Tuesday, February 28, 2006

Inverted Yield Curve: Special this time?

As many of you know, the yield curve (a graph showing the yield of treasury securities against their maturity) has inverted. This means that long term rates are now lower than short term rates. This is widely recognized as one indicator of a future downturn in the economy, also called a recession.

I was struck by the Jan 31st testimony of Alan Greenspan, who seemed to think that the yield curve won't be predictive of a recession due to special circumstances this time. How many times do we have to learn that special circumstances are rarely all that special when it comes to economics. It reminds me of the talk of the "new economy" in 1999; how the business cycle was dead and all that. Turned out the miracle economy was a bubble, and the correction came as many predicted.

An inverted yield curve can only mean that the bond market thinks inflation will be lower long term than it is now. As we know from the expectations theory of interest rates, yields are a sum of the numerous expectations of investors. When the long rate is lower than the short rate, investors sense something is about to change; that inflation is going to fall. Inflation falls when business activity is reduced, meaning that the economic growth declines or goes negative outright.

On the plus side, long rates being as low as they are is a good signal for the dollar, IMO. I don't see any evidence of the feared capital flight, which would drive rates, particularly long rates way up. That will be little comfort when the prediction of the yield curve comes to pass --- recession in the next 12 to 18 months (end of 2007).


Monday, April 11, 2005

Social Security Shell Game

The efforts by President Bush to highlight the "crisis" in Social Security financing has been in the headlines recently. According to Bush and friends, there is a pending crisis in Social Security that can only be solved somehow by investing in "private accounts," courtesy of the government, of coarse.

Last time we had a "crisis" in Social Security, the government raised taxes and the retirement age (yes, the new age is 67 not 65 any more). The result was not only solvency of the program, but the run up of huge surpluses that now reside in the "trust fund." Naturally, the government spent every penny of the trust fund, so all we have is a bunch of house from Uncle Sam in a file cabinet somewhere in Washington.

In my opinion, Bush should leave FICA alone and focus on Medicare, which is a real crisis. Thanks to the recently enacted prescription drug benefit, Medicare is bound to be unable to pay its obligations in only a few years. Social Security, on the other hand, is solvent through 2017. Let them raise taxes in 2018 to bail out FICA. If they raise them now, they will only increase the surplus and associated "trust fund" while spending all the money on unnecessary items and waste it away. Let the American taxpayer keep his earnings until its needed to pay seniors their due. In the mean time, let Bush ask for a tax increase if that's what he needs.

At least lets be honest about it.


Thursday, January 06, 2005

Buy Gold! A tribute to my Dad

My father, Charles J. Parlagreco, died unexpectedly on December 21, 2004 early in the morning. He was 68.

My dad was an inspiration to me and the reason that I found finance so interesting. He was always promulgating different "dooms day" scenarios that he read in highly questionable newsletters. When he wasn't telling me to buy gold for protection of value (which is an actual reason to buy gold, even if his reasoning was a bit exaggerated), he was explaining his latest "hot" stock tip and why I should load up on it immediately. These are the memories we shared, often joking about some financial disaster or another. The most famous one, or should I say infamous, was the "Churches Fried Chicken" fiasco. He got me to bite on this one, buying 100 shares of CFC at about $9. Anyway, it was a great tax write off and worth the many hours of joking we enjoyed together about our stock picking acumen.

Its funny what you remember from your childhood and how it affects you. The frequent discussions of economics, politics and finance were instrumental in my interest in business. My Dad always thought I would be either a teacher or a business person, of which I am now both. If only all the Dad's in the world had such high expectations of their kids, maybe we'd have few problems. Who knows?

We said goodbye to this great man just after Christmas. May he rest in peace. He will not be forgotten.


Wednesday, December 15, 2004

Gas Prices and Crude Oil Prices

Today's Wall Street Journal commented that gasoline prices were not necessarily following the path of crude oil prices, even though over half of the cost of gasoline is represented by the cost of crude oil used to produce it. The major reason was a restriction in the ability of energy firms to refine the crude oil into gasoline. The refining process is a complex and dangerous operation involving explosive chemical unit operations and very expensive equipment.

There has not been a new refinery built in the United States for nearly two decades, because NIMBY (Not In My Back Yard) groups like homeowners associations and neighborhood associations challenge almost all new plant proposals and because a protracted depression in the price of oil discouraged profitable investment in refinery plants. Refinery capacity has been increased by a process called debottlenecking, which involves identifying the choke point in a production process and increasing its capacity selectively, resulting in a much larger output from the plant with minimal (sometimes no) capital outlay. After twenty plus years of this, however, the US refinery industry will need to add new capacity by building plants soon.

Another problem afflicting the industry is environmental regulations, both in terms of product specifications and building restrictions on chemical plants. Add to that endless red tape and fears of terrorist attacks, and you can imagine the difficulty and cost of building a new plant. Regardless of this difficulty, however, as demand for new products increase, the refining industry will have to respond with additional capacity --- if not in the US, then somewhere in the world where regulation and NIMBY concerns aren't as great.

Tuesday, December 07, 2004

Downgrade of US Debt???!!!

In a Wall Street Journal Article today, there was some discussion of degrading the rating of the US Government debt from AAA to AA. Only a short time ago, there was talk of panic because people thought the US Government might pay off its debt. What a long way we have come.

If debt is downgraded (which would be the first change since 1917, when the government first earned AAA status), interest rates can be expected to increase. While the US Government can certainly pay off its dollar-denominated debt by resorting to inflation (the functional equivalent of printing money), there may be a time when the government will have to borrow in a foreign currency, most probably the Chinese Yuan or Euro. This would eventually plunge the US into a third-world like currency crisis, with unknown implications for the world economy.

While unlikely (much as paying off the federal debt was unlikely a few years ago), its now possible that the US could loose much of its status as a world economic power in only a few short decades.

Friday, December 03, 2004

Interest Rate Parity Brought Home

One of the final topics studied in most undergraduate finance courses is something called "interest rate parity." The concept is a simple one. It states that investors should earn an equal rate of interest on equal risk investments, regardless of the currency involved. In mathematical form, this means:

Forward Rate/Spot Rate = (1+kh)/(1+kf)

Where the forward rate and the spot rate are in terms of home currency per foreign currency unit, kh is the interest rate at home and kf is the interest rate in the foreign land.

Recently, exchange rates have been changing, with the dollar becoming weaker (less foreign currency is provided per dollar exchanged). To counterbalance this change, the above equation implies that interest rates at home will have to increase, since the change in currency rate is accelerating (the difference between the spot rate and the forward rate is becoming greater).

A related concept is purchase price parity. The classic example of this is the Big Mac. We assume that if a Big Mac costs $10 in the USA, then the same Big Mac must cost the equivalent of $10 in any foreign country into which it is sold. This is summarized by the equation:

Spot Rate = Price at home / Price in Foreign Land

Where the price at home would be in the home currency and the price in the foreign land would be in the foreign currency. Since the cost of a Big Mac in Europe is pretty stable, the fall of the dollar in terms of Euros purchased per Dollar implies the cost of the Big Mac will soon increase by a like amount in the United States.