This week did not at all go the way we wanted.  There was no Obama rally and the rest of Europe is following England off that cliff we discussed in yesterday’s morning post.  France is our first Big Chart market to crack their November low of 2,838 and the Germans are marching right behind with the Dax at 4,128, less than 100 points away from the Maginot line at 4,034.  Both the FTSE and the DAX are hovering at 4,000 and if eitther one breaks down there for the day, it’s going to be a very tense weekend as the FTSE still has 335 points (almost 10%) left to fall before they retest their October low of 3.665.

So good morning World Leaders – clearly the investors have no confidence in you whatsoever and the rats are leaving the ship in droves – certainly not without good reason as it is getting very wet in here!  The Nikkei dropped 3.8% this morning with a very ugly finish as they barrel towards a re-test of the 60% off mark.  The Hang Seng broke below 60% off the highs and the Shanghai finished the day 66% off the 2007 highs, which seem like a long-forgotten dream at 588. 

Asia was rattled by losses at Samsung on top of yesterday’s SNE news but what really spooked the markets over there was our man Geithner, who flat out accused China of manipulating their currency (they do) – fighting words ahead of the April Treasury report on international currency practices as US trade law dictates that the designation would require the Treasury to open formal negotiations with Beijing over currency policy – something that could turn very ugly.  The Bush administration has refused to allow China to be labeled and one of the reasons Paulson was appointed was his ability to kiss up to the Chinese but, when he was in the Senate, Obama co-sponsored legislation to create new penalties "so countries like China cannot continue to get a free pass for undermining fair trade principles."  There is certainly a new sherrif in town and the deputy is already getting his guns!

So of course the markets are freaking out – nobody likes a trade war but, with China’s rapidly slowing economy, this is the first time in many years that the US has had leverage.  Of course China’s counter-punch can always be to forclose on our debt by dumping their US paper on the open markets or simply not buying more as they are generally our biggest supporter but that is exactly what the Inflation Nation plan is all about.  We’ve already gotten the Yen to record levels against the dolllar and now we turn to our other great creditor, China, as we seek to repay our debts at a slightly more favorable exchange rate in the future (for Japan, "slightly" is defined as now 88 Yen to the dollar when we borrowed at 200 Yen so China has a long way to go).

As I’ve said before, all assets are relative and right now the US is looking for ways to devalue the dollars that our people don’t have enough of and re-value their assets (homes, stocks, intellectual property, labor) relative to the things we need (oil, food, materials).  This is quite the tightrope to have to walk and things can quickly spin out of control.  Here’s one way this works: If you bought a home in 2007 for $750,000 it cost you 10,000 barrels of oil.  Today your home is worth only $500,000 but that’s 12,500 barrels of oil.  This would be great news if you were a tractor but people also need food and sneakers and IPods so all those things need to come down too for us to retain our relative wealth. 

We can see this happening now but the next stage of this game is to deal with the ugly problem that we borrowed dollars, not barrels of oil, to pay for our home and the lender (ultimately China, Japan and anyone else who was silly enough to lend us money) wants dollars back.  The next stage is to devalue those dollars WITHOUT reflating essential commodities but increasing both the value of the home and the ability of people to pay those loans off with wage inflation that keeps pace with whatever commodity inflation creeps in.  This can be done quite cleverly by pushing down lending rates so the homeowners can borrow at lower rates and, since people buy a mortgage, not the home price, that will allow housing prices to stabilize and bring a little demand back into the market.  If we are VERY, VERY lucky, this will stimulate the labor pool and force employers to raise wages but there are so many things that can go wrong on this convoluted path to prosperity (fake though it may be) that the slightest misstep can crash the dollar and cause runaway inflation (I may have mentioned I like gold as a hedge to all this).

Inflation is the furthest thing from European investors’ minds as the UK is officially in a recession with a 1.5% decline in Q4 GDP.  Banks are leading the EU lower as the ECB stated they are "likely to move cautiously in lowering its key rate closer to zero because the bank doesn’t see deflation threatening the euro zone now and is wary of creating another credit-fueled bubble."   Without evidence of deflation — a prolonged fall in prices and price expectations — "there is little room left to reduce the nominal interest rate" below its current 2%, Lorenzo Bini Smaghi said in an interview.  Europe has borrowed money from its own citizens and is less inclined to screw them over by devaluing their currency than we are looking to do to our own foreign lenders.

Gold is, of course, flying this morning, up 10% from our last buy call last week but oil is down another 2.5% in pre-market trading as another massive build in inventories yesterday took the wind out of the sails of the new March contracts.  Whle it is very tempting to panic today, let’s keep in perspective that, as of yesterday’s close, we have generally fallen just 5% for the month and, although we are breaking our critical support levels this morning, we are still quite a ways off the US bottom.

Perhaps that just means we have a lot further to go but let’s keep an eye on those 50% lines, which most of our indexes will be testing this morning.  In our last Big Chart Review we were worried about Asia dragging us lower and yesterday we expected turmoil surrounding Geithener’s confirmation to drop us back to the November lows.   While certainly the macro fundamentals for the market have improved since the time LEH went boom, that’s not going to stop technical traders from taking us down to the tests.  If it were not Friday, I’d be looking to sell naked puts into this panic (assuming the S&P holds 800) but if we finish at this morning’s lows, Asia may have a very nasty Monday.

PFE has finally called a bottom and made a bid for WYE for $60Bn, 20% more than yesterdays close and about 80% off the bottom of October.  We've been waiting for PFE to pull the trigger on someone but I was hoping they'd go for something a little more speculative.  GE's earnings were not too bad and they reaffirmed their dividend, which is now 10% of the current stock price so they are our BUYBUYBUY of the day at $12.60 and we can hedge those out with March $12.50 puts and calls at $2.80, which drops our net entry to $9.80/11.15 – not too bad for a stock with a $1.24 dividend!

Strap in kids, it's going to be a rough one but if we can hold 2.5% this morning we may not have such a bad finish but it's a big if at the moment…