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Just a quick heads-up before I crash tonight. Long day at work, then 3-hr hockey game with the 4 daughters (well, the friend was hangin’ with us tonight, so we adopted her for the evening).

The dollar is at a critical level around 1.28-1.30 per Euro:

If the big head-and-shoulders holds, we would break down (stronger dollar) decisively from here. Although the H&S is a major pattern, I just can’t see that happening. Leading Dems have been pushing to speed up the rate at which China revalues the yuan, so I can’t imagine the election results having a strengthening effect on the dollar, UNLESS there is some great fiscal restraint showing up really soon. Heh, not with our politicians, of either ilk.

If the H&S gets broken, and the dollar heads up thru 1.30 and 1.35 per Euro (i.e. weakens, which seems more likely from a fundamental perspective [did I just use the “f” word?]), it would actually make sense with our deficit, anemic growth, nothing but increased spending in the future, more pressure on China, etc, etc.

The rapidly-weakening dollar would show up, of course, in higher gold and oil prices and more expensive imports. Caveats to the stock market.

We’ll see the result of this multi-year setup within the next few days to weeks. Let’s not forget its profound effect on every facet of our lives, not the least of which is our trading.

China has allowed its currency, the yuan, to revalue a bit more against the dollar. Next to real estate, currencies are one of my favorite soapboxes to jump onto, so here goes.

If our economy were growing strongly, and if as a result the Fed were actually having to “fight inflation,” this would be great news. I’m all for free markets and floating currencies. But we’re too far down the rabbit hole- our economy is about as strong as a cancer patient with severe bone marrow depression, so this type of move has to be “measured” in order to keep it from cratering our (and the world’s) growth. I’ve written various posts and articles about it, like here and here.

China allows the yuan to gain (and Japan the yen, for that matter) by purchasing fewer Treasuries with the hundreds of billions of dollars we send them. This decrease in treasury demand will result in lowering of treasury prices and a corresponding increase in yields.

So what?

So this: for those of you playing along at home, this would mean

• Cheaper dollars

• Higher gold

• More expensive oil

• Higher mortgage rates (you just think the bubble is bursting now)

• Higher rates on those credit card balances which enslave many of us

• More competitive prices for U.S. goods overseas (one glimmer of light in a murky swamp)

Too much too fast, and we could be looking at a deflationary spiral that would make the Japan of the 80s look like a cakewalk. And yes, it’s all our fault for not being more sensible with our personal, corporate and government spending. But as Walter Cronkite would say, that’s the way it is.

So let’s all thank China for doing what it should have done years ago, and letting its currency begin to find a “fair” level against the dollar.

But let’s not rush ‘em.

We got the test of the dollar’s July high which I had mentioned some posts back, and we failed miserably. Must’ve been the “good” PPI and CPI news.

Weaker dollars buy less stuff, or put another way, it takes more of them to buy the same stuff. Like over 60 of them for a barrel of oil and over 600 of them for an ounce of gold. Get my drift? The action in the charts of gold- and oil-related stocks confirms the situation. If you’re short, double-check that your stops are exactly where you want them; they may be called up for duty very soon.

For now, though, this funny money game continues. How long will it last? I don’t know. I do know that throughout history, all paper money has eventually come back to its true value, which is zero.

In his rather ominously-titled article The Last Days of the Dollar, columnist Robert Kiyosaki provides a good basic overview of the troubled international currency situation I love to mention at every opportunity.

It looks like we may get to test the July 19 “high” of 1.2456 dollars/euro. If the dollar can gather some steam here, it would open up a little breathing room- for the Fed to delay its rate-reduction cycle and, maybe, for China to let the yuan rise a bit. Sounds like a complete contradiction, but we could actually become more competitive, trade-deficit-wise, with a stronger dollar, if China and Japan would use that opportunity to let up in their purchases of Treasuries with the dollars we export to them.

A stronger dollar will typically mean suppressed commodity prices, as well. It takes fewer strong dollars to buy a barrel of oil. Anybody remember 1998? Not that we’re headed there by any stretch of the imagination, but $12 dollar oil and $250 gold were due in large part to the strong dollar.

As promised, I’ve worked out my Photoshop doodle showing how the Chinese and Japanese governments have “intervened” to keep their currencies- and therefore their products- cheap for us prodigal spendthrifts in the U.S. Their actions have served as a secondary National Bank to our economy (our Federal Reserve being the primary one), flooding the dollars we send them right back into circulation over here at virtually the same value as when we sent those dollars overseas (the repatriated dollars would normally be weaker).

Their actions also help to explain the seemingly paradoxical fact of our Treasury yields remaining low as the Fed raised the Funds Rate from 1.00% to 5.25%. As the foreign governments have used the dollars we send them to purchase U.S. Treasuries, they have created an exaggerated demand for those Treasuries, thus inflating the price and depressing the yield.

The first image is of the “normal” (if somewhat simplified) flow of goods and money internationally and how the free market adjusts currency rates to maintain a balance. Click unless you’ve got a magnifying glass:

The second image is of how the Chinese manage to prevent their currency from appreciating and our dollar from falling by buying U.S. bonds instead of exchanging the dollars for yuan (the Japanese government do the same with the yen):

Why do I think this is important? Because at any point the governments of China and Japan could decide to reduce the rate at which they purchase our Treasuries or, God forbid, actually start selling those Treasuries rather than accumulating them.

What would happen then is a rapid devaluation of the U.S. dollar, and a skyrocketing bond yield at the same time. If our economy were anything less than rock solid, we could see an uprecedented economic collapse, and our Fed only has a few points of room to “ease” and try to add liquidity.

How rock solid is our economy? Look at the rate of inflation brought on by our tepid economic growth. We’ve killed it with a Funds rate of only 5.25%. Look at the bond yields. Inverted, and yes it does matter. Look at REAL ESTATE! Home sales falling with 30-year mortgage rates below 6%!! What would happen if mortgage rates went to 12% in a matter of a couple of years?

I’m concerned. That’s why I keep hoping for these PPI and CPI numbers to show some more impressive growth. I’m afraid this big 747 is trying to stall on us.

Added a new post to Da Rules! Check out Rule 7: When To Average Down. Of course, we already know when, don’t we?

I’m off from the ICK! regular job tomorrow, and so will be shooting for a little day trading. As the market’s in a pullback right now, and many participants are on hold until next week (i.e. next quarter), we may not be able to take advantage of much excitement. We’ll know in about 12 hours.

I’m a big fan of currencies. I’ve followed currencies actively for about four years now (as opposed to 20 or so years for stocks). I’ve never traded currencies– I’m much too small of a fish, as I see it. But I believe the currency markets often hold the missing piece to the puzzle of how all this economic activity adds up on a global scale, and they often can show us a clearer picture of where our consumption habits and the policies of our government are taking us than we’ll ever see on TV or read in the news.

To get an idea of the scale of the currency markets, I did a little impromptu research to find some current numbers. Right now the NYSE and NASDAQ combined account for about 105 billion dollars in trades each day. This figure is dwarfed by trading in the Treasury market. Bonds and their siblings account for approximately 900 billion dollars’ worth of trades daily.

This leads to the currency market. It’s known as the Foreign Exchange Market, or Forex for short, and accounts for nearly 2 TRILLION dollars in trades every day!!

Free markets are one of the greatest miracles of modern life. They allow us to trade our skills and labor for currency, then to trade that currency for the things we need and want, even if those things are created by the cooperative efforts of thousands of different people all over the world who don’t know or necessarily even like each other.

Free markets work brilliantly, creating the most efficient pricing and the most efficient flow of the current supply to fill the current demand. The problems arise when someone meddles. This someone is usually a government.

Our government’s meddling… er, intervention began in earnest after the Great Depression, always with the best of intentions, and with some success along the way, but at the price of the greatest economic tragedy in our history- the unfunded entitlement programs which, without draconian reforms, are destined to crush our economy and our childrens’ future.

When a government meddles with the currency market, the results can have severe global repercussions. For years now the Chinese and Japanese governments have meddled, in order to keep their currencies weak relative to ours. This has allowed their trade surplus with us (i.e. our trade deficits with them) to continue to expand when a free market would have checked that expansion through the escalation of the price of their products we demand and the (gradual) devaluation of the dollars which we supply.

This artificial sale on their goods has happened at the worst possible time… the period when our own Federal Reserve was flooding our market with dollars like a pusher floods the youngsters with free drugs, to get us addicted to spending and to encourage us to continually expand our habit, ostensibly for the “good” of the nation. (I’ll leave alone the question of whether the pushers had any political motivation).

As I state from time to time in an article or rant or when I just feel like dragging out my soapbox, our economy should not be teetering between slow growth and stagnation right now- it should be growing at a record-breaking rate with the Fed desperately trying to reign it in. The fact that we’re just drifting after so much “throttle” over the last few years is disturbing.

I’m working on a graphical representation of how the Chinese government in particular has interfered with the Free Market to try and maintain a competitive advantage. Right now I’m waffling between a doodle on Photoshop and just scanning my hand drawings.

When I post the drawing, I’ll continue with this topic, and particularly with my concerns over how the Chinese and Japanese may be forced to reduce the rate at which they are adding liquidity to our markets by buying U.S. Treasuries, at precisely the moment when our economy is stalling and going into the recession delayed, and intensified, by our Fed’s excessive intervention at the beginning of this century.

Today’s economic news saw the PPI rising 0.1%, with the core rate falling by 0.4%. Estimates were for up 0.3% and 0.2%, respectively.

Discussion currently seems to revolve around whether the Fed will definitely stay “on pause” now, or perhaps whether they “went too far” with the string of rate increases.

I want to use this opportunity to bring out an OLD soapbox of mine: the increase in the money supply in the early years of this century was waaay overdone and credit was loosened waaay too much. The resulting spending binge we Americans went on, which was multiplied as we re-financed and re-re-financed our golden geese rapidly-appreciating homes, should have sent the economy into a hypertensive crisis. The Fed should have had to raise by leaps and bounds to get things under control, and should have had to overshoot “normal” to cool off the economy, “normal” being a 6+% Funds Rate.

Instead, we’re sitting at 5.25%. The Fed has not “hit the brakes,” it has only let off the accelerator somewhat. For the economy to be slowing, or even threatening to slow at this point, is ominous. Spooky. Dark clouds on the horizon.

I was encouraged by the recent reports of healthy economic growth, the little blip in bond yields, and the slight strengthening of the US Dollar, which is skating on the thinnest of ice.

Now we’re placed squarely back in a position where we could be faced with waning economic growth, unmanageable debt, a falling dollar, and rising interest rates all at the same time. Yes, rising. If… no, make that when, the Chinese and Japanese slow the rate at which they are accumulating US Treasury debt, the price of that debt (i.e. those bonds) will fall with the slowing demand, and the yield will of course rise, causing the rates on virtually all credit products to rise as well.

These are ingredients for a terribly nasty-tasting economic cake. Let’s hope today’s PPI is subject to some significant revision, and that the economy continues to grow at least at a simmering pace for a number of months.

We are due a recession- overdue if you count the one the flood of new money a few years ago postponed. I think the inverted yield curve is telegraphing that fact. But remember, we need something to recede from.

Note: I’m turning off comments on this post– for some strange reason, it seems to be the target for a flood of comment spam.