Oil dropped sharply on Tuesday as Fed Chairman Bernanke highlighted growth risks in testimony before the Senate Banking Committee. The prospect of a slowing economy and evidence that demand for crude is already dropping off at an increasing pace sparked an aggressive bout of profit taking. Oil registered its biggest one day drop in dollar terms since the 1991 Gulf War.

We also heard a rumor that a large hedge fund had missed a margin call and was forced to liquidate a sizable oil position. That selling reportedly triggered stops, which forced oil sharply lower.

Given how quickly oil dropped and given that Bernanke's testimony didn't really hold any surprises, this seems a pretty plausible explanation. Nonetheless, we haven't seen that rumor confirmed in the press this morning, so Mr. Bernanke seems to be getting most of the credit for knocking oil from its lofty perch.

Elsewhere, President Bush lifted the executive ban on offshore oil drilling and implored Congress to do the same. OPEC also reduced its estimated growth rate for global oil consumption, predicting that 2009 demand would be 100,000 bbl/day less than this year. This along with a MasterCard report that showed gasoline demand dropped last week for a 12th consecutive week offers evidence of considerable demand destruction.

While heightened concerns about the US economy and banking system have pushed geopolitical tensions in the Middle East from the front page, those tensions have been reduced somewhat. Reports that a senior US diplomat will participate in talks with Iran over its nuclear program are expected to be confirmed today.

While all of the news over the past 24-hours seems to be bearish for oil, gold is proving to be quite resilient. We have seen the gold/oil ratio climb convincingly back above 7 for the first time since Jun. We have been calling for a rebound in the gold/oil ratio for several months now and we see potential back toward 8 initially.

Since gold corrected back in March, oil has essentially stolen the show, setting new record highs while leaving gold in the dust. Yesterday's sell-off in oil may be the trigger that returns attention to gold as the primary hedge against a weak dollar, inflation, systemic risks and general economic uncertainty.

Money coming out of the oil market is going to need to find a home and gold is arguably the best place to store wealth during periods of economic turmoil. This logic is consistent with the rebound in the gold/oil ratio. Gold has also benefited from safe-haven flows in the wake of the Fannie/Freddie rescue, as well as diversification flows out of equities.

Despite the sell-off in oil, inflation is going to remain an ongoing threat as pass-through effects of two months with oil above $130 bbl continue to accumulate. US CPI surged 1.1% in Jun, well above market expectations. This was the largest monthly jump in CPI since 1982. The government's measure of year-on-year inflation is now 5.02%. However, the Shadow Government Statistics alternative CPI now shows the actual rate of inflation is probably nearing 13%.

The sharp jump in CPI has increased speculation that the Fed may have to raise interest rates to get inflation in check. This comes in the wake of yesterday's speculation that the Fed was unlikely to raise rates any time soon, given Chairman Bernanke's grim assessment of the US economy.

Yes, we are stuck between a rock and a hard place. Look for volatility in the bond market to remain high as traders try and figure out what the Fed will view as the lesser of the two evils. I maintain that risks to growth and employment will be viewed as the greater threat and consequently any move toward tighter monetary policy is unlikely to be seen until next year.

Gold Market Movers:

US industrial production for Jun +0.5%, above market expectations. Cap ut 79.9%.

US TIC data for May showed a net outflow of $2.5 bln.

US CPI for Jun surged 1.1%, well above market expectations, core +0.3%.

US MBA mortgage market index for the week ended 11-Jul +1.7%; purchases -1.7%, refis +6.9%.

Eurozone HICP for Jun confirmed at 4.0 y/y.

Gold remains "crisis hedge" as inflation rises despite falling commodity costs

US faces global funding crisis, warns Merrill Lynch

Bernanke highlights risks facing US economy