The Aussie dollar gets the high-low

Ouch both times. Aussie stocks got hit by the old "high-low" overnight. The "high-low" is a gridiron technique where one man tackles you high and the other tackles you low. The net result is that you get smashed. Granted, a four percent decline in the Aussie dollar versus the greenback doesn't quite constitute a smashing. How bad, then, is the double-helping of unsettling news?

First China. The People's Bank of China raised interest rates for the first time in three years. It wasn't a big hike. One year lending rates were raised to 5.56% from 5.31%. But it was enough to remind markets that demand for Aussie commodities depends on China's continued expansion; an expansion largely fuelled by bank lending and fixed capital (real estate and infrastructure) investment.

Rate hikes...increased reserve ratios...you get the idea that China's central bankers are on bubble alert. That was probably enough to spook some traders to take profits in the raging Aussie dollar. But in our view the bigger factor on the Aussie came from America overnight. The mortgage crisis is becoming a big stink ball.

The Dow fell by nearly 1.5% points and below 11,000. Gold fell. And the banks stocks fell. Especially Bank of America (NYSE:BAC), which fell by almost five percent. Why? The news came near the close of the market, and it was menacing. Bank of America is being cornered by investors in its securitised mortgages to buy them back.

 "Pacific Investment Management Co., BlackRock Inc. and the Federal Reserve Bank of New York are seeking to force Bank of America Corp to repurchase soured mortgages packaged into $47 billion of bonds by its Countrywide Financial Corp. unit, people familiar with the matter said," leads the Bloomberg story. Uh oh.

Investors in mortgage securities are playing their hand now (presumably to get something out of BAC before something worse happens to the band and its nationalised because it's too big to fail). The investors are claiming that the bonds, originally issued by Countrywide Financial, which Bank of America acquired, have not been serviced properly.

This is largely a legal claim. And that was made clear when Kathy Patrick,  a lawyer representing the bond holders, appeared on CNBC later in the day and said, "We want to enforce the holders' contract rights...Today's action begins the clock ticking ... If these issues of non-performance are not addressed and cured, then our clients will be able to enforce their rights in court."

"There were representations made to my bond holders when they purchased these securities. They are contractual representations about the credit quality of these mortgages...and my clients are concerned that the mortgages in question did not, at the time they were securitized, conform to those representations."

That sounds like a fancy way for the bondholders to tell Bank of America, "You lie!"

For its part, Bank of America says it can't be blamed for a lousy economy and deadbeat borrowers. But the vultures are already circulating and figuring out how much all this is going to cost the company. And remember, what's true for this bank is probably true for three or four other major American banks that sold (or bought companies that sold) hundreds of billions of dollars worth of securitised mortgage.

What's perplexing is why the New York Fed is putting the screws to BAC. Normally, the Fed's job is to find a home for troubled bank assets and prevent a crisis at any one large firm (except for Lehman, which everyone in New York hated for not participating in the LTCM bailout). Granted, the NY Fed owns some of the securities in question. But would it really take action that could produce a crisis in a major bank?

Probably not. We agree with our colleague Kris Sayce on this one. First, the current political environment suggests that the major banks are simply too big to fail. It could be the Fed is trying to soften up the banks for a GM-style takeover by making them appear evil/weak/incompetent.

It could also be a kind of Fed False Flag operation. A false flag operation is an action carried out by one entity (a government) but designed to look like another entity (a foreign government) actually carried it out. It's a way of ginning up anger towards someone you want to attack anyway.

In this scenario, the New York fed would precipitate a low-level crisis in the mortgage market before a full-blown crisis emerges (as it surely will, if the claims are taken to court). This creates the rationale for the Fed itself to purchase said mortgage securities, make investors whole, and once and for all purge the mortgage problem from the balance sheet of major banks.

And oh by the way that would cost a lot of money, which just so happens to coincide with the Fed's plan to print a lot of money via QE!! Maybe, then, the Bank of America action by the New York Fed is the scouting party for the Quantitative Easing invasion from Big Ben that we’ve all been waiting for. Are those helicopters we hear? What does it mean, though, for Aussie stocks and the Aussie dollar?

Here's what we said about the immediate future last Friday, in our weekly update to Australian Wealth Gameplan readers:

At the risk of making a foolish prediction I will do so anyway: the [US} dollar will remain oversold as the Aussie reaches parity and gold goes over $1,400. But doubts about the Fed's ability to do anything about America's economy and the mushrooming mortgage foreclosure scandal are nipping at this market's heels. Having broken those key psychological barriers, the big reversal/correction will come.

Mind you it's incredibly strange that screaming red indicators of serious weakness in America's financial system should be, of all things, [US] dollar bullish. But the important point to remember is that the "risk trade" that has powered Aussie shares and commodities higher will be off the boil on renewed worries about the health of the US financial system. The world will suddenly appear a lot riskier to traders and that should lead them pull in their head a bit on commodity prices (which are already looking toppy).

This doesn't mean I’m a long-term dollar bull (far from it). But look for a reversal soon, probably next week. And then, the next phase...the actual quantitative easing from the Fed and the escalation of the mortgage foreclosure crisis.

This latter event threatens to blow an iceberg sized-hole in the hull of the American financial system, requiring another Federal bailout of trillions of dollars that America doesn't have. This will be the death blow not just for the dollar standard but for the Bretton Woods two system of floating exchange rates. Gold will move up against all paper in that world. And it's coming sooner than you might think.

Based on that prediction, we're still in the first phase of effects, where the "risk trade" reverses and stock and commodity prices fall, along with the Aussie dollar. Our guess is that faster and further the market falls, the easier it is for the Fed to make the case for Quantitative Easing. There will be a lot less resistance after another mini-crisis/market fall.  It's a clever tactic.

You can allay the fear that Quantitative Easing II is hyperinflationary by engineering a crisis in which investors lose a few hundred billion dollars in a matter of days. A 10% correction in stocks and commodities puts the market at a lower base from which QE II can begin. It also neutralises the price signals commodities are otherwise screaming to prudent investors (inflation dead ahead!).

But maybe we are being a bit too conspiratorial about everything. The banking cartel that runs America's money would never manipulate the market like that, would it?

Embedded in our analysis is that the recent strength of the Aussie dollar is only relative. That is, the local currency has become the plaything of the moment for US dollar bears seeking yield. When the dollar bears take profits, the short-term gains in the Aussie will reverse too, even if the RBA raises rates on Melbourne Cup Day. This is probably bullish for the Australian price of a certain yellow metal that lives at number 79 on the periodic table of elements.

But don't forget number 47 either! That's silver. According to another Bloomberg story, "Silver exports from China, the world's largest, may drop about 40 percent this year as domestic demand from industry and investors climbs, according to Beijing Antaike Information Development Co."

"Customs data show exports plunged almost 60 percent to 970 tons in the first eight months. Cancellation of an export rebate in 2008 is also hurting shipments...Reduced exports may bolster prices that are trading near a 30-year high on speculation that governments worldwide will take further steps to stimulate their economies, weakening currencies and increasing demand for assets that are a store of value. China, the third-largest producer after Peru and Mexico, revoked export rebates in August 2008 to curb use of natural resources."

China taketh away credit...and silver and rare earth exports. That's a whole lot of hoarding going on. Of course, China can't "put back" nasty American Treasury debt to the US Treasury the way investors can "put back" mortgage debt to banks. It appears to be doing the next best thing, buying and accumulating real metals of real value.