The Energy Report for Friday, August 6, 2010

Are you looking for an exit strategy from the historic amount of economic stimulus and quantitative easing that has dominated global stock and commodity markets? Well look no further than Europe. While we here in the United States are raising the possibility of more quantitative easing and more ways to stimulate the economy, the President of the European Central Bank Jean Claude Trichet is sending signals he is looking for a way out.Yes, I know. It's crazy!

The EU and its three freaking pillars were on the verge of crumbling into pillars of dust just months ago. Now EU growth is improving and even Greece passed the EU stress test and now Mr. Trichet seems to be stopping just short of flying a mission accomplished banner. Of course Jean- Claude, ever the optimist, said not long ago that people were just too darn negative on the EU and now he seems to be saying get ready to start the long road back to economic normalization. The US on the other hand, has Fed Governors talking about Japanese style Deflation.

Comments by St. Louis Fed President James Bullard said that the Fed should be ready to resort to aggressive quantitative easing if it needs to stimulate the economy further and this seems to suggest that the US economy somehow is in worse shape than the EU. This apparent difference in the moods of the two great economic powers helped reignite the carry trade. The euro has rallied and the dollar has fallen and the price of commodities has dutifully increased. The carry trade with the euro is not the only one.

According to Bloomberg News, investor's reaped bigger gains since the start of June by funding investments in higher-yielding currencies with dollar-denominated loans than similar strategies using Japanese yen or Swiss franc based funding. A basket of currencies including the legal tender of Australia, Canada and New Zealand and Brazilian real financed with U.S. dollars returned 7.8 percent since the start of June, compared with 2 percent when funded in yen and a loss of 2.5 percent in Swiss francs. Is it all just happening by accident or is there a plan behind this move?

The truth is the carry trade, inspired by the Feds printing of money, helped bail out the US and by default, the world banks as well. It seems that global leaders like the way the carry trade wiped always billions of dollars of bank debt. Or as the Wall Street Journal said, the bank bailout, it seems, has succeeded better than anyone wanted. Policymakers wanted sober, responsible Bruce Banner. Instead we got the Hulk banks, led by JPMorgan Chase and Goldman Sachs.

Last year was the best ever for Goldman; this year's on track to be even better. Cheap money as well as negative real interest rates allowed banks to make back their incredible losses. At the same time this brought a sense real or not of economic stability back to the system. Now with the recovery perhaps faltering is the Fed in conjunction with other global central banks conspiring to give a repeat performance? Are they hoping to jack up bank balance and profit books in hopes they will start lending money and inspiring some economic growth? Are they trying to create the illusion of economic activity and inspire a sense of urgency to business's that seem to be content with a return to profitability by basically sitting on their hands? Is this a plan by the Fed and other global central banks trying to ward off deflation and at the same time inspiring a commodity rally?

Are global central banks encouraging all of this because the last big carry trade seemed to help bring back the global economy that seemed to be on the brink of extinction. Well the truth is it is all being done on purpose. The return of QE 2, and I am not talking about the ship but a second round of quantitative easing, is a real possibility and one the Fed believes might be needed. A second shot of that nuclear espresso is what they think they might need.

Yet perhaps real problem with real commodity price inflation may make it more difficult to execute this strategy than it was in the historical soft demand drop in late 2008 and early 2009. Take the move in the wheat market for example. Wheat surged to a two year high as a drought in Russia had Russia cutting all of their exports .This is leading to fears that we could see food shortages and perhaps even some of the riots we saw break out during late 2007-2009. Food inflation, as well as a potential rise in oil prices and other commodities, might make it harder for the consumers to survive.

This will be especially true if we do not see a substantial rise in global employment that still is in pitifully bad shape. Not to mention the fact that because of the last round of printing money prices of almost all commodities are already higher than they should be. There are other risks as well. One noted economist, Nouriel Roubini, said that while the combined effect of the Fed policy of a zero fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe, it could also lead to another dangerous global asset bubble of, as he says, the mother of all carry trades.

Roubini thinks that what the Fed and other central banks seem to be doing again is reckless US policy that is feeding these carry trades and forcing other countries to follow its easy monetary policy. This is keeping short-term rates lower than is desirable. He says that central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies such as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse, and if there is no Forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative.

If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes will get's bigger by the day. Roubini says he believes this story will end badly leading to the biggest coordinated asset bust ever especially if factors lead the dollar to reverse and suddenly appreciate. If that happens he says a stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a coordinated collapse of all those risky assets including, equities, commodities, emerging market asset classes and credit instruments.

The truth is that with the increasing cost of wheat and oil, along with a weakened economy and consumers, the global central banks are doubling down on last year's policy. If they go bust then we will go bust right along with them. Forget that bullish injection in natural gas that came in at a less than expected 29 billion cubic feet.The Energy Department's Energy Information Administration said natural gas inventories held in underground storage in the lower 48 states stand at  2.948 trillion cubic feet  8.1 percent above the five-year average. Still natural gas fell when Reuter's News reported that U.S. government scientists on Thursday cut their forecast for the 2010 Atlantic-Caribbean hurricane season but they still expected a very busy year.

The National Oceanic and Atmospheric Administration said it now expects 14 to 20 tropical storms, with eight to 12 of those strengthening into hurricanes. It forecast that four to six of these would become major hurricanes during the six-month season that began on June 1. Still long term natural gas prices could rise as the New York State Senate voted on a moratorium to temporarily ban drilling in a natural gas-rich region of Western-Central New York known Marcellus Shale. Stay Tuned! And make sure you stay tuned to the Fox Business Network where you can see me every day! Make sure you are getting my daily trade levels on all the different commodities by calling me at 800-935-6487 or by emailing me at pflynn@pfgbest.com to open your account.

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