"Please Accept Our Cash"

Another economic panic - Three-month U.S. Treasury rates reaching negative territory. With the stock market crashed, commodities sinking, housing underwater and banks starved of liquidity, it seems that investors are searching safe heaven at the US Treasury. In other words investors are ready to “pay” the US Treasury for “borrowing” their capital where they think that they can protect the values of their capital.  But that also means that borrowing becomes even more difficult with widening spreads. The only silver lining is that bailouts would look much cheaper! 

Three Month T-Bill Rate [12/9/2008] 

[The three-month T-bills rate is lowest rate since the US Treasury started auctioning the securities in great depression era according to Bloomberg.com]

© Rohit Deshpande

Financial_Crisis@harvard.edu

Global financial crisis has now reached the most prestigious and probably the richest academic institution in the world - Harvard University. 

Harvard Universit President Drew Faust said the school is preparing for ``unprecedented'' losses in its $36.9 billion endowment and will seek new sources of revenue and savings.

Another option is ask for a bailout package to avoid the potential "systemic risk" !

© Rohit Deshpande

In Search of Bottom

Recently I discovered two interesting correlations between exchange rates of leading currencies and S&P 500 index.

First relation is very well-known. If you compare Yen-US Dollar exchange rate with S&P 500 index (or Dow-Jones Industrial Average) in long term, you get near-perfect reflection images of each other. When S&P 500 falls, yen rises and vise versa.

US Dollar per Japanese Yen Vs. S&P 500 Index

The explanation is simple – Yen is relatively undervalued in terms of other major currencies partially because of monetary policies of Bank of Japan which keeps benchmark rates low in order to boost exports and fight deflation. Because of the low rates investors prefer to lend the money in cheap yen, convert to high yielding currency like US dollar and take risk by investing in US stock market for even more returns. But as US market slows down, investors start abandoning US market and buying Yen to cover their positions as well as in search of a safe and strong export dominated economy where central bank is to defend currency and fight deflation. 

The second relation is bit more complex. If you compare Euro- Yen (Yens per Euro) exchange rate and S&P 500, you will find that they perfectly follow each. 

Japanese Yen per Euro vs. S&P 500 Index

Again investors borrow money in yen and invest in another high yielding currencies, instruments and derivatives. But the carry trade of Euro in terms of yen apparently also overlap S&P 500 index. This trade collapse is parallel to the S&P 500 index collapse.

Both the graphs represent institutional investors readiness to take risk in the market. Higher spreads between JPYUSD and S&P 500 means investor is willing to take higher risks for higher returns. As the spreads narrow, the willingness of the risk also reduces. The second curve represent anti-growth environment where investors are running from new ventures, and capital investments to safer environment. Both graphs also confirm a widespread economic slowdown to the degree of recession.

But the real question is does this mean we are closer the bottom that to the top? 

© Rohit Deshpande

Commodity Crash

Remember, just few months back everyone was speculating over commodities - Analysts at Goldman-Sachs forecasted price of oil barrel could reach $ 200, even oil baron T. Boone Pickens forecasted $ 150 (Pickens also spent millions of dollar to promote his oil independence plan)

And today oil is below $ 75, and it’s not only oil. Copper dipped to $ 2.15, wheat neared $ 550.

Does it help the consumers? Well, at least for short term. Especially decline in energy prices brings tax cut effect estimated up to $ 100 billion. But as prices fall, conservation efforts also come to halt and so does alternative energy development projects. It is interesting to see how alternative energy index fund collapsed with crude price decline.

Bizarre Mechanism : Central banks all over the world are pouring liquidity in the market. That should increase the inflation. Then how the prices are coming down? 

The latest commodity price decline is another classical example of free market mechanism. For example as  oil prices peaked demand in developing markets reduced since governments can no longer afford subsidies. Even in United States demand reduced. On the other hand, supply increased to OPEC increased production. Decreased demand and increased supply brought prices down. 

© Rohit Deshpande

Airline Industry – “High” and “Dry”

Recently I came across a very funny video on You Tube. In this video, flight attendance charges passengers fees for use of seat belts, reading material and even emergency oxygen masks. It seems that the parody is coming to reality. Just yesterday, in a letter to the Federal Aviation Administration, United Airlines' Pilot Union alleged that four recent engine failures or compressor stalls on United 737 aircraft may signal the "maintenance standards have deteriorated at United as operational decisions are increasingly driven by economic considerations." [WSJ]. Last Month US Airline Pilots Association complained that the airline was pressuring pilots to carry less fuel to reduce the weight of the plane. [Fox Business]

The sky-rocketing oil prices have clearly crippled the airline industry. Airlines are taking major decisions to keep operating costs low; ranging from consolidations, eliminating routes, and cutting jobs to charging for check-in baggage and in-flight services including food, beverages, blankets and pillows. There have many arguments from both sides of the fence. The critics criticize declining value of service while supporters argue pointing that the cost of air travel has not been increased significantly with the increased fuel prices.

In my opinion issue real problem is not oil price but the business model itself. 5 of “Big Six” airlines have gone through chapter 11; some of them have gone more than one time. There is an urgent need to refine the complete business model:

1. Demanding cutting edge technologies that will reduce the risk exposure to volatile energy market;


2. Building strategic partnerships with all the stakeholders, particularly with the customers;


3. Eliminating the non-value addition processes. They have done it well in recent days; But most importantly:


4. Defining the business as ‘transportation business’ instead of just ‘airline business’. This will open avenues to sustainable horizontal growth. (This is much analogues to railroad industry decline in “Marketing Myopia” by Theodore Levitt)

Few days back I got email letter signed by the CEOs of major airline companies urging to join campaign against speculation in oil futures market that allegedly drives oil prices. With 20% drop in oil prices in last few days, I hope they don’t take away the ‘complimentary’ seat belts.

Airline stock performance with compared Dow Jones Industrial average (last six months)

Airline stock performance with compared Dow Jones Industrial average (last one month)

Links:
Airline Video –
http://www.youtube.com/watch?v=Q-nX6g148mA

Airline CEOs sign joint letter to frequent fliers -http://www.stopoilspeculationnow.com/uploads/An_Open_letter_to_All_Airline_Customers.pdf

Nature of the Beast

I was in the middle of a very important ‘financial decision’ last few days. I was recently assigned on a project in a small town in Tennessee countryside, 50 miles north of Memphis. My earlier plan was to rent an apartment in the farthest suburb of Memphis and drive everyday. But as gas prices marched towards $ 4 / gallon, my plan began faltering. My other option was to rent an apartment in this small town, just across the street from my workplace. This plan would have definitely saved 10-15 bucks everyday, but my preference was to stay in Memphis. Also there is such a little visibility about the validity of gas prices; commodity market is so volatile right now.

In order to facilitate the decision process, I set-up a spreadsheet and developed a ‘complex’ financial model involving all the factors such as miles saved in daily commute, miles driven for leisure trips, incremental travel to airport and also other factors such incremental cost of auto insurance, tax difference, depreciated car value which would otherwise incur due to daily commute and so on. I ran this model for different scenarios of gas prices varying from $ 2.5 through $ 5 per gallon to account the volatility in the oil prices.

The financial model showed that renting apartment in this small town would be beneficial as long as the gas prices stay above $ 3.12 per gallon. If the gas prices start falling below this benchmark price, the benefits would also start diminishing. Based on the these results I decided to rent an apartment in the small town for 6 months, assuming that there will be major correction in the commodity market by the year end. Please note that this decision was purely based on the quantifiable benefits and I did not consider any intangible benefit on either side such as cutting daily commute or benefits of small town, city life etc.



My financial analysis would appear rather stupid, since there is low risk involved in either of two alternatives for a very short term. But if you amplify the scale of this project over million times, the risk will also amplify substantially. What I am trying to simulate is the decision process of investment in an alternative energy venture.

There are so many energy alternatives: some renewable such as solar, wind, bio-fuel, and some traditional such as offshore drilling. But viability of every alternative would depend on the same analysis I have just demonstrated. If the price of crude oil, which is the major source of energy today, stays elevated, these investments look particularly lucrative. On the other hand if the prices fall, these investments would go red. For example a major energy company recently started investigating viability of using oil-shale (mud-rock) for oil production, but only when crude oil crossed $100 mark. It would be difficult to justify the same investment when the crude oil is below $60.

Traditional energy companies are not necessarily evil as they have been portrayed whenever there is hike in energy prices. But they certainly have their first accountability towards their investors for every dollar invested in such projects. It is true that these decisions can not be based merely on the investment returns. These traditional energy sources will come to depletion at some point of time in the future. Such issues as greenhouse gas emissions and global warming must be addressed on highest priority. Thus it is the responsibility of the energy policymakers to create environment for attracting the investors towards renewable energy sources. Wind energy was once considered one of the ‘text-book energy sources’. Today it is one of the most profitable businesses worldwide. That became possible only when government subsidies and tax-breaks created a very conducive investment environment.

Well, soon after relocating to this small town, I was eating dinner with some of my friends. The topic of discussion directed towards gas prices. Everyone was complaining about the gas prices and started talking about green technologies. When it was my term, I said – “Today we are talking about all these green technologies because of the hurting gas prices. Tomorrow if the FED increases interest rate even by 25 basis points, the gas prices will start falling down and I bet you, we will stop talking about ‘green technologies’ at very same moment …” Apparently no one liked my statement !!

I don’t know what the energy future is. As far as I am concerned, I have tried to minimize my own ‘carbon footprint’ by relocating to this small town. But I am sure that this happened only when gas prices reached beyond the reach and unfortunately that’s the nature of the beast!

Outlook

I am not an economist, neither by profession nor by hobby. I don’t claim to be … Economists are in high demand especially during time what they call recessions. It is one of the professions that appears to be harmless to humanity. In a sense everyone is welcome to offer his or her free (well...mostly) opinions. You can pretend to be intelligent. And since no one is taking you seriously, world is safe! But I do like economics. So here are some of my predictions about the economy in near future.

1. Energy: Global oil markets will likely remain tight through 2008. Crude oil has already crossed $ 100 per barrel psychological mark. It will remain mostly above $ 90 unless supply and demand cycle changes dramatically. That means be ready to pay $ 3.5 to $ 4 per gallon at the gas station.

2. Consumer Debt – At the end of 2007, consumers held over 2.5 trillion dollars in debt not secured against real estate. For example, average household debt is estimated to be 6.34% of annual salary. On the other hand 3 out of 10 have ever been 60 or more days overdue on any credit obligation. Now good credit is always a good sign of economical health of individual as well as the economy but not outstanding debt!

3. Employment: Major issue of concern. Construction employment decreased by 27,000 in January 08 and has fallen by 284,000 in past 12 months. Manufacturing lost 28,000 jobs in January and over 269,000 jobs in the past 12 months. Since reaching a peak in December 2006, employment in financial activities has declined by 99,000. Statistics indicates the future trends.

4. Inflation: Mostly because of higher energy prices. But not a major issue, in my view. Escalating energy and food prices may shake home economics though.

5. Dollar Decline: Dollar is not likely to regain the historic strength in coming years and even may continue downfall. It may worsen energy prices. But I take is as an opportunity. This makes US attractive investment destination and accelerate the influx of foreign capital. On the other hand cheaper US dollar can boost exports and help to regain mostly lost manufacturing industry.

6. Housing: Not likely to improve and conditions may even worsen. Prices will continue falling, inventory will continue rising which will adversely affect construction industry, building material industry, banking sector and the common consumer.

Economy stimulus package: Most of the experts, on both demand and supply side, agree on the one single thing - putting extra dollars in the pockets of tax-payers will have a limited effect. It will mostly help low-end retailer chain such as Wal-Mart and of course the junk manufacturers across the pacific!

Again – I am not an expert, but everything seems so obvious, logical, realistic and horrific.

Next time - world economy outlook … it’s even easier.