Storm Brewing?

I’m a skeptic al and analytical person for the most part. Anything that has to do with trading, economics, and forecasting are issues I take pretty seriously and am passionate about. I do want to discuss a few issues that have been on my mind the past few days.

This stuff might sound like I’ve gone off the deep end but I believe it’s worth at least some food for thought. There’s a few fundamental and geo-political issues sitting in the frying pan and as soon as the pan gets some fire put to it they could become explosive resulting in global financial markets being rocked.

Basically I just have this gut feeling that we’re going to deal with a catastrophic event(s) that goes down between Labor Day and Thanksgiving. War, bank failure, surprise monetary policy move by the Fed or ECB, manipulation of crude, or all of the above or maybe something I haven’t even thought was possible.

One issue is with the U.S. banking/financial system and overall credit conditions in the U.S. and the banking system’s tight correlation with Wall St. I’m convinced we’re going to see a major bank or financial institution failure during the third quarter. The fact that the housing market has yet to show one single sign of hitting a bottom means there has to be more bank writedowns and bank failures in the third quarter.

If Fannie and Freddie see their equity zeroed out and the Treasury steps in to save them this should halt the dollar’s rise to glory in its tracks and cause a sharp reversal. At the same time I’m also convinced several European banks will fail before the end of 2008. Somebody has done a really good PR job at hiding the issues with European banks.

When the first European bank fails and the media runs images of angry European pensioners with clenched fists demanding their money, the euro is going to take a brutal beating unlike many of us have likely ever seen. Basically there’s equal dollar and euro risk in my opinion in this regard of banking and finance.

The next issue that has me concerned will sound off-the-wall but I’m going to put it out there anyway. I have this feeling that Bernanke and Paulson know something crazy is about to go down in the U.S. financial market and they have used their direct access to the currency market and gold market to manipulate the value of the dollar in turn to bring down commodities and push up the USD Index because they know if there’s a catastrophic systemic shock in the U.S. financial market it’s just going to send prices back up.

There’s no way Bernanke, Paulson, and Trichet could have the EUR/USD trading around the 1.6000 level in the event a major financial shock hits the global markets in September or October. It would have created a dire situation for both the Fed and ECB.

Where my thinking gets a little crazy is that I believe it’s possible the Treasury might have to tell debt holders that the Treasury can’t pay and may have to offer some kind of buyout for pennies on the dollar. When I say debt holders I’m specifically referring to buyers of U.S. debt – bonds. I’m talking U.S. government issued bonds.

One of the reasons bonds are called securities is because they are considered “no risk”. The U.S. government has never once defaulted on paying a debt holder. If budget deficit or monetary reasons somehow for some reason prevent the Treasury from meeting their debt payment obligations the effect on the dollar would be disastrous and could even start a military conflict. I only give this less than a 10% probability of ever happening, but it’s something I’ve thought of anyway.

The next issue is a geo-political one. It’s about the tensions with Russia. The media is portraying Russia as the bully and the aggressor who stirred up conflict with Georgia. Well, my understanding of the situation is not how the media reports have portrayed Russia.

I believe the real story is that Georgia provoked Russia into conflict and Russia reacted the same way the U.S. would likely react if a neighboring non-ally overstepped their bounds. In recent years Russia has become a force to be reckoned with as their economy has rebounded and vast wealth discovered from their trillion dollar crude market.

And now we have an agreement signed between the U.S. and Poland to allow missiles in Poland about 150 miles from Russian borders. Of course this is going to make Russia feel threatened by both the U.S. and Europe. I think it’s an extremely aggressive move against Russia and it goes against what the Constitution stands for and is extremely arrogant of the U.S. to make this kind of move.

I really don’t want to see the U.S., Europe, and NATO force Russia’s hand this fall because the Russians could really complicate global financial markets if they wanted to. Putin is clearly pulling the strings behind the scenes and I don’t think the dude is joking around. If the Russians wanted to they could shut off Europe’s energy supply and it could be a cold winter in Frankfurt and points west.

I really don’t like the relationship that exists between Russia and Iran. But I can understand why a Russia-Iran partnership is mutually beneficial for both sides. It just bothers me that they are allied because collectively they could wreak some havoc in geo-political realm.

Those are some issues I’ve been thinking about and I believe could cause some chaos this Fall. I’m also sure we’re going to see a big bank failure or financial institution failure sometime after Labor Day. Maybe Fannie and Freddie will finally be put out of their misery and taken to the field and shot by Paulson and Bernanke. That should be a several hundred billion dollar tab for the taxpayers to pick up.

The U.S. budget deficit, current account, and trade balance issues put risk on the rising dollar. When is enough debt enough? How much more can the Treasury inflate the money supply and how much debt can we possibly sell to try to cover our deficit? How many more bailouts can we afford? Those issues are extremely USD- and it’s hard for me people are buying dollars so vigorously the past few weeks.

These extremely USD- issues have not gone away the past six weeks. The U.S. financial system is more unstable and on the edge of the cliff than they were last August went money markets went haywire. There’s absolutely no way the Fed can even dare to think about raising rates at least through the rest of this year.

The credit and equities markets are way too unstable for the Fed to raise rates, it would be a disaster. All you have to do is look at USD LIBOR rates and you can see that the Fed’s 325bps worth of rate cuts haven’t done their job yet. The housing, consumer, and employment sectors are still too much to the downside for the Fed to raise rates even though the inflation data tells us that Fed Funds should at least be above 5.50% right now.

How much more will the Fed allow the USD to appreciate? U.S. exporters, which have been the backbone of the Trade Balance will be screaming bloody murder if the dollar gains too much ground against the euro. If the USD breaks through the 80 level on the USD Index this puts exporters at risk and that puts the Trade Balance at further risk and I don’t believe this is a situation the Fed wants right now.

At the same time the depreciated euro makes Trichet’s job a whole lot easier. The dude is serious about inflation and with the euro dropping several hundred points vs. the dollar it gives him more leeway to keep the ECB’s key lending rate where it’s at and prolongs the process of starting the rate cut cycle.

Fundamentally, the crap is hitting the fan in Europe. It’s not going to be pretty from here on out in Europe as far as growth and production data is concerned. Recession has already hit in some of the Eurozone and will likely spread in the near-term. I’m very bearish on the euro’s fundamentals and the ability for Trichet to stay hawkish too much longer.

I think you can see where’ I’m going with all this. There’s a lot that could all go terribly wrong in the next few weeks and this means we all need to stay at the top of our game and manage risk with the precision of an orthopedic surgeon.

For me, the worst case scenario is that I just went off the deep end a little bit and over analyzed all the markets and erred on the side of strict risk and money management.

Last night we were watching the women’s 4X400 relay race and it was a classic. It came down to the last lap and the last few meters. The Russians were in the lead coming down the homestretch. Right towards the end of the race the camera caught the last Russian sprinter do something that likely cost her team the gold medal.

The sprinter took her eyes off the finish line and looked up to the video board to see how close the U.S. sprinter was. It was at that point that the Russian lost the race and the U.S. sprinter took control to win the gold for her team.

The exact same thing can happen in this market. Being careful with your trading and with your risk management strategies will be key in order to survive the next few weeks. I’m not even going to waste my time or energy trying to call a top or bottom under these conditions. It’s pointless in my opinion and it wouldn’t serve any purpose to how I actually trade the market. MIG, a broker from Switzerland made a bold call on the EUR/USD’s near-term range – 1.4300 to 1.7000. Now, that’s a way to take a stand and narrow things down…

It’s pretty simple… the markets are going to be razor thin between now and the first week of September. The price swings will likely be volatile and extended at times. Prices will be moved by data, commodities, Fed and ECB, and any geo-political events, so those are the areas I’m to stay focused on.

Be smart with your trades and please do not overlevarage.