When will interest rates bottom?

Back in the days of QE, I noticed a pattern that during QEs, the expected future date of the first rate hike would remain relatively level, but when QEs were stopped, the expected future date of the first rate hike would move ahead in time.

In other words, if the first rate hike was expected to be in December 2012 when a QE round began, it would still be about December 2012 when QE ended.  Then, after QE ended, five months later, the expected date of the first rate hike will have moved back to May 2013.

I never put this observation to intensive statistical scrutiny, but it was a pattern that I saw.

Today, we might look at another pattern.  Since the short end of the yield curve inverted in late 2018, one way we could think about the Fed's posture is to infer from Eurodollar futures markets what the expected last rate cut will be.  The further into the future that expected last cut occurs, the longer we can expect the Fed to have taken a somewhat too-tight posture.

It's not actually that easy to measure, because the curve has more of a bowl shape than a V-shape, so there are several quarters that could be called the bottom.  But, I thought it might be worth seeing.

The first graph shows the quarter with the lowest rate in Eurodollar futures markets.  The second graph shows how many days we are from the quarter with the lowest rate.  So, we could be on a trajectory with a lot of noise that is basically headed for a bottom around the middle of 2021.

But, the bottom is about the same as it was about 6 months ago.  If the bottom happens to jump up another quarter, we could be in a situation similar to the QEs.  Maybe if the Fed holds rates steady, the date of the future rate bottom will move forward in time, and if the Fed drops rates enough, maybe we will continue on that trajectory to mid-2021.

Housing: Part 360 - New Homes vs. Existing Homes

When the federal government made it effectively illegal to originate mortgages to many families after the financial crisis, the effect of that development was clear in the prices of homes.  Low tier home prices collapsed and sales of new homes at low prices collapsed.  The combination of those effects meant that the median price of new homes moved much higher than the price of existing homes.  The median new home has long had a price about 30% or 40% higher than the median existing home, and that ratio was slowly declining during the housing "bubble" because the "bubble" was mostly facilitating the construction of more affordable homes and the mass migration of Americans out of the expensive, housing-deprived cities.  New homes were being built, mostly, where they could be built, and that means they were built where they were cheaper.

When the feds quashed that process with draconian new lending regulations, the median price of new homes shot up to about 70% more than the price of existing homes.  For the past several years, that has been moderating.  Some of that moderation has been because low tier home prices have done some catching up over the last few years.  Some of it might have been due to some recovery in building, but sales of homes under $200,000 is still sitting near cycle lows. So, I don't think the decline in the median price of new homes is due to a compositional shift back toward entry level units.  It must be due to a pullback in buying among the existing, "qualified" buyers with high incomes.  The same basic group of buyers are buying the same number of units that they were a couple of years ago, but at slightly lower prices.  Maybe the intrinsic value of homes was knocked down a bit by the 2017 tax bill.  I would say that is a bearish development, even though homebuilding has such pent up demand that it's tough to be too bearish.  On the other hand, we just had this blowout number in housing starts for December.  Housing will be interesting to watch this year.

My comment to HUD on affordable housing.

Today, the Mercatus Center posted my response to HUD's request for public comments on how to achieve more affordable housing.  Here is the closing paragraph:

There are certainly many areas where regulatory barriers to building need to be eliminated in order to keep housing affordable throughout the United States. That should certainly be the priority of government at all levels. Yet today there are many areas in this country where those barriers aren’t the binding constraint that is blocking supply and pushing up rents. Those cities do lack adequate supply today, but it is because they lack suppliers. They lack potential home buyers. Potential home buyers frequently need mortgages. The most direct and immediate boost to housing supply that HUD could create today would be to increase suppliers, to broaden the availability of mortgages to households that have been locked out in one way or another from today’s market. Trends in prices, building, and borrowing suggest that many of those potential buyers would buy more affordable and more modest homes than the homes that are bought by buyers who can qualify today. The most important task for HUD today is to figure out what is preventing the construction of homes that would sell for less than $200,000. The answer to that puzzle is surely a bit counterintuitive, because it is clear that more broad-based lending and more residential investment will be required for that to happen. The families that would use that funding, for the most part, aren’t living under a bridge or in a car today. They are stacked into the existing housing stock, where they frequently spend much more on rent than they would need to spend on a mortgage to buy that very same house. Spending less on rent must begin with spending more on residential investment.

Here is the comment on the same question from my Mercatus colleagues, Salim Furth and Emily Hamilton.

Housing: Part 359 - Recent shifts in housing may be related to GSE activity

There has been a bit of a mystery recently in housing markets.

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For a couple of years, the square footage of new homes has been declining.  This could be because of a decline in demand for housing, in general.  Or, it could be from a compositional shift to more entry level homes.  That would be bullish.



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Rent inflation remains high, suggesting that demand for shelter remains strong.  Residential investment has levelled off at really low levels.  Rates of homebuilding have levelled off, both in total, and specifically for single family homes.  This suggests that it is a decline in demand (at least for homeownership, if not for shelter) is the cause.  That would point to a retraction in lending markets, or sentiment, or an effect of the progressive housing elements of the 2017 tax law.

There has been a bit of a recent rise in homeownership among young families.  But they are flat among older families.  That calls for some optimism that there is rising demand for entry level homeownership and homebuilding, to meet the existing demand for entry level shelter.  But, the New York Fed's Quarterly Report on Household Debt and Credit doesn't really show any rebound in the number mortgages outstanding or in rising originations among buyers with low FICO scores.  That would suggest that the rebound among young homeowners is limited to those with very good credit.  Yet, if that was the case, why is the average new home size declining?  It could be that young families generally demand smaller homes, even if they are financially secure, because their families are still growing.

I think a clue to what is happening is here, in this AEI update on housing markets.  Here is a slide from AEI.  Notice that at the GSEs, there has been a recent clampdown on high Loan-to-Value and high Debt-to-Income lending.

I suspect that there is a combination of things happening:

1) Some continued tepid improvements in the ability of high-tier buyers to buy or trade-up as equity continues to recover, the economy grows, etc.

2) Still no compositional shift to low tier buyers that have been locked out of the market since 2007.

3) A decline in demand among some subset of those high tier buyers, as a reaction to new tighter standards at the GSEs.  These buyers might be somewhat reducing their demand for units. But the amount they can borrow with conventional loans has been capped by new GSE standards, so they may also be reacting by buying smaller homes.

If this is the case, then I don't think we should be particularly bullish about housing.  I don't think smaller new homes reflect a recovery of low tier borrowing.  But, we also shouldn't be particularly bearish.  The decline in new home size and the levelling off of housing starts may just be a temporary reaction to the change in lending standards to the existing pool of qualified buyers under the current regime.

This might mean that housing will return to a moderate level of growth.  A level of growth that isn't particularly vulnerable to a pullback because there is so much pent up demand for shelter.  And, also a level of growth that could really accelerate with any reasonable expansions in lending standards.  I would call that a bullish expectation in housing, but it's not as bullish as the context where smaller new homes were the result of already expanding the set of potential homebuyers.

PS. This also tweaks my expectations for the broader economy to a more bullish position.  I have posted about how the yield curve is effectively inverted, so that, at least, I expect yields to decline, and possibly some contraction in equity markets or GDP growth.  The pause in housing growth could be a sign of weakening demand, in general.  But, this suggests that it could just be related to a one-time shift in lending standards at the GSEs.

December 2019 CPI Update

Not much to say.  More of the same.  Shelter inflation tracking over 3%, non-shelter core around 1.5%, and core CPI about 2.2%.  I don't think short-term inflation fluctuations are very informative at this point, unless they veer wildly in one direction or the other.  I still think the most likely event in the near term is a decline in interest rates, so I am still mostly holding on to bond exposure and keeping powder dry on some potential tactical equity positions, except for positions with some defensive elements.  For instance, Hovnanian, a homebuilder, (HOV) that is highly leveraged, financially and operationally, and poised to recover because of the both defensive and speculative potential of that sector.  I actually consider that position a sort of hedge against a bond position, in part, because I think a primary factor holding yields down is the lack of residential investment.

Disclosure: I own shares of Hovnanian (HOV)

The 20th Century Equity Sine Wave

A while back, probably even before I started blogging, I noticed that US equities in the 20th century seem to follow a fairly steady sine wave.  This is data that Robert Shiller makes available on historical S&P 500 or equivalent values dating to 1871.  Equity returns were fairly linear before 1900, according to this data.  Here, I use total real returns, which includes dividends and is adjusted for inflation.  That's really the only way you should look at long term index returns.  (The values on the y-axis don't match the current value of the S&P 500 because this is in inflation-adjusted dollars, with re-invested dividends.  The trend is important.  The values are somewhat arbitrary.)

Here is a chart of the fitted wave.  This only uses 1900-1999 data, so the last 20 years are out of sample, yet still seem to be following the trend.  Of course there are lots of technical theories about predictable movements in asset prices, most of which are questionable.  There could be a reasonable explanation here, though, having to due with baby boomer types of generational fluctuations, for instance, which might create long-term shifts in real growth rates that are difficult to arbitrage because they literally cross generations.

Anyway, for what it's worth, the sine curve fluctuates from annual total real gains of about zero to about 10%, and we are currently right at the peak, where expected annual returns would be about 10%.  Make of that what you will, if anything.

There is still a standard deviation of close to 30% in the difference between market prices and the fitted curve, but if that means that in, say, 5 years, equity holdings after reinvested dividends would be expected to be worth around 15% to 75% more than they are today, that seems reasonably better than if (using a linear trend line instead) they were only expected to be worth 0% to 60% more.  With equities, it is still the holding period that should dominate one's allocation, because short term noise is the key risk factor.  But, this seems like something to consider on the margins.

December 2019 Yield Curve Update

The yield curve continues to press upward from the mid-year lows.  This is mildly bullish, but I would still say that the yield curve is in bearish, inverted territory (below the trendline in the second chart).  We may sit here for a while (several months?), but my guess is, per past patterns, that either 10 year yields will move up above 3%, and the Fed will keep the target rate low, and we might escape a contraction, or 10 year yields will remain close to where they are, and eventually the entire yield curve will move back down toward zero, and we will have some sort of contraction.  I don't think the contraction would be extreme, and it may not even bring much of a decline in equity markets.  The ingredients that made 2008 so disruptive aren't in place today.  The Fed appears to be ready to react to contraction without as much delay as they allowed in 2006-2008.  And, though perma-bears will always be with us, as are the poor (in the long run, maybe they are one and the same!), I don't get the sense that the same suicide cult mentality is so strongly shared as it was in 2008, when Americans would only be satisfied with some sort of financial meltdown.

So, in short, this month doesn't change my posture much.  I think the odds are greater than 50% that future near term yields will be lower than current forward yields, maybe a slight rise in unemployment and decline in equities if the inverted yield curve, as I see it, does signal some coming contraction, and housing that will probably look a lot like 1999-2001, at worst seeing a slight pause in growth.