Friday, August 18, 2017

Housing: Part 251 - Elements of our current cycle

I have been critical of the Fed's current stance.  I think they are destined to over-tighten because of Phillips Rule thinking and because rent inflation induced by throttled housing supply causes them to overestimate the inflationary effects of monetary policy.  I expect the yield curve to eventually decline to a lower level.  And, stocks might move around a bit, but I suspect they will eventually be lower than the current level over the next couple of years, though not necessarily too much lower.

In the meantime, I had been waiting for a convergence between interest rates and home prices.  There has been a divergence since 2007.  Yields on real estate (especially low tier real estate where credit constraints have cut off demand of owner-occupiers) have been at long term highs while long term TIPS yields have been very low.

I don't know how much trading there actually is on the relationship between housing and interest rates, but the colloquial take on it is that rising rates make affordability harder, and cut into homebuilding.  I don't see any reason in the historical data to consider that relationship important.  Rising real long term rates could reduce the intrinsic value of homes, causing price/rent ratios to moderate.

However, there is a divergence now.  So, I think it will take a resurgence in residential investment to pull real long term interest rates higher again.  That resurgence either needs to come from loosening the supply constraints in the Closed Access cities or from loosening entry level mortgage standards, which have been quite tight.  So, rising rates would likely be related to surging homebuilders.  Like I said, this is contrary to the colloquial take on this, but I'm not sure it's that contrarian to past experience.

Yields aren't the binding constraint in housing, so I don't think rising rates will pull down intrinsic values in housing.  I think this will make homebuilders more positively correlated with interest rates than normal over the business cycle.  Also, at current levels, homebuilders are fairly defensive, because there is so much pent up demand.

Data from Zillow (ZVHI)
I think we are starting to see a resurgence of low tier housing.  Here are 12 month price changes in Miami.  This is pretty typical of today's market across MSAs.  By my count, in 17 of the top 20 MSAs, low tier prices are rising faster than high tier prices.

We need this.  Cumulatively, since the late 1990s, low tier prices have lagged high tier prices in most cities - by 15% on average (more than that outside the Closed Access cities).  This is because in most cities, low tier prices didn't behave much differently than high tier prices during the boom, contrary to common reports.  But, when we clamped down on lending, low tier prices collapsed.  So, they have a lot of ground to make up in the return to normalcy, if it ever comes.

We have also seen moderate very recent rises in mortgage lending, according to some measures.

In the meantime, though, Fed policy might be pulling interest rates down by causing economic contraction.  So, I'm not sure we will see an immediate convergence of housing yields and interest rates (rising home prices and falling bond prices).  On the other hand, there could be some interesting ways to create defensive hedges that also have upside potential as these markets evolve.

And, this could happen sort of under the radar.  The entry level markets don't amount to much in total dollars, because the home values are low.  So, I think we could see healthy improvement in entry level homebuilding while credit markets look meager because a lot of these homes might be purchased without moving the total dollars borrowed that much.

In the meantime, if these trends lead to a pick up on the margin of homebuilding in these markets, finally, it could really perk up some homebuilders, even if the macro-economy doesn't look that exciting.

1 comment:

  1. These guys think the current account deficits cause the house price booms, not vice-versa.

    But then, that is the nice thing about macroeconomics. No one is ever wrong or right. There is always a study somewhere….