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The Calm Before the Storm 28 June 2004 Nigel H Maund BSc (Hons) Lond., MSc, DIC, MBA, MIMMM, SEG Economic Geologist Even to the most complacent investor, the quiescence of the financial markets given the backdrop of economic and political turbulence and deep, unaddressed, systemic financial and economic problems is eerie. Several writers, such as Adam Hamilton and John Maudlin, have drawn attention to the unusual set of circumstances current in the markets. Nonetheless, these fundamental major financial and economic problems, highlighted and described in detail by the some of the best analysts on the web, such as Jim Puplava and Richard Russell, have far from disappeared. Instead, they continue to worsen. Figure 1: Dow Jones Industrials, 1-year chart Whilst the DJIA and S&P500 appear to display remarkably little volatility, often presaging a major change, the 200 day MA climbs to meet the 50 day MA, which should be "the moment of change;" shown on Figure 1. Given the Feds' "high gear" money printing operation, some writers believe that the stock markets will move upwards to new highs at this juncture. However, the US dollar, as shown on Figure 2, has failed to significantly breach the 200 day MA, and last week ended with it turning south again to conform with its long term, 30-month bear market, underscoring the runaway US multiple deficits and hitherto historically unprecedented fiat creation. New US debt is now running at more than 5% of GDP and is still accelerating under a President who appears to exert no financial control whatsoever. A collapsing US dollar is highly unlikely to result in improved US competitiveness, and, hence, an improved trade balance, as the issues are very much more deep-seated than mere competition based on price. Indeed, the falling US dollar is depreciating the value of all US based assets and securities, with potentially calamitous consequences. As a substantial proportion of US treasuries and equities are held by foreigners, one may expect them to demand compensation, including a higher yield on bonds, to offset growing exchange losses, and, furthermore, to exit US equities in favor of those listed on foreign bourses in Euros, Sterling or Swiss Francs, in order to avoid currency losses. Figure 2: US Dollar, 3-year chart Mr. Greenspan appears to believe he has the situation well under control. His "gradualist" approach to raising interest rates is a measure of his greatest nightmare, the terrible twins "FANNIE MAE and FREDDIE MAC." He now is in the unhappy position of facing the eventual collapse of these institutions, which, because of the immense scale of their liabilities, will bring down the entire US financial system with them. The Fed is already "way behind the curve" with raising interest rates, as the markets are already some 200 basis points ahead of him. However, this situation is likely to worsen dramatically over the coming weeks and months. With inflation already running way ahead of the manipulated CPI, and accelerating, prospects of the Fed continuing its "gradualist" approach look grim. Further collapse of the dollar can only accelerate inflationary pressures and push bond yields up. These factors will eventually force the Fed's hand over interest rates. Merely threatening action and following up with "watered down compromises" will not keep the markets tame for much longer. The Fed's propaganda machine, and credibility, is increasingly resembling "a busted flush." To what extent the markets continue to swallow Fed executives' "market soothing statements" will be determined by events over which their control is seen to be increasingly wanting. Mr Greenspan's Fed cannot be compared with J Pierpont Morgan in the 1907 Panic. Unlike Pierpont, Mr. Greenspan's problems are several orders of magnitude greater and his options extremely limited, if not to say non-existent. Any significant rise in interest rates will have a severe impact on Real Estate Mortgage markets, and, more importantly, for the US, upon its incredibly highly leveraged Government Sponsored Enterprises (GSE's), "The Purveyors of Dreams," FANNIE MAE and FREDDIE MAC. These two institutions have more liabilities than CITIBANK. Both GSEs are in effect quasi-private firms chartered by Congress to create and provide liquidity in secondary mortgage markets. Together, these GSEs purchase, retain, or guarantee more than 70 percent of the conforming US mortgage market. Mortgages are originated by retail institutions, mostly banks. Fannie purchases standardized ("conforming") mortgages from the originators. Fannie then either holds the mortgages or packages them together as securities, called mortgage-backed securities (MBSs or "agency debt") and sells those securities on credit markets. Many of them are purchased by money market funds. In the (mistaken) belief that the Treasury will back Fannie Mae and Freddie Mac debts, many lending institutions have granted these institutions loans on much more favorable conditions; i.e., a full 50 to 75 basis points below normal interest rates on loans. This has had the adverse effect of encouraging both GSEs to adopt a far riskier investment profile than had they been companies competing under normal commercial financial constraints. Given both GSEs enormous debt risks, heavily based in the derivatives market, any significant rise in interest rates would quite literally wipe both of them out. Such an event, in which Fannie Mae's and Freddie Mac's liabilities comprise a substantial proportion of the US economy, would result in an all-out systemic financial default sufficient to bring down the entire US economy. Stock in these companies can be likened to Michael Milken's "Junk Bonds," with a similar mix of speculative gain versus high risks. As the US dollar resumes its voyage to the bottom of Mariana's Trench, Mr Greenspan will have much to think about. Like a chess grandmaster in "Zugzwang" (every move he now makes loses) his worse nightmares are upon him. Monetizing Fannie's and Freddie's debts must be at the forefront of his last remaining strategies. However, this will only buy time. The end game is moving towards his ultimate "checkmate," and the eventual destruction of the US dollar as the world's reserve currency. Should such an event occur, it will have enormous implications for global stability, resulting in a fundamental power shift of epochal proportions. Indeed, it will be "one of history's turning points." 27 June 2004 Nigel H Maund eMail: c/o Clive.Maund@t-online.de Charts by Clive Maund Footnote by Clive Maund: Previous articles by Nigel Maund have been mistaken for my work. I did not write any of this article, my contribution was limited to providing the 2 charts accompanying it. Copyright © Nigel Maund 2004. All Rights Reserved. ______________ reprinted at 321gold Inc Miami USA