ALERT - Aug. 12, 2007

JOHN WILLIAMS' SHADOW GOVERNMENT STATISTICS

A L E R T

August 12, 2007

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Systemic Liquidity Problems Turn Ugly

Communist China Fires First Dollar Salvo

Given Deepening Recession, Financial Market Woes Are Just Beginning

July M3 Growth Holds at 13%

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The SGS-Ongoing M3 series for July has been posted on the Alternate Data Series tab at www.shadowstats.com. -- Best wishes to all, John Williams

Last week saw extraordinary developments, with a widening systemic liquidity crisis forcing central banks to reaffirm their statuses as lenders of last resort. At the same time, Communist China fired its first serious salvo against U.S. financial market dependence on foreign capital, and Washington appears to have capitulated to early demands. With the U.S. economy in a deteriorating, inflationary recession, and with Mr. Bernanke possibly facing his two other worst nightmares at the same time, one can make the case that the negative turmoil in the U.S. financial markets and for the U.S. dollar are just beginning.

China Threatens Its Dollar "Nuclear Option."What friends we have in Communist China! Just as the Western markets erupted anew with escalating liquidity crises, "China threatens 'nuclear option' of dollar sales," ran the headline in last Wednesday's Daily Telegraph. Well-timed to trigger or exacerbate a financial panic or crash, China threatened to dump potentially a trillion U.S. dollars from foreign currency reserves onto the open market. The threat ostensibly was made to thwart any U.S. trade sanctions against China for its blatant, anti-competitive currency manipulations.

Despite cries of "absurd" from U.S. Treasury Secretary Paulson, and "foolhardy" by President Bush, the President held an unscheduled news conference later that day where he reassured Mr. Paulson's Beijing Buddies that China's interests were protected. According to the New York Times (Aug. 9), "Mr. Bush ... said he would oppose legislation aimed at punishing China for its economic practices, including its efforts to control the value of its currency to encourage cheaper exports."

Today (Aug. 12), an Associated Press article noted: "China sought Sunday to dampen speculation it will conduct a massive sell-off of U.S. dollar holdings, with a central bank official saying the dollar remains a mainstay of its foreign exchange reserves."

So, China-handler Treasury Secretary Paulson, appears to have cut some sort of a short-term deal to assuage China's dollar dumping instincts. Such accommodation likely will be short-lived, however, as dollar selling will intensify otherwise, causing China further loss from its dollar holdings.

One cannot impute to the Chinese Communists either the political inanities and shortsightedness of the Washington establishment, or the short-term greed so rampant on Wall Street. Dealing with a culture that views a 10-year planning horizon as short-term, there likely is much more at work here than has surfaced. Last week, China said "jump," and George Bush and Henry Paulson appeared to jump. The commands and responses will get much trickier as the markets unravel further and as global political circumstances become more unstable, particularly when Taiwan comes into play.

My days involved in trading currencies extend back to the pre-floating-dollar era. Then, the bets would ride on looming currency devaluation or revaluation. Frequently, the final signal for a pending move was a formal denial by a central bank or banker that no change would be made. Today's soothing dollar statement out of China has the foul odor of one of those old "let's see if we can fool the markets one more time" statements that central banks used to make.

Also keep in mind that China's antics may have done significant other damage to the U.S. dollar's prospects. Many holders of greenbacks outside the United States realize that their holdings will suffer heavy losses when dollar dumping begins. Where no one wants to be the last one out the door, the biggest player has just publicly opened the door a crack and it smells the fresh air outside.

Fed's Job Is To Support The Banking System. Central bank statements sometimes run along the lines of Friday's (Aug. 10) Fed announcement:

"The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets.

"The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding."

The Fed, along with the European Central Bank, and the central banks of Australia, Canada and Japan infused the global banking system with more than $130 billion on Friday, making clear to the markets that they stood as lenders of last resort to their markets.

Despite the popular hype that the Federal Reserve's primary function is to control inflation or to maintain sustainable economic growth -- areas over which the Fed has limited control -- this bank-owned corporation's actual primary function is to maintain the health and liquidity of the banking system. The jawboning and liquidity infusion are signals of deteriorating conditions in the markets.

As outlined in recent newsletters, the Fed has been hamstrung as to policy in terms of fighting inflation and stimulating the economy. While action could be justified in both areas, the conflicting tightening and loosening policies would have been ineffective, and the Fed knew it. Accordingly, the U.S. central bank was holding policy steady and managing market expectations of policy so as to avoid a feared market meltdown.

Two risk cases were posited, one where systemic liquidity problems could force a systemic liquefaction, and easing. The second risk case was a dumping of foreign held U.S. dollars and dollar assets. Given the U.S. financial markets' dependence on foreign capital for liquidity, the Fed would have to tighten, raising interest rates in defense of the dollar. The first risk case is in play, and the second is not far behind.

As to the mounting liquidity issues, there is a recession in place that no one in the financial markets or regulatory system was even willing to consider, at least publicly. That recession, however, promises credit quality issues in asset-backed and collateralized instruments (see the July SGS) that will dwarf the subprime mortgage problems. Those other problems may be surfacing already. At least that is the way the Fed is behaving.

Despite protestations to the contrary, it would not take much more of a crisis for the Fed to be pushed into an easing. The Fed will do everything in its power, including pumping every dollar it can print into the system, to preserve the banking system, and to prevent a major bank failure(s).

The one factor that could be holding the Fed back from easing, is fear of what might happen to the dollar. Back in 1987, Alan Greenspan gave thumbs down to the dollar, lowering rates and flooding the system with liquidity following the 1987 financial panic. Ben Bernanke faces a circumstance where the liquidity of the U.S. financial markets is now so heavily dependent on foreign holdings of dollars that ignoring the greenback is no longer a viable option, at least within the bounds of normal operations for the current financial markets and currency system.

The currency markets have been relatively stable in the last week or so, as has the gold market, but there have been disquieting twitches. Flight to safety has not yet begun to be out of the dollar, but that will happen soon enough. It even could be triggered by a Fed easing, which quickly could be rescinded. Therein would begin Mr. Bernanke's final nightmare, having to raise rates to stem the dollar's collapse while already embroiled in a systemic liquidity crisis. Unfortunately, there is no easy way out for the Fed.

The lender of last resort appears doomed at some point to abandon the dollar, to monetize the dumped Treasuries and to start down the path to an eventual hyperinflation and full debasement of the U.S. Currency. That story is being updated in the still-pending Hyperinflation Summary Document.

July Ongoing M3 Annual Growth Holds at 13%. In a week quiet in terms of major economic reporting, a late surge of weekly growth in M2, large time deposits and institutional money funds kept the estimated monthly average annual M3 growth at 13.0% for July, the same as in June, and up from last week's preliminary estimate of 12.8%. Where the monthly estimate is based on 30 out of 31 days for key components, a revised estimate will be published next weekend.

Week Ahead. Look for growth in retail sales (Monday) and housing starts (Thursday) to be weaker than consensus, and for deterioration in the trade deficit (Tuesday) to be worse than expected. Pressures already may be in place to "improve" the reported deficit with Communist China. On the inflation front, both the PPI (Tuesday) and the CPI (Wednesday) are fair bets to top already weak expectations. If financial markets remain in turmoil, pressures also will intensify to bring the numbers in on the happy side of expectations in the month or two ahead.

Additional detail will follow in the August SGS newsletter.

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This Alert would have been part of the August SGS's opening comments, but it was published tonight for the sake of timeliness in a volatile and changing market environment. Considering the preceding, and given a week ahead of likely continued stress in financial market activity and the heavy economic calendar over the next several days, the August "Shadow Government Statistics" monthly newsletter now is targeted for the end of the coming week through August 20th. An e-mail advice will be made of the posting of same and any further intervening Flash Updates/Alerts.