tensions between Washington and Pyongyang will undermine private consumption and investment while much weaker US- and China-bound exports will slow export sector growth. Like Japan, Korea is also a major importer of US corn. Won appreciation against the dollar will be limited by growing security concerns. As a result, inflation will accelerate, further undermining the won.Economic growth in South and Southeast Asia will also slow sharply. In addition to slowing US economic growth, increasing global geopolitical instability will lead to more frequent and violent terrorist attacks, especially in India, Indonesia, the Philippines and Thailand. These attacks will produce further political and social instability. Foreign capital flight, driven by much slower than expected economic growth and a sharp correction in US equities, will make these countries Asia’s worst investment performers in 2007.Economic growth in Latin America will also suffer from the US downturn in 2007. Mexico, where political and social instability are expected to increase substantially while US-bound exports grind to a halt, should follow the US into recession. Capital flight will weaken the peso, preventing exchange rate appreciation from offsetting the impact of sharply higher corn prices on the domestic food industry.Economic growth in Brazil, Colombia and Peru will also slow sharply in 2007. Brazil’s export sector will benefit from soaring grain prices, while Colombia and Peru will suffer from the same. Equities in all four countries will follow US equities downward. Economic growth in Venezuela, Ecuador and Argentina will benefit from soaring commodity prices. This will not prevent equity market correction, but should underpin exchange rates in all three countries.With the notable exception of Turkey, economic growth in Europe should suffer the least from slowing US economic growth in 2007. Monetary policy in the EU will tighten further, underpinning currency appreciation. Economic interdependence between EU members will insulate the region somewhat from slowing economic growth in the rest of the world. Russia will benefit from rising commodity prices. Despite more promising economic prospects, equities across Europe will follow US equities in a sharp correction.Bond markets around the world are likely to be very volatile in 2007. Rapidly changing economic growth and inflation expectations will produce wide price swings. This volatility will be led by US bonds, which will see falling yields in early 2007 be replaced by rising yields in mid-2007 as inflation increases and foreign capital flight accelerates. Spreads on emerging market bonds will widen with falling equity markets around the world. Commodities, including energy, grains and precious metals, will probably perform much better than traditional investment assets as both investors and central banks speed diversification.Jephraim P Gundzik is president of Condor Advisers. Condor Advisers provides investment risk analysis to individuals and institutions worldwide. Visit www.condoradvisers.com for more information.