Investing Newsletter

Today demonstrated that the bond insurance agencies hold more near-term economic power than does the Federal Reserve. Implied volatility plunged from 28 to below 25 after the Fed's 50 basis point rate cut (the higher end of the expected range), and then rose to nearly 28 again after Fitch downgraded bond insurer FGIC from AA to A. Moody's and S&P downgrades of FGIC are coming, to say nothing of MBIA and Ambac. A single downgrade of one bond insurer by one ratings agency turned a “Fed rally” into a “Fitch rout.”

Emerging markets shed 15-20 percent on Monday and Tuesday. India's BSE 30 plunged 20 percent from Friday afternoon to the Tuesday close; Hong Kong dropped a comparatively milder 10 percent, although it remains 30 percent off its high in late 2007. Germany, France, Brazil, Spain, Mexico, and everywhere else experienced cumulative double-digit declines on Sunday and Monday nights, American time.

My worldview of competitive currency devaluation remains unchanged. I am extremely bullish on commodities; extremely bearish on bonds; neutral to mildly bullish on equities; and I am still betting on reflation. I believe the current Merrill Lynch and Citigroup write-downs and recapitalizations mark a bottom in the market in the medium term. Unless the dollar drops drastically, there is simply too much money in the market for it to continue dropping in nominal terms.

Jean-Claude Trichet, chairman of the ECB, has built up for himself a substantial wellspring of respect for currency observers as a currency hawk, even as private bankers fumed with self-entitled rage. While the Federal Reserve reacted to Wall Street's panic-mongering with all the icy, calculating deliberation of a lab monkey at a cocaine switch, Trichet paid much more heed to rising inflation, rising inflation expectations, and soaring commodities prices. Although the ECB used repo operations very liberally, it stood firm on interest rates. Bankers were aghast at the thought of taking pseudo-responsibility for bad decisions (they were still drenched in temporary repos), but the euro soared as the currency markets quietly applauded Trichet's independence.

The Fed announced their decision to cut the fed funds rate and the discount rate by 25 bp's. The accompanying statement did not explicitly highlight economic weakness, the subject of market participants' greatest concern.

Six months ago, I would have said that the dollar or the yuan needed to break. Today, the same either/or applies to the yuan and the euro. Until one of those break points occurs, the global financial party will go on. The euro cannot carry the weight that the dollar did, because European manufacturers will not stand for it. But for a while, the euro will be “the overvalued currency” which the dollar was in 1998-2005.

There was a conspicuous absence of bankruptcies among the biggest (presumably the most exposed) mortgage originators, and a surge in notes outstanding from the FHLBs. Put two and two together, and it does not take a rocket scientist very long to surmise that the mortgage industry is getting bailed out by the federal government in a massive way, through the Federal Home Loan Bank system.

I guess it would be pretty lame for me to come out of hibernation after the most volatile week since August and say, “I told you so.” But for those of you who stomached the rise of the GBP and held onto your short position, you have finally been rewarded, and rewarded extremely well (~500 pips). This was why I said to short both the dollar and the pound!

Two newsletters ago, I predicted that “time could well be running out” for the “super SIV,” also known as the M-LEC (Master Liquidity Enhancement Conduit) or as I termed it, the “one SIV to scam them all.” For the banks most deeply involved in the structured finance industry – especially Citigroup and Merrill Lynch – it has been a disaster.

Bernanke, I now believe, is trying to blow up the yuan-dollar peg by devaluing the dollar. The Chinese have shown themselves politically paralyzed and completely unable to forge an internal consensus to act, in the face of rising domestic inflation, unsustainable trade disequilibria, and a glut of easy money. Higher inflation, a falling dollar, and a raging bull market in commodities will be symptoms of Bernanke's competitive devaluation of the dollar, which will itself continue until the Chinese surrender the yuan. But the yuan's revaluation day of reckoning is a lot closer than people think.