So, the market dropped again. As Calculated Risk notes, it’s down 26.6% from last year’s peak. There have been worse declines, but this is a big one. I would expect continued declines, though there will be good days as well as bad. Ironically, the decision to not allow shorting of key financial stocks unless the shorter owns the stock may increase volatility. Naked Shorts (people who sell a stock they don’t have) provide support on the way down, since they have to buy the stock at some point to cover the sale they already made. Reducing shorting thus reduces price support and increases market volatility.

Commodities, including oil, continue to drop in price. Expect this to continue to occur. As Stirling Newberry comments, the problem with oil wasn’t so much oil under supply, as dollar oversupply. While central banks are rushing huge amounts of money into the economy, even larger amounts of leveraged money are being destroyed. That is drying up the money for the really huge speculative bets we’ve been seeing. (None of this obviates the fact that actual physical oil supply is still tight.)

The US’s monetary base, which is based on real estate, is imploding. The pyramid on top of it, built with highly leveraged borrowed money, is also being destroyed.

However, because there is a real oil bottleneck, and because real demand is growing faster than real supply, don’t expect this drop in commodity prices and the resultant drop in inflation to last.

But the real important thing to keep an eye on in the short to medium term is not the stock market, it’s currency and debt markets. There’s currently a flight to "safety" with credit drying up for everybody but governments (even banks are not lending to each other), but really, how safe is anything denominated in US dollars? If you were a foreigner, would you be real easy buying more dollar denominated assets, or even Treasuries? Sure, the government can always come up with more, but how much are they going to be worth? Heck, even if you are an American, and pay for everything in US dollars, doesn’t the way the dollar keeps dropping make you queasy?


And if you’re foreign governments, owning trillions of dollars and dollar denominated paper, do you want to keep adding to that when the prospects for the economy and the dollar look really bad? Really, really bad? And when the paper you bought, all that mortgage backed junk, is looking like toilet paper? Yes, you don’t want the US economy to really crackup, because who’ll buy your lousy manufactured goods then? But, how much is it worth you, how much bad money after good, to keep the US from cracking up? And do you think it’ll stop the crackup anyway?

Remember, also that China has to print Yuan to buy dollars. And Chinese inflation in coastal areas, according to friends, is running 15% to 20%. Think about that. That’s a direct cost of supporting the dollar. And Chinese retail sales are doing pretty well, which means that they might think "this is the time to make the switch to an internal consumer economy, rather than a mercantilist exporting economy."

So the question I ask is this: will the Chinese and other large holders of US dollars and US dollar denominated assets decide to get out? They’ve been slowly trying to reduce exposure for years, not wanting to cause a panic. But if you’re in a crowded theater and someone shouts fire, well, leaping for the door first may be your only chance.

Less catastrophically, but still bad, is the scenario where foreigners start demanding much higher interest rates. "The US is a risk. I’m not lending it money unless I get a risk premium." In such a case, the Fed would have to increase interest rates substantially to keep financing going. 10% or more isn’t out of the question. Doing so, however, would completely steamroll the economy.

And that’s why AIG, Freddie and Fannie all got bailed out. China holds a ton of mortgage backed securities. AIG insures many of them. Freddie and Fannie guarantee many of them. Failing to bail those firms out, failing to guarantee that paper, meant that China would be stuck with cents on the dollar. And after taking a loss like that, they might not be willing to keep extending the US what amounts to loans. And if that happens, the dollar crashes, or interest rates have to go through the roof.

And that’s the barrel of the gun that Bernanke and Paulson are looking down.