The U.S. dollar is under pressure Friday, in what is probably a consolidation of the its recent gains (non-commercial traders are record short the euro), although many are citing chatter regarding desires by China and perhaps other foreign central banks to further diversify their reserve assets as a catalyst for today's move.

Concerns about central bank holdings of dollar assets were probably spurred by yesterday's late afternoon release of data on the Federal Reserve's custody holdings of agency securities, on behalf of foreign central banks. The data showed a very large decrease of $10.175 billion to $955.69 billion, the fourth straight decline, an unusual string. Foreign central bank holdings of agencies have now fallen $28 billion from the peak set on July 16.

The dollar's rebound is important for the economic outlook, as it has helped to restore lost purchasing power both by its impact on commodity prices and import prices more broadly.

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Second Opinion:

- CNBC Video: Why Dollar Will Fall vs Euro

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This week's behavior of agencies and mortgage-backed securities suggest that foreign investors might have returned to the buy dollar fixed-income product, but we won't know for sure until next week's data on custody holdings. It is possible that foreign investors were big sellers of agencies last Thursday and Friday, before the Treasury's announcement, but we can't know because the Fed's data detail only the cumulative activity through this Wednesday -- there's no day-by-day breakdown.

In addition to the focus today on central bank holdings of agencies, there is also focus on a story in the China Daily suggesting that China might cut is dollar holdings (see chinadaily.com ).

The notion that foreign central banks want to diversify their assets is hardly news. Central banks have been diversifying their reserve assets for the past six years, reducing their dollar holdings to 63 percent of reserve assets from 70 percent in 2002.

Meanwhile, the euro has ascended to 27 percent of world reserve assets from 20 percent in 2002. There clearly is room for the balance to shift more, say to 60 percent/30 percent and beyond.

In other words, today's chatter is nothing to fret about; and, as I noted many weeks ago, there are a number of factors that are supporting the dollar at present that are likely to last a bit, before giving way to the diversification trade again.

New Book from Tony Crescenzi ... "Investing from the Top Down: A Macro Approach to the Capital Markets."

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I’m sure you haven’t forgotten, but today is 9/11. Ordinary people remember even if the media elite will give this anniversary small coverage. Let’s not forget why Al Qaeda hit the WTC, because they don’t believe free market capitalism is the best path to prosperity. In fact, they hate it. It has been destroying their hold over vast swaths of the world whose people reject Jihadism in favor of a life of peace and prosperity.

They thought they would collapse the global economy, and instead they barely gave us a minor recession. They underestimated the resilience of decentralized markets. They thought of Manhattan as some kind of capitalist Mecca, without which our system would shut down. But markets are just meeting places. Attack one, and people will meet and exchange someplace else. As long as there are free people anywhere in the world, there is a market. It doesn’t have a capital with a palace or a caliphate. It can’t be destroyed with a bomb or a plane.

2,500 years ago, Persia (now called Iran) attacked the Greek Peninsula. They were turned back decisively by a small band of 300 warriors at the pass of Thermopylae. The Persian emperor was shocked. Later, he told a Greek historian that all over the East he saw cities with palaces and temples in their midst, and he saw those cities as strong. But in the West, he said, the cities had empty spaces in the center reserved for open markets.

• US Marks 7th Anniversary of 9/11 Terrorist Attacks

He took this as a sign of weakness, and so he attacked. He found that these marketplaces created a stronger people than the monarchies and theocracies of the East, because a large state creates a small people. While a small state doesn’t mean a lack of power; it means distributed power. It creates the kind of warriors who will fight to the death because they defend what is theirs. Their families; their cities; their farms; their markets. Unlike the conscript armies of the empire; they fight without a whip at their back. They fight for what they love.

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Fannie and Freddie were too big to fail. Bear Stearns was too "interconnected" to fail. At the time of the Bear crisis Wall Street didn't know what would happen to the credit default swap market if one end of it (Bear Stearns) started to unravel. But there has been a default event when the government took over Fannie and Freddie and the credit swap market handled it. While the debt outstanding of those two entities was not trading at depressed levels, the market still handled it. The market will handle the demise of another financial institution. We can have no more government bailouts.

I don't think that Lehman will default, but it's way past time for all the plans that have been floated to be put into action. Lehman can't raise capital for itself, so they need to sell Neuberger and spin off the commercial real estate portfolio. A spin requires someone to put in capital and there has to be an investor at some price. Lone Star took some toxic waste from Merrill at $0.22 on the dollar. It was probably worth a lot more (or why buy it ?), but Merrill had no choice but to sell to put to rest the rumors of its troubles. Lehman has no choice and CEO Fuld needs to bite the bullet or the stock will continue to go lower.

Goldman and Morgan Stanley report earnings soon, and AIG will announce its reorganization on September 25. The market needs additional data points from these leading financial companies before it can have a hope of having anything more than a trading rally. Washington Mutual seems to be on the ropes and if failure is in the cards, better to get it over with.

There is an ocean of liquid capital available. Money market funds have something like $3.5 trillion, sovereign wealth funds and private equity pools have trillions more. But there has to be some sign of stability in write-offs before there can be any confidence for additional investment.

What are Options Saying About Financials?

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OPEC ministers went ahead with a decision to reduce oil output, as they set out to defend the $100 price level for crude oil.

Clearly, the cartel has been startled by the precipitous drop in prices from the all-time high set back in July, of nearly $150 per barrel. The majority of members prevailed upon a reluctant Saudi Arabia to go along with the reduction. The Saudis were likely feeling the heat from their peers, who felt that they were almost baited into the last production increase, due to the price rise.

It is not surprising to see Saudi Arabia go along with their counterparts. The Saudis have learned the hard lesson over the years of an undisciplined production regime and its consequence. OPEC was seemingly powerless to halt the price juggernaut, as most members produced at full capacity. The extremely high prices sowed the seeds of their demise, in terms of consumer demand that finally buckled under the strain.

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CNBC.com Feature Article:

OPEC Output Cut Won't Stop Oil Prices From Falling

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No one can suggest that $102 per barrel is a bargain -- which was the Saudi position going into the meeting. However, most members expressed their desire to maintain price levels in the $100 neighborhood. By acting now, the attempt is being made to halt the slide.

Demand continues to contract, as the most recent data from the International Energy Agency shows, as well as weekly U.S. data from the Energy Department. If the trend continues, OPEC will have to undertake a good deal more cutting in the weeks and months ahead.

Supply and demand dynamics are only a part of the story. The dollar’s rally has been equally swift, but it represents more of a race to the bottom, among the various world economies, than any kind of U.S. economic ascendancy. Our economy is looking less bad, right now, than Europe’s or Japan’s economy.

If prices are to continue precipitously lower, another shoe will need to drop. That will come in the form of reduced economic activity in China. If their industrial output and consequent energy demand slackens, crude oil could easily trade down to $85 per barrel.

At this point, though, I believe the Chinese economy will maintain a level of growth sufficient to stave off energy prices falling another 20 percent. While forecasts of $150 per barrel by year-end are too rich for my blood, I don’t see much lower prices in the cards, either.

OPEC’s ability to manipulate prices has been called into question in recent times. As I mentioned, above, they were unable to stem the price rise with production increases; and the market has reacted almost defiantly to production cutbacks in previous years.

During the run up, I always feared OPEC could have made matters worse, but they did not. I doubt their ability to muster the discipline needed to ameliorate a price decline driven by contracting demand, as well. I liken the group to dieters around a dessert table, during times of needed production rollbacks.

The grey cloud in this silver lining of lower energy prices is the deteriorating global economic outlook. At least, when prices were rising, there was a backdrop of frenetic economic activity, especially in Asia. I am not sure how good we are all going to feel overall, if energy prices fall dramatically because there is not very much going on out there in the world.

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Energy ETFs:

- United States Oil Fund

- United States Gasoline Fund

- iPath S&P GSCI Crude Oil Total Return Index

Refiners:

- Valero Energy

- Marathon Oil

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On Friday — whilst the employment numbers were being dissected like a cadaver, and traders were puking in revulsion because Armageddon was at hand — behavioral traders were looking where others were not.

We noted the steady climb of Fannie and Freddie since August 26 and the recapture of the 50 day exponential moving average on the Financial Select Sector SPDR () by Friday's close. We also marveled at the acrobatic contortions in the foreign exchange markets beginning after the close on Thursday where there was a wild west atmosphere rivaling the gun fight at the OK Corral. Between Thursday night and Friday morning, the euro circumnavigated a stunning round trip of some 600 pips, leaving much carnage in its wake.

This chaos and confusion are best explained by uncertainty driven by the migration of rumors through the markets. Rumors are amorphous with no clear end or beginning — but they eventually reveal themselves as truths or imposters. The revelation came in the form of one magical word: Backstop. Abracadabra!

First you see Fannie and Freddie fading into the darkness, and then you see them creeping steadily upward and ending up dangling like a worm around the middle Bollinger band in after-hours trading on Friday. Collaboration between Criss Angel and David Copperfield could not have rivaled this spectacle.

No one knows exactly how this will end since, as with so many acts of magic, more will be revealed in the passage of time. Thus, as many market participants were contemplating the end of the world as we know it, the indices were steadily creeping up into positive territory until the magical word appeared to provide the ever-illusive and always-required “why?” The market knew this a week or more ago, and showed its intentions to those who were not otherwise occupied with tropical storms, prediction mania or political convention fever. There could not have a been a better week to stage this, because too many people were looking somewhere else.

Behavioral traders anticipated it, and we now believe that there is likely to be a positive response to the backstop story. This is likely to provide an upside respite of several days to a week before magic show is over, people slump out of the darkened theater and stagger, squinty-eyed into the harsh daylight of reality.

By Abracadabra, we signify an infinite number of things. ‘Tis the answer to What? and How? and Why? and Whence? and Wither?
‘Tis a word whereby the truth ( with the comfort it brings) is open to all who grope in the night, crying for wisdom’s holy light… Ambrose Bierce, The Devil’s Dictionary, 1911

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Janice Dorn, M.D., Ph.D., is a financial psychiatrist and chief global risk strategist for Ingenieux Wealth Management in Sydney, Australia. She also offers trading consulting and coaching services via her Web site, TheTradingDoctor.com .

The markets will like the government actions regarding Fannie and Freddie. The stock market will rally, the Treasury market will sell off as money is switched back into agency (paper that will carry a yield premium to Treasuries with the same backing.) The dollar will continue its rally and all looks OK with the world.

I would be skeptical of any rally, however. We still have the problems of a glut of unsold homes and what appears to be a deteriorating job environment. There was an article in the Wall Street Journal that said for every 100,000 lost jobs (we have lost 600,000 so far this year), consumer spending gets nicked by about $3 billion. Also, we will have to see if the decline in jobs leads to a further deterioration in the loss ratios on auto loans and consumer credit card portfolios.

The government takeover of F and F was a needed step, but it doesn't end the cycle. We entered into bear market territory a while ago and while it looks like the lows of July could prove to be the lows of this market, a continuation of the volatile trading range is the likely outcome after today's initial reaction on the upside.

Let's enjoy the rally, but I'm skeptical.

Crescenzi: Watch the Dollar

Is There Hidden Fannie, Freddie Stock in Your Portfolio?

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I believe that most investors will ultimately recognize that the announced solution to Fannie and Freddie's problems was already built into market prices, as evidenced by the recent performance of both the common and preffered shares of the two companies, as well as the recent compression of credit spreads for agency debt. In recent days it was also obvious by the way that investors were grumbling about being held in limbo on the GSE issue that something had to happen soon. The most prescient call on this front was the now-famous virtual pounding on the table on television last week by Bill Gross at Pimco whose clear and concise voice was a clarion call and warning to Hank Paulson to put the finishing touches on the capital-fortifying plan and announce the Treasury's takeover of the GSEs.

The Treasury's solution is unlikely to be viewed as a cure-all for the housing problem--the elimination of the excess supply of unsold homes is the cure--but it is one of many things that had to happen in order to fix the housing problem. This means that there will be continued low valuation of mortgage collateral, bank failures, and general angst in the finacial sector, at least until home prices bottom, which I again emphasize depends upon the inventory picture. The Fannie, Freddie solution merely enables the liquidiation process to continue; it will not hasten the process.

Consumer sentiment probably won't be buoyed much by the bailout because the bailout in itself is unsettling and complicated, which will overwhelm any sense that the bailout will keep the drops dripping from the spigot for the financing of mortgages. In the end, people care most about the value of their own homes, anyway.

I think it good that the GSEs are being allowed to expand their portfolios (to $1.7 trillion from $1.5 trillion) before shrinking them (to $500 billion), which will keep money flowing into the housing market and help bring inventories and hence prices into a more stable condition. There is risk, however, in the timeline, as the new rules call for the GSEs to begin shrinking their portfolios by 10% per year beginning in 2010, which will likely be well before the inventory situation has been materially improved. The proverbial fingers will be crossed in hopes for a meaningful drop in home inventories by the end of 2009, or at least an extension of time before the GSEs are shrunk. Thank goodness progress has begun on this front, at least in the new home category and prices are now more consistent with incomes and rents.

Treasury yields were set to rise before the GSE announcement because yields fell too close to the funds rate and the Fed is not likely to cut interest rates. For example, the 2-year note was trading under 2.20% and it is rare that Treasury yields fall below the funds rate unless a rate cut is less than 6 months away. No major increase in Treasury yields is likely, however, as the housing problem has not gone away and there remains the potential for adverse feedback loops where problems in the economy feed back to the financial sector and vice versa. Credit spreads are unlikely to narrow substantially as a result of the FNM/FRE bailout, although they could narrow in the very short-run. The outlook on company bonds is far more dependent upon the economic outlook and the outlook for corporate profits and corporate cash flows.

After an initial hit, the bailout of the GSEs will help keep the dollar's rally intact, which is extremely important to the economic outlook given the benefit that economy will reap from the decline in commodity prices. Moreover, the dollar rally I believe is creating vast pent up investment dollars for riskier assets, as vast sums of cross-border capital flows have been directed to the U.S. of late. I believe there is the potential for a very large rally in share prices as a result of the capital flows. Seen another way, any decline that occurs in share prices will be reduced by the infusion of capital from abroad, as the world is now in the midst of a massive unwinding of commodity-linked investments, which for many reasons benefit the dollar more than most other major currencies.

New Book coming from Tony Crescenzi ... "Investing from the Top Down: A Macro Approach to the Capital Markets."

More: Click for Latest Economic coverage ...

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Compared to all the contortions through which the media have gone through to slap that uppity woman from Alaska, this latest one deserves the gold medal:

That the recent market drop was caused by Sarah Palin.

The ever-entertaining Quentin Hardy of Forbes Magazine advanced this argument to the viewers of CNBC's Kudlow & Company on Friday night. Markets, he told us, were selling off because of Palin. Even the lovable Quentin couldn't come up with this one on his own: he got it from John Tamny, the editor of RealClearMarkets.(Markets Boo McCain's VP Choice ).

The angry left: Daily Kos, Atlantic Magazine; Maureen Dowd have their long knives (and claws) bared and ready for Alaska Governor and McCain V.P. pick, Sarah Palin. Faked pregnancies, hair criticism; breast pump references…ugly, ugly, ugly. They had plenty of practice slapping Hillary around, so it got nasty rather quickly. Apparently, beating up on a woman comes easier with practice.

Barack issued words of restraint to the army of left commentary that constitutes a kind of isolated-from-the-chain-of command militia for his campaign. That’s a gimme. He had no other options. However he blew it comparing his CAMPAIGN staff to Sarah’s mayoral staff. Dumb. He had to jump to her previous job in order to get his resume to surpass hers in experience. He has a campaign staff of 2,500 in his current job, he told CNN, while she ran a mayoral staff of 50. The problem is that she currently runs a state with a payroll of 15,000 state government employees. And state government is a far tougher management environment too: civil service and unions. I’m quite sure all of Barack’s employees are ‘at will’, so no lawsuits alleging improprieties every time you let someone go. Her employees make life and death decisions: arrest bad guys; fight floods; put out fires. His employees issue press releases; call donors; put up banners.

There’s a big difference between a Senator and a Governor. Senators go to Washington. They breathe DC air and drink in the DC mindset. They take a Chevy Suburban a couple of blocks down the street to enter a studio and be on a national talk show like Meet the Press. Governors are farther away, in Sarah’s case, much farther away, in fly-over territory. There’s a visibility gap.

There’s also an authority gap, in the other direction. Governors are more important than Senators: there are only 50 governors, but 100 Senators. It’s automatically a more elite position. Senators (like John Corzine) run for governor, generally, not the other way around. Senate is stepping stone to Governor; Governor is a stepping stone to President. Under normal circumstances he would be getting ready to run for her job, governor, in Illinois. Four of our last five presidents were governors; the fifth was the chief executive of the CIA.

This is a sloppy jalopy market that is trendless and range bound. It is unable to hold solid gains in the major indices, despite the downage in oil and gold. The seasonals are intact for continued sloppiness into the election and a much-needed correction in oil and gold. Financials are the key to these equity markets, and have seen a nice run off the bottom, just as everyone was proclaiming their imminent death. Once again—the herd is always looking in the same direction. When everyone is looking in the same direction, no one is really looking.

See-sawing with a slight upward bias in equities into the elections serves three purposes: Intermittent positive reinforcement for broad market participants, lessening of fear, and increases in risk-taking behavior.

Intermittent reinforcement breeds complacency and fosters hope---neither of which work well for investors. Most investors will be greedy when they should be fearful and vice-versa. As the cry goes out that “the worst is over for the dollar and there is smooth sailing ahead” people will begin to take the other side of the “ short dollar, long metals” that is now unwinding.

Herding is powerful and contagious. Just as the “short dollar, long commodities” trade became too crowded and has been forced to unwind, the “long dollar, short commodities” bandwagon is picking up steam. This trade is not yet crowded enough, and may need until the end of 2008 to draw the herd into to what will then be the wrong side of an overcrowded trade.

We are seeing what looks like capitulation in the precious metals markets, but bounces will be sold because — contrary to the resounding voices over the past two weeks that “the bottom is in for silver and gold so back up the truck before it's too late!" — it is not. More time is needed to flush out all weak hands in these markets and this could take several more months. Again — there will be bounces that act as intermittent reinforcement, i.e., all is well and the worst is over.

Don’t believe it. The people that are making the most profits in these markets are short-term oriented and nimble. This is a trading market, not a buy, hold and hope market.

What are Other CNBC.com Guest Bloggers Saying ...

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Janice Dorn, M.D., Ph.D., is a financial psychiatrist and chief global risk strategist for Ingenieux Wealth Management in Sydney, Australia. She also offer trading consulting and coaching services via her Web site, TheTradingDoctor.com .