As Tropical Storm Hanna makes a blitz into the East Coast, details were released after hours regarding the proposed zombification of Fannie Mae [[FNM]] and Freddie Mac [[FRE]] .

By all accounts, it appears that the common stock will be diluted to protect the  preferred stock. In other news, the after market dropped over a dollar for each Fannie/Freddie as non bond holders sought life jackets and jumped over board.

At this point most,  of this information is stale and has already been or will be promulgated ad nauseum so I would like to present something that has been rattling around in my brain for a few weeks now.

The Next Leg Down

As has been noted here and in other areas – there has been a noticed correlation between the index price of the US Dollar and the rises/retreats of the Dow Jones. Put directly – it is allegedly an inverse relationship whereby the Fed has adjusted currency rates to either prop up the market or put the brakes on rapid inflation.

Many a market theorist has opined that Ben’s predecessor created the sub-prime fiasco in vitro by pushing the real interest rates lower to stave off the necessary recession which would have come at the end of the dot-com bubble bursting frenzy.

However, one of the side effects has been the increase of the sovereign wealth fund investment in the US Market due to the massive dilution of the buying strength of the US peso as well as the bear rally from 2000-2007.

Yes, I am calling it a bear rally because when all is said and done, I think we may see a retreat to 2000 era levels.

Uneasy Graves

1. US Currency

2. Chinese investments in US securities

Night of the Dread

For the last twelve months, the Fed has been trying every idea it has to keep the growing miasma of fear from infecting the entire market. First it lowered rates after rates until there were concerns of sparking a hyper-inflationary cycle in some quarters.

But in other quarters, notably China, where over a trillion US Pesos are residing currently – there has been a growing concern over the value of their investments.

China’s central bank is in a bind.

It has been on a buying binge in the United States over the last seven years, snapping up roughly $1 trillion worth of Treasury bonds and mortgage-backed debt issued by Fannie Mae and Freddie Mac.

In fact, the Chinese central bank went on such a buying spree that they are now in a capital shortage situation.

The central bank’s predicament has several repercussions. For one, it makes it less likely that China will allow the yuan to continue rising against the dollar, say central banking experts.

and the China Investment Corp bought more than FNM/FRE:

The Finance Ministry, however, has pushed for investments in overseas stocks. Last year, it wrested control of the $200 billion China Investment Corp., which had been bankrolled by the central bank. That corporation’s most publicized move, a $3 billion investment in the Blackstone Group in May of last year, has lost more than 43 percent of its value.

Bankers estimate that $1 trillion of China’s total foreign exchange reserves of $1.8 trillion are in American securities.

….

Still China finds itself hemmed in. If it were to curtail its purchases of dollar-denominated securities drastically, the dollar would likely fall and American interest rates could soar.

….

Along with Treasuries, China has invested heavily in mortgage-backed bonds from Fannie Mae and Freddie Mac, the struggling mortgage finance giants that are sponsored by the United States government. Standard & Poor’s estimates China’s holdings at $340 billion.

The kicker to this is:

He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.

“A lot of policy makers in China, at least midlevel policy makers, believe this,” Shih said.

The Takeaway

A rising US currency and a backstopped [[FNM]], [[FRE]] do much to protect China and other market maker league investors but will push the Dow first higher, and then the steam will run out and the bloodletting that has been seen this week will be tame by comparison.

One thing that I noted and no one else has commented on re: Extreme Value Theory that the ~300 pt moves were not common until within the last seven to ten years.

As the dawn comes and shines it’s glare on the market – I expect 300 pt moves will be the norm, not the outlier.

Theme Song