Today at 11:10 AM ET, I’ll be appearing on CNBC’s the Call with Larry Kudlow discussing the outlook for China’s economy. Then I’ll be back at 11:40 to discuss how geopolitics will impact the US dollar in 2010.

Yesterday, I tweeted about the Xmas Eve decision by the Obama administration on FNM and FRE. The cap to lending to these two mortgage giants was lifted and could cover unlimited losses over the next three years. The US Treasury receives preferred stock in both companies paying 10% dividends. Already, the US has paid out $111 billion: $60 billion to Fannie and $51 billion to Freddie. The previous cap was $400 billion. Treasury said that this was “necessary for preserving the continued strength and stability of the mortgage market.”

Why was this done at this time? The driver was a December 31st expiring agreement that allowed the US Treasury to make amendments to the original September 2008 conservatorship deal. The Treasury had the authority to make changes by the end of 2009 without the consent of Congress. Given the fight over extending the debt ceiling, this would likely have been another major battle.

Back in October, I met with the top US Treasury officials on a number of topics. When the subject of Fannie and Freddie came up, they said that there was no oxygen at this time to deal with them. It was more likely that something would be accomplished in February. Apparently, they must have changed their mind when they realized how fractious Congress was becoming over health care.

The bigger question remains unanswered: will the Obama administration begin the process of winding down these institutions? The combined mortgage portfolios of these companies is $1.6 trillion. Fannie and Freddie’s debt doesn’t show up on the nation’s debt totals, but the US taxpayer is on the hook due to the “conservatorship” agreement. This is why these two companies can keep coming back for money to shore up their declining loan portfolio.

The yield spread between these agencies and similar US Treasury debt compressed when the Federal Reserve began it’s quantitative easing program. The Fed will complete this $1.25 trillion mortgage purchase program by April. Given the current trajectory of the recovery coupled with the ending of QE, we could see a significant rise in US Treasury rates and even higher US mortgage rates.

This is likely why we are currently hearing calls for significantly higher rates from US investment banks………and by Freddie Mac’s economist. Can there be a bigger red flag than this?

December 28th, 2009
Chicago, Illinois

Andrew B. Busch
Global Currency and Public Policy Strategist
(312) 845-2879
1-800-438-0434

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With Chinese Premier saying no to yuan appreciation and US holiday retail sales better than expected, the greenback is marginally lower against most major currencies in thin trading. The US dollar index is down .12 at 77.60. Australia, UK, Germany, and Canada (and others) are out for Boxing Day……I’ll do the OIS tomorrow when everyone gets back.

10:30 Dallas Fed Manufacturing Outlook
12:00 PM ChicagoFedMidwestManufacturing Index
1:00 PM Results of $44B, 2-Year Note Auction
4:30 PM Money Supply
4:30 PM Fed Balance Sheet

Not many are open, but global equities are mainly positive with the US S&P 500 is up 1.6 pts at 1123.10. Commodities are mainly higher with Gold at $1110.10. Crude is $78.40, nat. gas is at $5.80, and home heating oil is at $2.05. The CRB is at 282.20. Wheat is at 5.34 and corn is at 4.1675. Ahead of $118 billion in auctions this week, the US 10 yr note yield is at 3.83% and the 2yr note at 0.99% with the spread to 282. Freddie Mac’s deputy chief economist said interest rates were going a full point to 6.0% on 30 year mortgages in 2010. The TED spread non-fear factor is at 18.67, the VIX is at 19.54, and the CVIX closed at 13.49. TED and VIX and curve are all pointing towards continued equity market strength.

Another holiday, Another Charlie Sheen Arrest…… Unlike Tiger Woods, Sheen’s commercials are still running…..

Interest Rates: Our Justin Hoogendoorn writes, “As the Treasury prepares to auction $118 billion in 2-, 5-, and 7-year notes this week into a skeleton market, higher rates are on the minds of many with the 10-year Treasury having moved 64 basis points higher in December. While the current 3.84% on the 10-year note is not problematic, forecasts of a 5 handle on this rate should stir extra vigilance into Ben “One More Term” Bernanke. Such a large increase in rates would have the potential to disrupt the recovery; however, we view it as very unlikely in an environment with low capacity utilization and high unemployment and would look to stay involved in the fixed income markets in 2010.”

China’s Inflation and Currency Problem

In an exclusive interview with Xinhua News, Chinese Premier Wen Jiabao discussed two key issues that are the economic equivalent of the immovable object meeting the irresistible force.

First, Wen said that the government would maintain order in China’s property market. “As the property market is recovering rapidly this year, housing prices in some cities are rising too fast, which deserves the ‘great attention’ of the central government.” Wen said the government would stabilize real estate prices with economic tools of taxes, interest rates and land policies according to Xinhua.

Next, he address the international pressure to allow the Chinese yuan to appreciate. “A stable Chinese currency is good for the international community.” Some countries demanded the Yuan’s appreciation while practicing trade protectionism against China, said Wen, adding that this in essence was aimed at checking China’s development according to the article. “China will work together with other countries to curb trade protectionism and push forward with the Doha Round trade negotiations,” Wen said.

The world is not happy with the Chinese currency policy due to the currency weakening alongside the US dollar. This means that the economic adjustment process from a US recession has fallen on countries that have free floating currencies. What makes this particularly onerous is that the Far East and in particular China have weathered the downturn extremely well, but have not had their currency appreciate.

With China’s currency not appreciating, there is another way that trade partners have addressed the issue. 19 countries and regions have launched 103 trade related investigations against Chinese products and both the number of the cases and the money involved was at record high.

The ironic twist to this story is that a strong currency with a loose fiscal policy (tax cuts) would mean consistent growth for the country. It would also increase the purchasing power of Chinese consumers and increase foreign direct investment. It would also help cool inflation for consumers which is likely a critical concern for Chinese leaders. A stronger currency would also allow tighter monetary policy as FDI brings in flows to offset the increased cost of capital.

So far, the Chinese have not had to make a choice between the benefits of a weak currency and the disadvantages of inflation. With soaring home prices and trade related investigations, they will soon have this Faustian choice foisted upon them.

Over the last two years, many government officials have critiqued the United States for their handling of the crisis. The problem with most of the comments is that they come from countries that are engaging in similar behaviors. Therefore, the validity of their analysis is similar to a family advice column by a golfer.

This is not the case with Canada. The Canadian banking system is held up by many as the shining example of how to avoid financial disaster. (FULL DISCLOSURE: I WORK FOR A CANADIAN BANK.) So when the Canadians offer advice or voice concerns, I think the US might want to take a moment and listen.

In an interview in Canada’s Financial Post, Finance Minister Jim Flaherty warned, “The situation in the United States is serious in terms of the size of their deficit.” Flaherty said that the deficit is a “persisting concern” for the Canadian economy, as the United States is by far Canada’s largest trading partner.”

Here’s the key point: “We want the U.S. economy to return to health [because] it is good for our economy. We need to see that once American governments, including U.S. states, are through the crisis that there be indications as to how they will manage this huge deficit – because it has consequences both within and [outside of] the United States.”

The Canadians see the looming problems of not only a 2009 $1.4 trillion budget deficit (40% financed by debt), but also the debt-to-GDP ratio surpassing 100% by 2012. They are concerned over what their American counterparts will do to address this as tax increases will reduce US consumers demand for Canadian products.

What must be adding to the Canadian and global concerns are any new promises the US government makes that would aggravate the already precarious fiscal position. As a Senate vote nears tomorrow morning, the conservatively estimated $1 trillion health care plan is front and center. The Associated Press details the major issue: “The costs of health care reform being pushed through Congress by Democrats will be felt long before the benefits.”

Here’s an interesting intellectual exercise: try to think of something that the US could do that is fiscally worse than this bill. Can’t? You’re not alone and we can expect more nations to join the Canadians in expressing their concerns. We just may not have anyone with similar gravitas we can trust.

If you have had the misfortune to follow this debate as it grinds through the Senate, several thoughts come to mind.

1. I’m glad a snowstorm hit the area.

2. I’m stunned that all the Senators can actually stand up to voice vote.

3. Politicians have now made a new inalienable right that the framers of the US constitution forgot: life, liberty, the pursuit of happiness, and government subsidized health care.

3. The extent of pandering to garner the last and critical 60th vote was a new low.

Hey rest of the 49 states, did you know that you will now pay for Nebraska’s Medicaid costs in perpetuity? This was the last piece o’ pork given to the last holdout, Senator (D. NE) Ben Nelson, so that he would vote for cloture and stop debate on the bill. “No bill is perfect, but this bill deserves to move along, ” he told reporters after the vote. No word if if he was laughing out loud or just smirking when he said it.

By the way, anyone earning more than $200,000 (a fat cat) or families over $250,000 (litter of fat cats) will see their Medicare taxes increase almost 100%. Okay, it’s going from 0.5% to 0.9%. There are all sorts of taxes and tradeoffs to reach this mythical $129 billion in savings over the next ten years that you have to question if it’s worth it. Remember, this bill spends $871 billion dollars. The $129 in “savings” comes from what the CBO has estimated the costs of the current structure will be status quo over the same ten year period.

Just one small problem, the CBO scorecard on the $871 billion in cost assumes static behavior by participants. Let that sink in. This means they don’t make any allowances for people changing their behavior to take advantage of the new system and drive up the costs. Hmm, I wonder if that will happen?

Hey, the good news is that it provides coverage for 94% of eligible Americans under 65, it prohibits insurers from denying coverage on pre-existing conditions, and creates regulated exchanges where people who do not get coverage through work can shop for insurance plans. The other good news is that the Senate has no provision for a public option.

Oh, but the Senate bill has to be merged into the House bill. The House bill has a 5.4% surtax on fat cats earning over $500,000 a year and litters of over $1 million. It also has cuts in Medicare payments to hospitals and other providers to get to their CBO score of only $109 billion in savings or cost of $1.05 trillion. And it has the public option.

We won’t know all the winners and losers in health care that Congress is picking until they finish the merging or conferencing on the bills. This is expected to be done sometime in January so that a final bill can be presented to President Obama by his State of the Union address.

Overall, this will be a seismic change to 17% of the US economy. It’s difficult to be optimistic that the US federal government will be accurate in their predictions of costs or benefits for their health care legislation. Given the dire state of the United States fiscal deficit and debt creation, this will likely exacerbate concerns over the ability of the government to pay for what it owes.

Xinhua News reported today that the government will target excessive growth in property prices in some cities. This comes on the heels of the Chinese cabinet saying that it will impose a sales tax on homes sold within 5 years. China’s Ministry of Finance has tightened rules regarding the purchasing of land, raising the minimum down payment for buyers to 50% as the government continues to clamp down on the real estate market amid growing concerns about a bubble forming in some large cities according to Xinhua.

The Ministry of Finance statement also said that developers need to pay the total cost of their purchases within a year, though some “special projects” will be exempt, Zhou Xiaoyun, deputy-chief engineer of the China Land Surveying and Planning Institute, was quoted as saying by the official Shanghai Securities News.

China property stocks got hammered on the news of the tax and dropped the most in four months. The Shanghai property index dropped 4.8% on the news. The largest developer, China Vanke Co. dropped 6.3% as did the second largest, Poly Real Estate Group Co, by 7.5%. The Shanghai composite index fell 2.05%.

On Tuesday, Fitch Ratings said China’s red-hot property market is a concern for its sovereign credit rating because of the threat of worsening asset quality in the banking system. James McCormack, managing director of Asia Pacific sovereign ratings at Fitch, said, ”The China property issue raises some concerns with respect to asset quality in the banks. The banking system is a sovereign rating weakness. Clearly banks in any country with a property bubble would be affected, but banks in China are, as noted, already a weakness.” (Rtrs)

Unlike the rest of the G20, China targets lending levels for their banks and has them comply. This is high powered, high velocity money that spurs growth and speculation. This year, Chinese banks extended a total of 8.67 trillion yuan ($1.2 trillion) in new loans in the first nine months and are on target to breach 10 trillion yuan. This would be a 100% increase in lending from the original targets set at the beginning of the year. The fear is that this has created a Chinese real estate bubble that will burst.

While regulators are concerned over real estate, the loan target levels for 2010 are likely to be set at 8 trillion yuan. Therefore, the Chinese may be able to cool speculation in real estate, but the high lending levels will see speculation in some asset class continue. Commodities, equities, or even foreign real estate will be prime candidates.

Benigans Part II

Today, the US Senate Banking committee will likely vote to recommend current Federal Reserve chairman for another four year term. This is not interesting. What is interesting is the increasing number of senators that are saying they will vote against him. Clearly, the American public needs a villain or several villains for what happened over the last 2 years. Goldman is one of them. The other appears to be Bernanke. Someone needs to take the blame for the 10% unemployment rate. Middle income voters feel that Bernanke & Co. bailed out Wall Street over Main Street. The banker bonus situation further fans these flames of distrust.

Oregon Democrat Jeff Merkley is the latest to join this camp. ” “We need to have leadership that understands the goal is not Wall Street profits. The focus should be on how do you enable families to thrive and prosper.”

Also, the American public is nervous over the amount of power Bernanke/Paulson wielded during the crisis. As I’ve written (and others), the meeting in September between Paulson, Bernanke, and Congress where they asked Ben how much money he could bring ($800 billion) to support the financial market crisis was an eye opener.

It underscored that the Fed was the fourth and unelected branch of government with freedom to access the taxpayers pocketbook via the Fed’s balance sheet. Essentially, no one has granted the Fed the explicit authority to expand the balance sheet from $800 billion to the now gargantuan $2.2 trillion.

This is why it’s very likely the financial regulatory bill that is winding through the US Senate will reduce the Fed’s ability to do this unsupervised. Also, there is strong agreement within the Senate Banking committee that the Fed should lose its authority to regulate the financial industry. Both of these actions underscore the public’s distrust and anger towards the Fed.

This will fulminate during the vote to confirm in front of the full senate in January. Normally, the vote will be very strongly in favor of confirmation with the yeas at 70+. This time, we could see a vote as low as 65. For the markets, this will create further questions over the independence of the Federal Reserve and whether the they will act to raise rates before the unemployment rate drops significantly.

I would expect the Fed to completely telegraph their moves before they act because of this predicament. They don’t want to surprise anyone in Congress (or the the markets) and want to mitigate the political fallout that will come from reducing the monetary stimulus.

With growth returning and unemployment seemingly peaked, will the FOMC have to exit their massive stimulus. Here are 5 things to ponder for today:

1. A Bernanke Fed has never raised rates in an aggressive manner to combat either inflation or bubbles.

2. Wages are the major factor influencing prices in the United States and Bernanke believes we remain well below levels that will create pressure.

3. Gold and other commodities indicate inflation is a looming problem.

4. Fiscal policy is on a path to a crisis with total debt in the United States growing almost 20% in one year. Congress continues to spend like a drunken sailor with each agency receiving a 10% increase for 2010 when the deficits are exploding. The Fed will be forced to react when the crisis comes to protect the US dollar and to ensure bond holders it is the guardian of the value of the currency.

5. Bernanke is up for a vote on whether he gets to keep his job.

If you think this makes the FOMC’s job difficult, consider that the American public has a very low opinion of the central bank due to 10% unemployment and the belief that the Fed bailed out Wall Street over Main Street.

Time magazine aside, there are plenty of folks out there that question whether Bernanke should keep his job including Ron Paul and Jim Bunning. For today, the markets are not expecting a move to change rates. The market is sniffing out whether the Fed will pull back sooner on their QE rather than wait until March 2010. The market is also sniffing out whether the Fed will indicate any change in “extended period of time” for the current easing.

By now, you should be aware of the 12 and 20 months the Fed waited after unemployment peaked during the last 2 recessions before they began raising rates. Like I said yesterday on CNBC’s Closing Bell, the clock is ticking for the Fed after we dropped to 10% unemployment from 10.2%. We’re all awaiting to see if Bernanke and Co. have the backbone to raise rates to fight inflation when growth remains sluggish in 2010.

Friday, the US House of Representatives passed their version of the financial regulatory reform package. By a vote of 223 to 202, the House followed much of what the White House wanted for the bill. The bill is broad in its scope from OTC derivative regulation to the creation of a new Consumer Financial Protection Agency (CFPA) to a new system for winding down failing financial institutions. The Senate is expected to move forward on their version next year.

Just weeks away from entering an election year, the Democratic leadership is pleased with delivering on a reform bill. At a news conference today on the bill, US Speaker of the House Nancy Pelosi said, “This is really an important day for our country. Because of the leadership of the people you see gathered here, we are sending a clear message to Wall Street: the party is over. Never again will reckless behavior on the part of the few threaten fiscal stability of our people.”

Last night on 60 minutes, President Obama said that he did not run for office to be “helping out a bunch of fat cat bankers on Wall Street……What’s really frustrating me right now is that you’ve got these same banks who benefited from taxpayer assistance who are fighting tooth and nail with their lobbyists up on Capitol Hill, fighting against financial regulatory control,” he said.

However, Congress should think long and hard about passing a bill that puts US financial institutions in a competitive disadvantage to other countries. How ironic is it that President Obama is meeting top banks today to get their support for a bill that would undermine their business. And undermine what the President truly wants them to do: lend more to small and medium sized firms.

Let me illustrate by what is happening in the Europe. The UK government on December 9th announced a one-time 50% tax on bonuses more than 25,000 pounds and France said that they would follow with a tax on bonuses exceeding 27,000 Euros. This far exceeds what the Financial Stability Board guidelines. They advocated for banks to discourage bonus guarantees longer than one year, encourage companies to defer bonuses for senior executives and other key employees and enable pay to be clawed back if losses occur at a later date.

This is not gone unnoticed by the rest of the industry. Deutsche Bank AG Chief Executive Officer Josef Ackermann said Germany has a “comparative advantage” over other financial hubs because it doesn’t plan to tax bonuses like Britain and France according to Bloomberg. “To strengthen the financial hub of Germany I think is a very wise move,” Ackermann said in an interview in Berlin late yesterday.”

In a global market, the more regulations/restrictions one government places on their banking industry, the less competitive that industry becomes. Unlike many industries, the financial sector is technology and people intensive. This allows the “assets” of a firm to be extremely flexible where they work. This means that if one bank can’t pay industry levels of compensation, those assets can move quickly to another firm or another country. This is the paradox of reforming finance.

While there is clearly need to change the way the United States regulates and manages its financial industry, the House bill way forward may be a major step backward. If the reform forces domestic banks in the US into an uncompetitive position, then they will be either be forced to move out of the market/country or they will lose their people…or both.

The one thing they will not likely do is increase lending to where the President wants.

Due to the explosion in deficit spending, the federal debt ceiling needs to be raised to legally allow the US government to continue to borrow to fund itself. The current debt limit is at an astounding $12.1 trillion and borrowing has been pushed to this limit by a $1.4 trillion deficit in fiscal 2009. Regardless for who you blame for 2009’s spending, 2010 will be a problem for Congress and the current administration to correct. As an example of the fiscal crisis, 40 percent of this year’s budget will be funded by borrowing.

The debt ceiling hike is a game of fiscal chicken right now between the Democratic leadership on Capitol Hill and fiscal conservatives in both parties. The leadership has to deal with this before the end of the year as the Treasury has indicated they will be at the limit by December 31st. They also want to ensure that they don’t have to deal with this problem later in the 2010 when the mid-term elections are in play. This translates into a plan to raise the US debt ceiling by a whooping $1.8 trillion. This is twice what was anticipated in last spring’s budget resolution for the 2010 fiscal year that started in October.

Where will this debt increase motion show up? Why hidden deep in an appropriation bill that funds the US military. House Appropriations Committee Chairman David Obey (D, WI) told Politico, “It is December. We don’t really have a choice. The bill’s already been run up; the credit card has already been used. When you get the bill in the mail you need to pay it.” Except in this case, the payment is going to be made by borrowing on another credit card.

Now, this is not going to go unnoticed and there is a group of senators banding together to call for changes to reduce the fiscal deficit. Led by Senate Budget Committee Chairman Kent Conrad and Senator (and almost Obama administration member) Judd Greg (R., NH), a bipartisan task force is being formed to design a large deficit-reduction package. The idea is to fast track their plan through the legislative process to get a quick yea or nay in Congress on the plan. The debt ceiling extension would be a perfect place to include language to create this task force.

Before we get excited about this prospect, we need to look at what Conrad has said recently during hearings. He said that “everything would be on the table” including “tax reform” to meet the “revenue challenge we face from an outdated and inefficient revenue system.” Let’s be clear on what this means: Everything on the table+tax reform+revenue challenge=tax increases.

Cato’s Chris Edwards points out three fatal flaws with this task force. One, the resulting tax increase would be on top of all the other tax increases on the table, including the scheduled rise in income-tax rates in 2011 and possible increases to fund health-care and climate-change legislation. Two, CBO’s long-term projections reveal a spending catastrophe, not a “revenue challenge.”…If Congress tried to raise taxes to match this soaring spending, the economy would enter a death spiral of declining growth and a shrinking tax base. Tax increases would be economic suicide in a global economy where American workers and businesses are already struggling to compete. Three, the government’s spending addiction cannot be cured in a one-shot treatment. If task-force proposals to cut spending were actually enacted, members of Congress would immediately go to work to reverse them.”

With rating agencies warning countries over their spending and lack of fiscal discipline, the US debt hike situation will inform investors what the intentions are for reducing the calamitous fiscal red ink the US is creating. A special task force to reform what is wrong with the US fiscal position reminds me of the legislation being worked on to reform what is wrong with US health care.