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Systemic Risks Tilted to the Upside

(June 12, 2009)

Dear Subscribers and Readers,

Never say never.  For those who are speculating on the long side of natural gas (judging by the recent tremendous volume increase in UNG, there are lots of speculators on the long side right now), there is one burning question you have to ask yourself: Do you have a competitive advantage when it comes to analyzing the natural gas market, and do you understand what is currently going on in the natural gas futures markets, especially if you are buying UNG, the natural gas ETF?  For those interested, the FT Alphaville has just posted an interesting discussion of the recent tremendous increase in UNG volume and its potential impact as the near-month natural gas contract rolls from July to August. Moreover, for those that are trading on the long side primarily because of the historical discount of natural gas prices to crude oil prices, please note that if the Gulf Coast experiences a "mild" hurricane season (this doesn't even take into account that much of the drilling infrastructure had been strengthened ever since the destruction caused by Hurricane Katrina and Rita) and if much of the US experiences a mild winter later this year, January 2010 natural gas prices could very well plunge to $4/MMBtu or below, given the record amount of storage.  Again, never say never.  I remember watching Transco Zone 6 (NY Citygate) prices spiking to $40/MMBtu during Winter 2000/2001 when no one had expected anything like it.

Now, as we promised in our “ad hoc” commentary yesterday, we will now bring you our latest views on global liquidity now that the latest weekly Federal Reserve data has been published.  For the latest week ending this Wednesday, the size of the Federal Reserve balance sheet shrunk by approximately US$40 billion.  This is primarily due to the shrinkage of the Fed's Term Auction Credit facility and its central bank liquidity swap programs, which amounted to a total shrinkage of US$45 billion.  A significant amount of this was offset by the Fed's direct purchases of Treasuries and agency debt and mortgage-backed securities.  Following is a weekly chart showing net purchases of US Treasuries and agency securities (which include agency debt and MBSs) for the week ending January 21, 2009 to the latest week ending June 10, 2009:

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - The Fed's purchases of both Treasuries and agency securities have stalled over the last few weeks - suggesting that the Federal Reserve is not being as accommodative as it was during the early March to mid May period...

As can be seen in the above chart, the pace of the Fed's direct purchase of both Treasuries and agency securities have slowed down dramatically over the last three weeks (the Federal Reserve actually sold agency securities on a net basis for the week ending June 3rd!).  This confirms our suspicions that the Federal Reserve, along with the world's major central banks, had been easing their accommodative stance over the last few weeks.  Unless crude oil prices decline to the $60 to $65 area in the next couple of weeks, there is a good chance that the world's major central banks will remain on hold in their next meetings (the European Central Bank has already indicated as such, and therefore should remain on hold in their next policy meeting in early July).

This recent scale-back in central bank liquidity creation (with the glaring exception of China) is also being confirmed by the Bank of Japan's latest statistics.  Specifically, while the year-over-year growth in the Japanese monetary base is still at an elevated 7.9%, it is down from the 8.2% year-over-year growth set in April, as illustrated in the following monthly chart (showing the y-o-y growth in the Japanese monetary base, its rate of change the y-o-y growth, and the y-o-y growth in the Nikkei 225 index):

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to May 2009) - The y-o-y growth in the monetary base declined from 8.2% to 7.9% during May. While liquidity conditions in Japan remain elevated, this also suggests that the world's central banks are no longer being as accommodative as they have been over the last few months.

In addition, the Japanese government has retracted on its prior plans to purchase Japanese equities from the domestic banking system, citing the latest strength in the Nikkei (both on an absolute and on a relative basis).  The retraction of this plan would further dampen global liquidity creation going forward.

In the meantime, there are strong indications the Latvian Parliament will approve the latest proposed budget cuts as soon as early next week.  The goal of the latest budget cuts is to meet a 4.9% (as a percentage of GDP) 2009 budget deficit target as mandated by the IMF/EU aid program implemented late last year.  Without the latest budget cuts, the 2009 budget deficit would've increased to 9.2% of GDP.  While the latest US$1 billion cut to the Latvian budget should allow the country to meet its goals on paper, it may be “too little, too late,” as the Latvian economy has been rapidly shrinking (it experienced an 18% first-quarter year-over-year decline in GDP!).  As the Latvian government slashes government wages by 20% and shrinks other services, there could also be unintended “knock-on” effects – threatening to throw the Latvian economy into another tailspin.  By the end of next week, we should have a better idea on whether Latvia will receive aid from the IMF and the EU.  Should the IMF and the EU determine that Latvia isn't eligible, there would be no option but for Latvia to effectively declare bankruptcy and subsequently devalue its currency (which is now pegged to the Euro).  A Latvian bankruptcy/devaluation would be disastrous for the Central and Eastern European region, as many countries in this region have also mismanaged their finances (although not to the degree that Latvia had) leading up to the current financial crisis.

Signing off,

Henry To, CFA

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