Dollar intervention?, SWFs buying houses, flotilla heads to Iran?, and CDS market failures.

Dollar surge may end commods supercycle (August 10 – Reuters LONDON)

The debate over a possible end to the dollar's seven-year downtrend will take centre stage this week as the supercycle in oil and commodities runs out of stamina, helping stocks and bonds in times of slowing economic growth. A rising dollar and falling oil prices create a virtuous circle and help risky assets as they ease inflation pressures, giving central banks rooms to fight the one-year-old credit crisis with interest rate cuts.

Reflecting such optimism, world stocks, measured by MSCI, stayed last week well above the 21-month low hit in July even though financial firms and other corporates unveiled more damage from the credit crisis.

"Financial markets look considerably perkier than a few weeks ago. Their recovery has been helped by a softer oil price, encouraging a revival in risk appetite," said Michael Dicks, head of research at Barclays Wealth.

This is exactly why I say I smell a rat in the recent dollar strength and commodity weakness. It was just too convenient by half for the world’s central banks, who desperately needed:

1) Inflation to abate so that they could keep interest rates at unnaturally low levels. Since commodity inflation is the one the voters tend to experience most painfully, a big commodity collapse was just what they needed.

2) Paper assets, especially stocks and bonds, to rally, so that crippled bank balance sheets could be stabilized, if not repaired.

And, hey, they magically got both. As the article above makes clear, it is considered a “virtuous circle” when people rush back into risky assets and out of “things” like oil, which tend to call into question the utility of central-bank-managed money as a store of wealth.

The well respected blog commentator Michael Shedlock (“Mish”) disagrees with this line of thinking, stating, “Here's the deal for dollar bears: The dollar rallied because it was damn good and ready to rally. Those with their eyes open spotted fundamental reasons in advance. Those who did not, blamed intervention.” However, Mish has a very strong bias towards deflation as what the future will hold (while I am more agnostic on that matter), and this colors his analysis somewhat. In my mind, the fundamental reasons weighing against the dollar are more numerous and larger than those supporting the dollar. Our interest rates are lower than Europe (a negative), our trade balance is still $50+ billion to the negative each month, we are fighting two very expensive wars, and our federal fiscal deficit is set to hit $500 billion next year.

None of these are what I would term good fundamental reasons for a dollar rally. In the absence of fundamental reasons, I seek other reasons.

That, plus the fact that the currency markets are widely known to be regularly interfered with by central banks. They say they do it, they (sometimes) tell us after they do it, and they use hidden proxy banks to do their bidding. I am of the mind that if someone says they are going to do something, admits they do it, and then I see signs that it happened, I tend to think that maybe they did it.

Of course, I could be wrong and Mish could be right. I’m keeping my mind and my eyes open.

LOST SOVEREIGNITY - OIL-RICH FUND EYEING FORECLOSED US HOMES (August 10 – NY Post)

There's a new land grab starting in America. Foreign money, which up to now has focused its attention on investing in iconic commercial real estate - like Barneys New York and the Chrysler Building - is now moving to scoop up tens of thousands of discounted foreclosed homes across the country.

One sovereign fund, said to have earmarked $29 billion to purchase foreclosed residential real estate, recently hired a West Coast mortgage broker and is starting to search for bargains, The Post has learned.

Well isn’t this just dandy. Foreign central banks buy our bonds and drive down our interest rates. This sets the stage for a housing bubble that causes a lot of people to get into trouble buying more house than they can afford. Now the same countries are stepping back into the mess buying US properties for ~50 cents on the dollar with the same money that they originally used to drive down interest rates. The circle is complete.

I, for one, am not at all happy with the prospect of selling our domestic assets (houses!) to foreign “sovereign wealth funds” (read: recycled oil and trade deficit money). The price of our overspending would seem to be the loss of our homes to the very people we bought too much from on credit. While I am normally a big a fan of consequences, this sticks in my throat.

Three major US naval strike forces due this week in Persian Gulf (Aug 11 – Debka)

DEBKAfile’s military sources note that the arrival of the three new American flotillas will raise to five the number of US strike forces in Middle East waters – an unprecedented build-up since the crisis erupted over Iran’s nuclear program.

This vast naval and air strength consists of more than 40 warships and submarines, some of the latter nuclear-armed, opposite the Islamic Republic, a concentration last seen just before the US-led invasion of Iraq in 2003.

I don’t normally post ‘news’ items from Debka (which I consider to mainly be a form of propaganda), but this seems to provide confirmation of other rumors that I was tracking down this weekend concerning a very large naval flotilla heading towards the Middle East. What is left unsaid in this article is that the arriving ships are meant to replace departing ships. However, if that does not come to pass, then this will be the largest naval presence since, uh, well, since the 2003 attack and invasion of Iraq.

This bears watching.

Credit default swap market under scrutiny (Aug 10 – IHT)

Credit default swaps, known as CDS's, allow investors to bet on a company's prospects or hedge against possible default by an issuer whose debt they hold. If a default occurs, the party providing the credit protection - the seller - must make the buyer whole on the amount of insurance bought.

At the urging of Eric Dinallo, the New York State insurance superintendent, Merrill Lynch agreed two weeks ago to unwind $3.7 billion of insurance it had bought on the mortgage-related obligations. Merrill received $500 million from XL Capital to close out the insurance contract that one of its former subsidiaries, Security Capital Assurance, had written.

The Credit Default Swap market is now more than $60 trillion in size. Of course, because each transaction offsets the other, the whole thing should sum up to zero at any given time. That is, if I am on the buying side of $1 trillion in protection (+1) and you are on the selling side of that $1 trillion (-1), then we could add those up and they’d equal zero. The problem comes in when the market for those derivatives changes in your favor, and you think that your position is now worth $200 billion while my position is worth -$200 billion. You go ahead and merrily mark up your portfolio to reflect this large gain and tell your happy clients how much they have “made,” while I am busy gnawing my fingernails knowing there is no way I could ever pay that amount.

That’s what has been outlined here. Merrill Lynch thought it had a $3.7 billion dollar stake on some CDS insurance it had bought, but only received $500 million or 13% of what it thought it had. IF this is typical, there are LOTS of companies out there sitting on “profits” (possibly already reported to shareholders) that do not exist because they cannot and will not ever be paid. This is called “counterparty risk,” and I have yet to see any financial statements that deduct an amount for this possibility.