S&P Downgrade - Market Crash - August 8, 2011

Dow is down 634.  Nasdaq drops 174 and S&P plumets almost 80.
Gold steady at over 1700.  Silver takes a minor setback.

Thank you Mr. President.  Your words have inspired the market - to panic.
The President says the debt ceiling must be raised, or the US cannot make it's debt obligations (US Treasuries).
Standard and Poors takes him at his word and combine it with the debt ceiling theater in DC and Downgrade US Debt.
Stock markets plummet.  The President makes some kind of speech - and markets panic some more.

The mass media says all of this was caused by an S&P downgrade of US Debt on Friday (after the market closes).   There is an FOMC (Federal Open Market Committee) meeting tomorrow where Ben Bernanke decides what to do.  At this point, it seems almost inevitable that there will be QE3 announced.  If it's not, then expect more market collapses.  Nobody with half a brain is in this market.

So, how does the S&P downgrade effect the stock market exactly?  A downgrade of US Treasuries (which are considered the safest form of debt since the US can print it's own money), implies that various debt instruments may have principle risk - ie: the bondholders might not get back their original principle.  This should lead to a bond sell-off - which does NOT go into the stock market.  Stocks are considered riskier than bonds.   If bonds sell off, then stocks get devastated.  People look to put their money into "safe" instruments (This has been discussed by John Exter (former NY Fed chief) in the 1960's - see here for details).

As markets flee towards safety, the natural places are - bonds, cash, and precious metals (ie: gold/silver).  The general media would lead us to believe that a downgrade of US Treasuries results in people buying US Treasuries.  I find this preposterous.  If somebody downgrades the financial instrument - people don't flee towards it.  They run away towards something else.  The fact that US Treasuries did NOT plummet - implies that somebody is buying US Treasuries.  There can ONLY be ONE entity which can buy US Treasuries in the face of a general market fleeing US Treasuries.  That entity is the US Federal Reserve Bank.

Let's look at how a downgrade would naturally work, and what would normally occur.  Bonds are sold at a discount to face value.  A $100 bond might be sold for $80 and when the bond matures, will be worth the entire face value of $100.  This discount is computed to a compound interest rate, and we say that a bond is paying 5% compounded.

When there are more buyers of bonds than sellers, the price of the bond goes up (towards the face value), and as a result interest rates fall.  The maximum price of the bond is it's face value, and this will result in a payment of 0% interest.  When there are more sellers than buyers, the purchase price of the bond falls, and interest rates go up.

So we see that the bond market is the real driver for interest rates.  The US Government pays interest on its bonds (Treasuries).  Since the rates are near zero, the government is not paying much interest.  Suppose that interest rates for Treasuries started rising.  In this case, the interest expense (which is currently near zero), would rise dramatically.  The money supply would shrink (consumed by interest payment), and the economy would grind to a complete standstill (if it isn't already).

So, let's look at what actually happened.  We see a stock market sell-off (in expectation of a shrinking money supply), and a flight towards bonds.  Buying bonds before the price drops ties up your money for a long time, or guarantees a loss.  So the logical reaction (buy people who want to make money) is to sell stocks and stay in cash, or even better short the market, or buy S&P out of the money puts (for a short term) - but NOT to buy bonds.  But we did not see the bond market collapse, therefore somebody must be buying the bonds.  I posit that the somebody can ONLY be a Central Bank, or several Central Banks working in collusion.  These institutions are not driven by profit, but by maintaining the status quo.  By purchasing US Bonds, they keep interest rates artificially low - which results in money going into the stock market (in effect the Central Banks prop up the stock markets of their respective countries).  Since the US Dollar is currently the world's reserve currency, nobody can afford the US Dollar to collapse.

Tomorrow's FOMC meeting should result in QE3.  Which should stabilize the markets.  The Fed will claim that they have no choice but to initiate QE3.  If it does not happen tomorrow, it will happen soon.  The markets will stabilize after this news - and trillions of new debt will be monetized.

It's a very interesting sequence of events...
QE2 ends - and the fed stops pouring money into the stock markets
Debt Ceiling limit reached - the US Congress cannot issue more debt (which gets monetized and become US Dollars)
Stock Market collapses
Fed becomes "forced" into QE3

If these events did not happen in this sequence, we would not see money being created and injected into the stocks market and into the banking sector (QE3 will also bail out the banks, as there are currently rumors of large US and European banks being in trouble).  It's almost like a script that is being followed.

Since QE3 increases the quantity of US dollars in existence, this makes gold priced in US Dollars go up, and similarly for silver.

The FOMC meeting will result in a statement being issued tomorrow at 2:15 Eastern time tomorrow.
It seems we live in "interesting" times (as per the ancient chinese saying).