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If the chart below doesn’t grab your attention then few things will. In my opinion, the performance of the dollar is the surest evidence of the kind of environment we’re currently in. The surging dollar is a clear sign that inflation is not the concern of global investors. This is almost a sure sign that deflation is once again gripping the global economy and should be setting off red flags for equity investors around the world.

The recent action in the dollar is eerily reminiscent of the peak worries in the credit crisis when deflation appeared to be taking a death grip on the global economy and demand for dollars was extremely high. The recent 16% rally in the dollar is a sign that investors are once again worried about the continuing problem of debt around the world and they’re reaching for the safety of the world’s reserve currency – the dollar. As asset prices decline and bond yields collapse this is a clear sign that inflation is not the near-term concern, but rather that the debt based deflationary trends continue to dominate global economic trends.

This is exactly the kind of market action we saw leading up to Lehman Brothers. In 2008 the dollar rallied as signs of deflation began to sprout up. This was an instant red flag for anyone who understood the deflationary forces at work (and a total surprise for the inflationistas). The dollar ultimately rallied 26% from peak to trough. Coincidentally, the dollar had rallied 16% from trough to peak just prior to the Lehman collapse when the dollar surge accelerated.

Of course, the inflationistas will argue that gold is rising in anticipation of inflation. In my opinion, this is incorrect. First of all, if inflation were a major global concern the Goldman Sachs Commodity Index wouldn’t be almost 65% off its all-time high and just 33% above its 2009 low. Second, and perhaps most importantly, bond yields around the globe wouldn’t be plummeting if there were rampant inflationary fears. For a much more detailed analysis on the reasons why inflation is not a near-term concern please see here.

As for the gold rally, I think it’s clear gold is rallying in anticipation of its potential to become a future reserve currency. The potential demise of the Euro has become a rally cry for inflationistas who don’t understand that the Euro is in fact another single currency system (like the gold standard) which is destined to fail. In the near-term, the rise in gold is likely justified as fear mongering and misguided governments increase demand for the yellow metal. Ultimately, I believe investors will realize that there is little to no inflation in the global economy and that the non-convertible floating exchange systems (such as the USD and JPY) are fundamentally different from the flawed currency system in place in Europe.

Debt deflation continues to plague the global economy. Thus far, policymakers have been unable to fend off this wretched beast and I attribute this largely to the widespread misconceptions regarding our monetary systems. This extends to the very highest levels of government and the misconceptions regarding the EMU, the Euro and the vast differences in their monetary system have only exacerbated the problems and are likely to further worsen the global deflationary threat. The ignorance on display here borders on criminal in my opinion as governments impose harsh injustices on their citizens due entirely to their own lack of understanding.

I’ve mentioned repeatedly over the course of the last 18 months that government responses to the credit crisis were misguided and unlikely to resolve the structural problems. I’ve also mentioned that this was something I have sincerely hoped I would be wrong about as the consequences have the potential to be enormously destructive. Unfortunately, the policy responses have been so tragically misguided that I now believe the global economy is on the cusp of a potential double dip. And as Richard Koo says, the second dip has the potential to be far worse than the first because investor confidence is shattered (which is clearly the case on the back of the recent market crash). Policymakers are doing little to rectify confidence and have in fact, through their ignorance of the way in which our monetary system actually functions, only increased the global risks in the economy. The dollar is the surest sign of the lack of faith in the policy response and an enormous red flag for risk markets. Allocate accordingly.

PS – There is a video going around called “Melt-up” and it is receiving a HUGE amount of attention on the internet. It is regarding the recent melt-up in stocks and how the U.S. is about to enter an inflationary spiral and a currency collapse. I would recommend to the good readers here at TPC to ignore this video. It is 100% factually incorrect (well, more like 75%) and full of the same fear mongering misconceptions that fuel the asset destroying portfolio strategies of well known inflationistas (we all know the names). Videos like these are based on the same misconceptions regarding the monetary system that have actually led to the current debacle. Positioning yourself for hyperinflation and a U.S. dollar collapse has been a recipe for disaster and will continue to be a recipe for disaster as debt deflation remains the single greatest risk to the global economy.

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