EUR/USD Weekly Outlook 9/21 thru 9/26 2008 part 1

USD:

Is the great dollar bull run of 2008 over? Possibly, but in my view, it never existed and was mostly smoke and mirrors. The dollar’s unstoppable run the past ten weeks, in my opinion, was manufactured by the Fed and ECB. Here’s why I believe this to be true.

First, look at the timing of the dollar’s rise. It happened while market participants were on summer holiday and the markets were completely ill-liquid. The field was ripe for harvest and the odds were in the Fed and ECB’s favor to manipulate the dollar during this timeframe. While Europe was on a seven-week holiday and the rest of the financial markets were focused on Wall St., the Fed and ECB used verbal and physical intervention to push the USD Index up and drop commodities. In fact the ECB started the gold sell-off which helped fuel the dollar’s run.

Do you remember our good friend Jean-Claude Juncker from the ECB? Do you remember how he shocked the markets three weeks ago by saying “the euro is overvalued in real terms”? He said that two times and both times he used that verbal intervention it pushed the EUR/USD down several hundred points. I do not believe it was pure coincidence he made those comments right before the U.S. financial markets melted down to the point they did last week.

The Fed and ECB knew all along what Wall St. would come to. Both central banks knew the government would have to take the entire U.S. financial system into receivership. And they knew what this was going to do to the dollar – destroy it. I’m not ruling out the possibility of more manipulation because this mess could ultimately send the USD Index and gold to places that are very dark and scary.

At this point we do not have full disclosure on the Fed and Treasury’s plan to save the financial system and to bailout Wall St., and to stop the housing market from collapsing. Basically, the U.S. government is going to buy bad mortgage assets, take on the risk, fund the programs with taxpayer money, and overtime re-price and resell these almost worthless assets to banks and financial institutions for a higher premium than what they are worth now.

For example, if Lehman Brother’s is only able to get $0.20 on the dollar for an asset, the Fed may be able to get $0.40 on the dollar. Then the asset is in the hands of another creditor, the original debt holder is off the hook for the worthless paper, the Fed makes a small profit, and everybody’s happy. That’s how it’s supposed to work, but the fact government is handling this delicate operation means it could be a disaster.

The Treasury says the plan will cost $700 billion and last a minimum of two years. The Treasury is raising the national debt ceiling to $11.3 trillion from its current level of $10.6 trillion. I put the cost at $1 trillion minimum. This is $1 trillion we don’t have and $1 trillion that will be created out of thin air. Debt must be created by the Treasury and sold to foreign investors. I’m not convinced that will happen right now, but more on that later.

We joke about the Treasury’s “printing presses”. It’s not a joke anymore because the presses will run. Bernanke and Paulson will have to inflate the money supply. You know what that means… inflation. That is the true definition of inflation – printing money – adding money to the economic system. We won’t really know how much money the Treasury prints because we don’t get M3 from the Fed.

But it makes sense now that we saw a season of dramatic deflation because the central banks knew we were headed into a prolonged period of inflation caused by flooding the money supply with a worthless currency. And that is the exact reason why I say the dollar’s bull run could be over.

Only further manipulation can prop the dollar up now. This is economics 101. This is the epitome of what Austrian economics teaches us. The Fed and Treasury’s programs and the money it’s going to take to run them are inflationary and suck the value right out of the dollar.

The dollar should be slaughtered. Gold should steadily rise. Foreign investment in U.S. debt instruments should continue to decline. More banks should fail. More panic should ensue in the weeks to come. And, in a perfect world, the dollar should be sold-off. Will it happen the way it “should”? Only the markets can decide the fate of the dollar… and if the dollar does get heavily sold-off I would expect to see more intervention.

Politics:

Politics are now coming into play and that’s a very bad thing. We are going to see some political battles over this plan to completely bailout the entire U.S. financial sector. Republicans and Democrats will battle and each party will use this disaster for their own political advantage.

The involvement of politicians means it will cost the taxpayers more money, it will be mismanaged, and it may even decide who the next president is. Both McCain and Obama are already using the issue to gain political leverage.

Last Thursday McCain said he would have fired the chairman of the SEC and on Friday he said he would not bailout Wall St. McCain better be sure all of his constituents and supporters and political allies feel the same way he does before he keeps running his mouth…

There are only two politicians in DC that I trust to do the right thing – Ron Paul and Jim Bunning. Paul and Bunning are the only two that understand free market capitalism and the problems with fiat currencies, inflated money supplies, and big government. They will be ignored during this process even though they are the only two voices of reason in DC.

Both Obama and McCain will fail miserably at their jobs as it relates to the economy and fixing the financial system. It’s a losing situation for both candidates. McCain knows as much about economics as I know about multivariable calculus (I never made it past algebra 1.2). McCain believes interest rates should be at 0.00%. Enough said.

I’m not real clear on what Obama thinks about the situation or what his plans are to fix it if he’s elected because he never says anything that makes sense. He talks in circles but you never get a definitive answer on anything. What I do know about Obama doesn’t give me any comfort that he has a clue.

McCain has a few big name corporate CEO’s and business people are aligned with him, but that doesn’t mean much to me. Warren Buffet is aligned with Obama… that doesn’t mean much to me either. No matter what, we’re in for a painful political war that will drag on while Wall St. continues to go from euphoric to schizophrenic and back again.

Bonds:

For weeks I’ve been talking about irregularities with U.S. bonds. I’m getting extremely concerned about bonds and it gives me just another reason to believe the dollar’s run could be over. When Paulson announced his bailout plan at the end of last week, bond yields shot up, prices dropped, and money flows poured back into equities.

This is a problem. The bailout plan is going to need heavy money flows going into bonds and not necessarily into stocks. We know that in July foreign buyers of bonds dried up to almost nothing. This is terribly USD-.

There are some very smart bond traders and very smart strategists in the bond market. I have to think they see what I see, which is a potential collapse of certain U.S. bonds and or the possible default by the Treasury.

Right before the big bailout plan was unveiled, panic-money poured into the 3-month T-Bill driving the yield to almost negative. I’ve never seen anything like that, it was shocking. But now that Wall St. is saved, money is going into equities and out of securities. The other issue is that I think the foreign view on the U.S. will be downgraded while this mess in the financial sector gets political and continues to drag on.

The U.S. government relies on billions of dollars of foreign money to buy debt in order to feed the deficit and keep the lights on in DC. If we see panic in the bond market or a collapse or the Treasury defaults, the dollar is going to take a whipping unlike anything we’ve ever seen.

As a currency trader I usually only focus on bond yields but now the prices matter because if the yields keep flying up that means the prices are dropping. If the prices collapse, we have issues. If we see a panic collapse with treasuries or treasuries get downgraded or the Treasury defaults on debt re-payments there will be a violent dollar sell-off. The central banks could try to intervene against that but the point to understand is any of those events would be highly USD-.

Fundamentals:

The data on the books this week is only going to serve to further complicate the issues were dealing with right now. We get a lot of growth data out of Europe. The bulk of this week’s fundamentals will come out of the U.S. as we get key housing, consumer, growth, and inflation data. Overall, I’m not expecting to see strong USD+ data this week.

Let’s not forget the fundamental landscape is not in great shape either. We’re still going to have a battle of to see whose data is worse, the USD or the EUR. But more important than this week’s data are the numerous speeches we get from the Fed and ECB this week.

The markets will be watching and listening for any clue, sign, or signal from the Fed and ECB on future monetary policy. Many believe the ECB will be forced to cut rates by at least 50bps before 2008 is over. I expect this speculation to ramp up as the pressure is put on the central banks to provide cheap money and easier access to credit.

We hear from Trichet, Bernanke, and Paulson this week. We also hear from several ECB’s plus we get Fed speeches from Fisher, Plosser, Warsh, Bullard, Lacker, and Evans. Bernanke and Paulson will be on Capitol Hill testifying.