The Fed is in a real quagmire here. Because of the "daisy-chain" nature of contemporary risk intermediation (specifically in the derivatives and securities financing marketplaces), a failure these days in one of any number of institutions would quickly reverberate throughout the entire (frail) system. As such, today virtually any player of significant presence in the derivatives and/or "repo" markets is likely to be perceived by the Fed as "too big to fail."

The dollar sank to a record low against the Euro and to the weakest level against the Japanese yen since 1995. As far as I’m concerned, the currency markets this week "officially" attained the status "disorderly." Not surprisingly, the dollar responded quite poorly to the Fed’s (so-called "ingenious") plan to accept $200bn of risky collateral from the "primary dealer" community, as it did to today’s financing arrangement for Bear Stearns. The $200 billion is certainly only an opening "ante" and Bear the first of many bailouts.

Undoubtedly, currency markets have begun to increasingly discount the "nationalization" of U.S. Credit risk – both by the Federal Reserve and our federal government. The Fed may plan on 28-day terms for its exchange of Treasuries for other "street" collateral. Yet, the way things are developing, I see little prospect anytime soon for an environment conducive to the Fed reversing course and transferring such risk back to Wall Street. Indeed, this week likely marks a key inflection point for what will soon evolve into a huge expansion of Fed holdings (and various guarantees) of U.S. risk assets. And, at some point, the federal government will be similarly forced into accepting Trillions of "financial guarantee" obligations – for mortgages, municipal debt, student loans, various "deposits" and who knows what.

In past analysis, I have differentiated between the Financial Sphere and the Economic Sphere. At the Fed and throughout the markets, the current focus is on Financial Sphere developments and possible policy responses. Even assuming that the funding crisis at Bear Stearns and elsewhere is resolved in short order (a huge assumption at this point), I doubt even this would restrain the headwinds now buffeting the Economic Sphere. Understandably, the focus now will be on inter-"bank" and securities financing markets. Meanwhile, recent developments will ensure a further tightening in already taut mortgage, municipal, and corporate lending markets. The vulnerable economy will suffer mightily.

The release this week of Dataquick’s California housing data (see "California Watch" above) provided strong support for our view that the Golden State housing market is crashing. Anecdotal accounts have markets throughout the state basically shut-down because of the inability to obtain mortgage Credit (not to mention housing "revulsion"). And with liquidity quickly drying up for various endeavors including student loans, auto finance, small business lending, and business finance more generally, our dire economic prognosis is regrettably coming to fruition.

There are now forecasts for a 100 basis point cut in the Fed funds rate for next Tuesday. Many are arguing that financial and economic developments support even more aggressive Fed rate slashing. I am reminded of the joke of the entrepreneur that loses money on every sale but is determined to make it up on volume. At this point, it should be apparent that rate cuts are destabilizing the system. They not only damage Federal Reserve credibility, they are battering confidence in the dollar and U.S. financial assets more generally. With the financial crisis having reached the "core" of the U.S. Credit system and the currency markets having turned "disorderly," we’re now on Dollar Crisis Watch. One of my greatest fears has always been an unwieldy dislocation in the currency derivatives market.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.