Dollar Musings and the Potential for a Significant Stock Market Decline

What to make of this US dollar rally?

The fundamentals are decidedly negative, looking at the Trade Balance and Current Account Deficit, despite the case many make that we are 'better off' than Europe.

Our take is that the dollar is much worse off because it has been the world's reserve currency for the past thirty years or so and that is unwinding, in addition to the slumping economy and ballooning deficits. There is really no good fundamental reason anymore for two countries to conduct their trade in a third country's currency, and to maintain a reserve in it for those purposes.

Arguments about this can go on almost endlessly tit-for-tat since there are so many variables and exogenous factors, and too many degrees of freedom to make an objective short term projection with a high level of confidence.

So let's do what we always do when we are in a position of uncertain outcomes, and try to decide what to look for and what data might be important to help us come to a better understanding. For us that includes some charts.

The last sustained rally we had in the dollar ran almost the entire length of 2005, starting on New Year's eve in 2004.

Here is what it looked like.



That was a classic bear market rally. It had duration, and the overbought condition never reached extremes for any extended period of time. It was sustainable.

The funds were leading the buying to the upside, as they always seem to do in the Dollar Index market. We are very aware that this is only a narrow snapshot of their overall positions, and will very likely be more predictive than causal.

Nevertheless, however it works, the funds are the price leaders in this market, and the commercials make the market for them.



If you look at the 2005 dollar rally period on the funds' Commitments of Traders chart below the net long positions are obviously built over time to a top.

In this latest rally the net longs of the funds soared quickly to a near term record. The explanation for this has been the unwinding of trading pairs that favored commodities to the long side and the dollar to the short side. There is also some likely forced liquidation of positions from failing funds.

Here is what the 2008 dollar rally looks like so far on a price chart.



Anything can happen, we will gladly stipulate that. But how does this rally stack up so far in this particular market. Percentages help, so here is a chart of the dollar with some fibonacci retracement levels.



As it stands now this rally is remarkably similar to another short covering rally we had on the same leg down in this obvious bear market. From a probability point of view, admitting than anything is possible, until the dollar can take out the long term neckline and stick a close and hold it over 82 we think this is just another bear market rally. The Trend is the trend until proven otherwise.

We also believe that this dollar rally is at least partially due to a flight to quality in addition to a short squeeze and a likely central bank intervention. Dollars are coming home from emerging markets, and fleeing stocks and riskier investments. This is indicated by the Treasuries rally.

We have to remind you all that significant market declines or "crashes" are notoriously low probability events, and that people who predict crashes typically predict lots of things, most of which are incorrect and quickly forgotten.

We think that there is a heightened chance of a significant stock market decline that will start in the next thirty days. As we have previously said we are watching for a 'failed rally' hall mark in our model, We are almost there.

A likely target for clarification will be around the week of this month's option expiration on 20 September.

Keep an eye on the volatilty index or VIX. We put links to most of these charts on our site every day on the left hand section labeled "chart updates."

This may turn into or be linked with an "October Surprise" or a major bank failure.

Working against this is the desire of the G7's central banks to prevent a global market crash from dampening economic and monetary growth, threatening the world's banking system.

Or it may be something else entirely. But we now have a few more signposts on this difficult trail.

Who's Next?

In order to regain a shred of credibility, the Fed has to let someone fail. Even if Ben does not realize it, Hank knows that someone has to take one for the team.

The question is, who?

Not the public. We're on the menu as a slow roast.

WaMu? Spreads say its a good bet. The question we're pondering is cui bono, who benefits. Ben has to be gagging on this one since they are a 'real bank,' but the breakup fees and carcass picking must be tempting indeed to the pigmen. Maybe, but more likely for later. It might be messy. Same goes for Wachovia. Possible, but potentially dangerous.

LEH? It would make a manageable splash and the desperation is apparent. Dick "The Gorilla" Fuld is widely disliked and he's been at Lehman for so long he's probably not very wired into the right places. He's on the Board of the NY Fed, but we'd bet he used his time there to generally piss off the wrong people. An asset sale and then death by boofoo seems like a decent bet. Or just a sudden death and fire sale after the fact. Contrarian-wise too many expect it, but that might just be a way to keep it from shocking the markets, which is a plus.

MER? They are in deep trouble, but John Thain is making the right moves and knows too many gravesites, and is well respected. Maybe, if he gets airlifted out first and taken care of in a big way. He'd make a great chairman of the SEC, Treasury Secretary, or a government Resolution Trust chief.

We'll be looking for the unwinding of obligations by the right crowd. They-who-must-not-be-named very publicly put one behind Bear's ear by pulling their business, but its unlikely to be that publicly obvious next time. That was payback for LTCM.

That's the gameplan unless something unexpected happens. Then its time to grab some gold and head for the nearest door. But for now it looks like the Working Group on Managed Markets has this one by the nose and is just taking care of business.

Not With a Bang But a Whimper

And of course discreetly-placed denials by KDB (and LEH?) in the media were quick to follow this statement...

Korean regulator says KDB talks with Lehman ended
By Steve Goldstein
7:02 a.m. EDT Sept. 9, 2008

LONDON (MarketWatch) -- South Korea's Financial Services Commission Chairman Jun Kwang-woo said Tuesday that talks between state-run Korea Development Bank and Lehman Brothers Holdings Inc. have ended, Dow Jones Newswires reported. He declined to say what conclusions, if any, had been reached, the report said.

Fannie and Freddie Used Accounting Tricks to Create a "House of Cards"

Fannie and Freddie have been the bastions of the housing industry holding trillions of dollars in securitized mortgages.

Housing has been a significant driver of the US economy for the past ten years, and a major source of credit growth and personal wealth in a long period of wage stagnation.

If Fannie and Freddie are a "house of cards' and an accounting fraud, what does that make our economy? Hollow, thin, and unstable?

Fannie, Freddie `House of Cards' Prompts Government Takeover
By Dawn Kopecki
Bloomberg

Sept. 9 -- Fannie Mae and Freddie Mac used accounting rules that created a ``house of cards'' as the housing market descended into its worst slump since the Great Depression.

While the two largest mortgage-finance companies met regulatory requirements for their capital, reviews by the Treasury, the Federal Housing Finance Agency, and the Federal Reserve found they probably wouldn't weather the highest delinquency rates on record, lawmakers and regulators said.

``Once they got someone looking closely at Fannie and Freddie's books, they realized there just wasn't adequate capital there,'' U.S. Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. ``They found out they had a house of cards.''

Treasury Secretary Henry Paulson and FHFA Director James Lockhart seized control of Fannie and Freddie less than a month after Lockhart, whose job is to oversee the companies, declared them ``adequately capitalized'' under law. The discrepancy highlights the flaws in legislation and in the regulatory oversight of Fannie and Freddie that didn't demand they keep more assets as a cushion against losses, according to Joshua Rosner, an analyst with Graham Fisher & Co. in New York.

``Fannie and Freddie's accounting during the housing crisis appears to have been more fantasy than reality,'' said Rosner, who first highlighted problems in 2003, before the two companies were forced to restate about $11.3 billion in earnings.

`Not Adequate'

Washington-based Fannie had $47 billion of regulatory capital as of June 30, about $9.5 billion above what FHFA required, according to company filings. McLean, Virginia-based Freddie's capital stood at $37.1 billion, a cushion of about $2.6 billion over FHFA's standard, filings show.

``They met the legal definition,'' Lockhart said in an interview with Bloomberg Television yesterday. ``As I have been telling lawmakers for a long time, that legal definition was not adequate.''

As their stock prices declined and yields on their debt rose to the highest in at least 10 years above benchmark rates, the FHFA saw ``big questions out there,'' Lockhart said.

``The issue is that the exposures are continuing and continuing to grow and it looked like in the future there were going to be significant issues and they were going to have capital problems,'' Lockhart said.

Lockhart said he brought in financial examiners for the Federal Reserve and the Office of the Comptroller of the Currency to help with a review of the companies' finances. Treasury also sought help from Morgan Stanley officials, who prepared a report after trawling through the accounts.

`Too Low'

After looking through the finances, Fed examiners deemed their capital reserves too low, Dallas Fed President Richard Fisher said yesterday.

``We concluded that the capital of these institutions was too low relative to their exposure,'' Fisher said in response to an audience question after a speech in Austin, Texas. Further, ``that capital in and of itself was of low quality.''

Fannie counted $20.6 billion in so-called deferred tax credits toward its $47 billion of regulatory capital as of June 30, according to company disclosures. Freddie applied $18.4 billion in deferred-tax assets toward its $37.1 billion in regulatory capital in the second quarter.

Fannie and Freddie have posted four straight quarterly net losses totaling a combined $14.9 billion and have said they anticipate more. The tax credits don't have any value unless the companies are generating profit. (They had to bring in the Fed, Treasury and Morgan Stanley to figure this out? - Jesse)

`Not Even Real'

``That's not even real money,'' Shelby said.

Senator Christopher Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee responsible for oversight of the companies, said yesterday he plans to hold hearings on why the Bush administration didn't act sooner.

``Why weren't we doing more, why did we wait almost a year before there were any significant steps taken to try to deal with this problem?'' Dodd said in a Bloomberg Television interview. ``I have a lot of questions about where was the administration over the last eight years.''

Market Value

After more than eight years of debate, Congress passed a law in July expanding Lockhart's authority to raise capital requirements, curb growth and to take over the companies' operations in a conservatorship or liquidate their assets under receivership. The legislation also gave Paulson temporary power to inject unlimited sums of taxpayer money into the companies.

The companies just four years ago admitted to $11.3 billion in earnings misstatements that led to $525 million in federal fines, tighter regulatory controls and the ouster of the CEOs.

Paulson said he stepped in to prevent a collapse of the companies, protecting investors owning more than $5 trillion of Fannie and Freddie corporate debt and mortgage-backed securities while potentially sacrificing holders of the common and preferred stocks.

The companies yesterday lost the majority of their market value, with Fannie falling 90 percent to 73 cents in New York Stock Exchange composite trading, its lowest level since 1982. Freddie dropped 83 percent to 88 cents, the lowest since the regular common stock began trading 20 years ago.