As we head into OpEx this coming week I want to talk first about something that has been bothering me in the "common knowledge" around the street regarding equities, the bond market, and currencies.

We sit right now perilously close to the "80" level on the Dollar Index. The Dollar Index (which you can find here) is a composite of the dollar .vs. other major currencies.

Why is 80 important? Because it marks essentially all-time lows.

A break below 80 risks a "run on the bank" as there is no downside resistance any more. Now we have bounced off this level - but, with the US Fed Funds "abnormally low" .vs. other major markets (ex Japan), it appears that we will continue to assault that magic 80 level, and it may fall.

There are a number of people out there who believe that this will be allowed to happen. Let's first talk about why it can happen and what can be done to stop it, assuming someone in the government wanted to.

On the "why", its quite simple - the price of dollars in other currencies is related to whether people want to own them or not, just like the price of anything else is directly related to whether other people want to own any other item. If the dollar is desirable to own, then its price will increase relative to other currencies and vice-versa.

How does the dollar (or more precisely, dollar-denominated assets) become more desirable? A combination of total return and safety.

This, in the end, devolves down into a bet on the economy and the treasury markets.

Both right now are not promising; our economy is on shaky ground due to the housing market and treasuries are abnormally low due to the Fed keeping rates low despite high headline inflation numbers. Historically there has never been a housing downturn that did not result in a recession. Never.

Ok, so let's say that the Dollar does take a run at 80 and threatens to break it. What can the government do to stop the collapse?

Only one thing. Raise interest rates and contract liquidity.

Now to that you say "Whaaaaat? That will cause a recession! "

Yep. It will. But it will add to the risk premium and reduce supply, and thus halt the decline. Simple supply and demand. Remember, we still have a stable political system, we still have a government that (so far) is paying its bills, and by addressing the risk premium and removing supply we will stop the dollar's fall.

This, however, thrashes the economy immediately, as it instantly will be reflected in a collapse in what's left of the housing market and consumer credit will shortly follow. There goes consumer spending; straight in the tank.

BUT - inflation is halted, and when the recession ends, we come out a stronger nation. Yes, equities will take a hit. A big one. 30%ish, probably. But if we do it now it will be over before the Presidential Elections and the economy will be on the mend!

Now let's say that the dollar is not defended and allowed to "go down the bowl."

The immediate impact will be hyperinflation. Why? Because the price of everything produced somewhere other than here will rise in direct relationship to the dollar's fall. $150/bbl oil anyone? And this is not just gasoline - its transportation fuels, its plastics, its agricultural products (energy is necessary to farm and petroleum goes into fertilizer), etc.

This rise in prices cannot be matched by a rise in wages or the spiral gets out of control - a risk the Fed knows about. But what's worse is that this fall will trigger foreign selling of Treasuries, which will precipitously spike treasury rates - real interest rates - to an extreme degree. 10% 10 year yields anyone?

The prices-paid component is especially bad because corporations can't pass that through as nobody will be able to afford it. Corporate profits will collapse, which means tax revenues will collapse too! But - everything just got more expensive, including for the government, at a precise time when they don't have the tax revenue to support it.

This will force contraction of the government. They cannot just issue more debt, as the rates at which they will have to offer it will just make this worse!

We get a spiral down the chute.

This cycle will destroy home equity, resulting in 50-70% or MORE in REAL value losses across the Real Estate sector. 20% of ALL mortgages will foreclose as job losses go through the roof and with the equity destruction half of all mortgages will be underwater, with no hope of recovery during the life of the loan. It will make absolutely no economic sense for anyone to keep paying these off - and with their credit already in the ditch, they will walk. It will destroy half of personal and corporate wealth, as what the Dollar buys will be cut in half, but the number of dollars you have will not change. It will trash corporate profits and government funding. As businesses struggle to avoid going under they will be forced to lay off millions of workers, spiking unemployment, perhaps to as high as 20%.

In short, its the 1930s all over again, and there is NOTHING the government can do to stop it once the spiral gets going.

NOTHING.

This would literally threaten the economic and political stability of the United States, and the policy makers and administration know it.

THAT, ultimately, is why the Federal Government will defend the dollar.

But they won't say it until they do it, because they know the immediate reaction in the markets to an announcement that they're going to do so will result in the very recession they're trying to avoid! Such "jawboning" will cause instant Treasury selling and push real interest rates, causing the very thing they're trying to prevent.

So they will sit on their hands and hope that the 80 level is not breached - and only act if a breach appears inevitable and imminent.

Or, if it appears inevitable even if out a bit and the decision is taken to take the pain now rather than risk the recession running into the '08 elections. A recession that is at its worst right as the elections occur will guarantee a Democrat White House and gains in Congress, possibly to filibuster-proof majorities in the Senate!

Ok, with that out of the way, let's talk about the rest of the day.

I'm happy to have taken the DIA trade off yesterday. While it looks like maybe there was a bit more in it, running for the door isn't a bad move when you see potential trouble and have a profit. While we may not be quite at the top, I don't see the confirmation for that strength here.

Specifically, this morning we got mixed consumer sentiment numbers - one report really bad, the other marginally good (above expectations but still solidly below "average", or 100.) The market ignored the bad number and seized on the good one. Wise? No - the blip up was an anomaly in a trend that there appears to be no reason to doubt.

Second, we got two more bad economic numbers today - import prices paid up 1%, which is a really bad number in terms of inflation, and an awful same-store sales report, down 0.9% and 0.4% ex-autos. Both were way on the wrong side of expectations, but both confirm the trends that are visible to anyone who looks - consumers are hitting the wall with revolving credit, the housing sector sucks, auto sales suck worse and inflation in food and energy is running rampant.

"Economists said the weaker-than-expected retail sales report called into question Thursday's big stock market surge, suggesting that investors were overly enthusiastic about an earlier report on sales by the nation's largest retail chains."

You think? I'll tell you how I see it: Chucky has been parboiled, coated with BBQ sauce, and is fixing to be tossed on the grill - as Bearfood.

The S&P ran up right to its intraday all-time high but failed to penetrate. Now we've got a little technical problem; that's a double top and with a seven year timeline, its very solid. So either we punch through or we do not, and the "punch" has to be pretty solid.

Of course everyone's talking about "Dow 14000", and we might get it. For a while.

Oh, Iran now wants oil sold to Japan to be paid for in Yen. That's bad; its yet another source of support for the dollar that is performing a magical vanishing act. This is likely to continue as dollar debasement accelerates.

We have even more people talking about the CDO mess; here's one example:

"There is nothing to worry about because according to a headline in The Financial Times on July 5th 'Takeover activity to fore as credit worries recede.' Given that the news about the two hedge funds at Bear Stearns blowing up was only two weeks ago and the consequences are so far reaching, we would take that headline with a big pinch of salt. We think more likely than not that the Pandora's box has opened and no amount of headlines will shut it.

One clue to solving the investment puzzle is the VIX which is we think poised to explode upwards rather than subside downwards. Following the VIX's coming surge, the world will be different as people's attitude to risk will dramatically change as the credit crunch bites hard. "

That's not the only one, of course, but it does kind of put things in perspective, no?

We had a huge rally in the entire homebuilding sector, fueled by a "Hedgistan" rumor.

"'It's just another junk rumor on a Friday,' said Greg Palmer, head of equity trading at Pacific Crest Securities Inc. in Portland, Oregon. 'But if you put a big name to it then away you go.' "

In other words, junk. Nice. But if you really want to extend a big rally, how better to do it than start a rumor or two in a badly-beaten down (with good cause) sector?

Now here's a counterpoint on the credit markets in general, but to be fair, we must also point out that these people have the most to lose if nobody will buy their crap, er, debt any more.

"Lehman Brothers Holdings Inc., the biggest underwriter of mortgage bonds, Bank of America Corp. and Barclays Capital say the worst of the global credit market rout is over for now and investors should buy investment-grade debt.

"Much of the pain has been squeezed out", Lehman's London-based credit strategist David Brickman said in an interview. 'There may be some aftershocks but investors are showing a willingness to take exposure to investment-grade credit.' "

Of course the fair question to ask these assclowns is "what if the credit you're selling as 'investment grade' really isn't, because the ratings are produced with knowingly-flawed models and the markets are illiquid and opaque."

And while we're at it, let's add this to the mix: "Oh yeah, we seem to remember that you *******s lied to us the last time around, and we got nailed with a few billion in losses as a result of believing your 'investment grade' claims - which you aren't going to refund to us, are you? Now you want us to believe you a second time? Do you REALLY think we're that stupid?"

Apparently so.

Peter Schiff, an acknowledged Bear on the American Market, had this to say today:

"In a sign of desperation, the U.S. has dispatched Housing and Urban Development Secretary Alphonso Jackson to Beijing to beg the Chinese to use some of their $1.3 trillion in foreign reserves to buy more U.S. mortgage backed securities.

Talk about chutzpa! We bash them publicly, but behind the scenes we go hat in hand seeking their help. If the Chinese have any sense they will send the Secretary packing. After all, why should they use Chinese taxpayer money to bail out the U.S. housing market by purchasing securities that no American would touch with a ten-foot chopstick?

Is it just me, or haven't I seen this movie before? In the 1990's, the very Wall Street firms that created these securitized mortgage products were busy packaging worthless dot.com start-ups into multi-billion dollar IPOs. Back then the game involved in-house analysts slapping "strong buy" ratings on companies that the investment bankers themselves knew were worthless. This time around, the bankers persuaded ratings agencies such as Moodys and S&P to rubber stamp investment grade ratings on mortgage backed bonds that the bankers knew were extremely risky."

Well, he's certainly right about the movie replay.... if the dollar is allowed to flush (see above; I do not believe it will) he gets the rest. Let's hope he's wrong on that point, because the consequences there will be catastrophic and no amount of "pre-planning", other than going ex-pat BEFORE it happens, will help you.

The S&P has broken above the all-time intraday high today intraday but could not hold it. Key reversal? Maybe. What I do know is that there was no futures "pump" this afternoon; quite to the contrary; the futures sold off hard into the close, outpacing the cash index before rebounding slightly following the close of the cash markets - only to bounce down again back to the lows set just after the closing. Hmmmm.... no "pump into the close" today eh? Nobody wants to be strongly long going into the weekend?

In "my favorite horror show" the ABX continues its decline....

Wanna buy some bonds in the ABX space?? How about in the CMBX?



That's pretty. I want to know how happy the bagholders will be there....

This afternoon I put the DIA CALLs back on but almost immediately took them back off for basically a trading cost exit. I didn't like what I started to see in the Dow and as it turned out, where we closed was almost exactly where I put them on - so leaving them open would have exposed me over the weekend - no thanks.

By the way, Bloomberg's call on the market's rise today?

"General Electric Co.'s $14 billion share buyback plan and speculation Warren Buffett may invest in the homebuilding industry catapulted stock indexes to records, capping the market's third straight week of gains."

Notice that nowhere do we hear how great the economy is, or that the fundamental business climate is great. Nope - speculation.

Nor do we hear anyone paying attention to to the Dollar Index. 80.575 right now. Down. Again.

With next week being both OpEx and the start of heavy earnings reports, including financials with known exposure to mortgage problems, we are likely to see fireworks in one direction or the other - indeed, it can fairly be assumed that there is no doubt that we will see fireworks.... the only real question here is "which way?"

One warning sign for Bears - I just got the CBOE update and the Put/Call ratio on the indices is WAY elevated. What this means is that Monday, if the news is good, we could see a continued blow-off to the upside. That ratio contracted bigtime yesterday but today, it looks like the PUT buyers were back in spades - although on individual equities, it was the other way around with CALLs outnumbering PUTs 2:1.

Have a great weekend!

Talk about it here!