It’s easy to see why homebuilders are getting nervous. Affordability — defined as the ability of someone on the median income to afford a median house at prevailing mortgage rates — had already dipped to its lowest level since the top of the last housing boom in 2006 by the time it was last measured at the end of the second quarter. Rises in average mortgage rates since then (shown inverted on the following chart) more or less guarantee that affordability has worsened:
The housing market is a critical area where tighter monetary policy can have a big effect, with a lag. Turning to the rental market, Zillow’s index of the rate of inflation in leases taken out each month is inflating much more slowly than at the peak last fall. The bad news for the Federal Reserve, and for those thinking of renting a house, is that monthly inflation continues to be significantly greater than it was in the years before the pandemic. There is a way to go before rental inflation (which accounts for about a third of the Consumer Price Index) is stamped out as the Fed must wish:
For a visualization of how this works in practice in a number of different locations around the US, check out this Odd Lots post, which includes plenty of charts put together with the Bloomberg ECAN function.
If all this sounds bad, Bespoke Investment Group suggests that the suddenness of the way the NAHB’s index has fallen is unprecedented:
While the actual level of homebuilder sentiment has yet to reach historical extremes, the intensity and consistency of the recent declines have. For starters, the six-month rate of change has seen one of the most extreme plunges in the history of the survey (going back to 1985). The only time sentiment deteriorated at a faster rate was in the initial months of the Covid crash. Even during the financial crisis, there wasn’t a six-month period where sentiment fell as fast as it has in the last six months.
This is good news for the Fed, in that it shows it’s having an impact. Now the question is whether the cure could be as bad or worse than the disease. The Absolute Strategy Research survey of investors, featured in yesterday’s Points of Return, revealed that house prices had begun to worry asset allocators, a lot. About half of the respondents in the survey are not based in the US:
As house prices tend to rise over time, this is startlingly bearish. It also implies rising concerns over credit. Absolute Strategy asked asset allocators how likely they thought house prices where they lived would be higher a year from now. A third thought it “very unlikely,” which the firm’s David Bowers said was “an aggressive call and suggests the tightening of monetary conditions is starting to impact an important source of collateral.’’
To be clear, this isn’t just about the US. Comparing house prices across geographies is difficult. The following chart is all in local currency terms, but it should be directionally accurate. Since the peak of the last US housing boom, US home prices have risen less than in Germany, where prices have turned downward. The UK is almost exactly in line with the US, if we use the S&P Case-Shiller indices:
All of this suggests the Fed is getting somewhere, but also opens new risks. This is from Gerard MacDonell of 22V Research:
The housing sector is dutifully weakening, as indicated in part by today’s HMI for September. We did not really know ahead of time what level of mortgage yields would be required to generate this result. But in an environment in which high inflation dictates forcing aggregate demand growth below trend, and with monetary policy carrying most of the burden of achieving that, it was inevitable that housing – the most rates-sensitive sector – would take it on the chin. From the perspective of housing activity, the mortgage yield drops out of the arithmetic. At the risk of overstating the case only mildly, rates would go to the level required to deliver the result. But the result was quite confidently known.
James Ragan, director of wealth management research at D.A. Davidson, makes a similar point. For the FOMC, he predicts:
… some discussion about if they believe that the rate hikes that they’ve already put in place this year are starting to have some type of an impact because we know there’s a lag. That would give the equity markets a little bit of hope that perhaps the rate hikes that have already been taken are working to some extent. The risk is that the Fed goes too far. If we haven’t had any impact of the previous hikes yet, or if it’s minimal… there could be a period when all of sudden things just really come to a halt in the economy.
There is also one other risk to monitor. Falling house prices are dangerous. For my favorite example, look to the London housing market as the 1980s turned into the 1990s. House prices had risen by a third in 1987, and the government in hindsight was too late to apply the brakes. As a result, prices fell uninterruptedly for all of the first four years of the 1990s:
The problem became self-reinforcing. Many buyers had over-extended, taking out big mortgages in the belief that otherwise they would miss out. Once prices started to fall, they found themselves in negative equity — even if they sold the house, they wouldn’t be able to repay the mortgage. Rather than do this, they toughed it out in houses that were often too small for them, while liquidity in the market steadily dried up. Lower prices forced a negative cycle from which it took years to emerge.
Hope springs eternal and London real estate has enjoyed more booms since then. But the critical point is that the housing market affects people very directly. Living in a house that is no longer appropriate for you sucks away at your quality of life. And housing booms that put homeownership out of the reach of the youngest generation intensify inequality and injustice. As with many other aspects of the economy, it’s possible that the fallout from the pandemic may lead to an overdue reduction in the inequality that is plaguing the western world. But that might come at a high cost. Investors are aware of this, and so is the Fed.
— Assistance by Isabelle Lee
Points of Return is often criticized for a US-centric bias, which is fair enough. The US stock market is by far the biggest and the newsletter is written from New York, but there are still huge variations across the world. Things look very different outside the US. This is FTSE’s index for global stocks (both developed and emerging markets) excluding the US. It has just dropped to a two-year low:
The key dynamic is the interplay between the US and China, the two greatest economic powers. For more than a decade, the Chinese equity market has been prone to bubble over but had managed to stay ahead of the S&P 500, which shouldn’t be surprising given the rate of growth in the Chinese economy. That has reversed dramatically since the peak in China’s post-Covid stock market boom early last year:
Since then, China has become a lead weight on the emerging world. Overall, the developed markets outside the US (as measured by the MSCI EAFE index) and the emerging markets have tracked each other remarkably closely. Exclude China from EM, and the rest of the emerging world turns out to have held up better than Europe and Japan, while China is falling and is now close to its low from March this year.
All of these indexes are denominated in dollars, and so the strength of the US currency has much to do with this. The Fed’s monetary policy, by making it harder to buy imports or borrow in dollars, has had its most direct effects thus far outside the US. The energy crisis is hurting Europe far more than the US, which contributes to the phenomenon. But the broadest lesson is that the two superpowers (through higher rates from the US and slowing demand in China) have combined to bring down other stock markets in almost uniform fashion. With a greater lag, we should probably expect US stocks to follow where others have led.
In less than 48 hours, the Fed will raise rates to rein in surging inflation for the fourth time this year, all while hoping such aggressive tightening won’t tip the American economy into a deep recession. The first key question is by how much.
Traders are pricing a 75 basis-point hike Wednesday, with a minority betting on a full percentage point. Rates haven’t been raised this much at one time since then-chair Alan Greenspan introduced transparency in announcing changes in the fed funds rate in 1990, according to Sam Stovall, chief investment strategist at CFRA. He weighs in:
We think a 100 bps hike would unnerve Wall Street, as it would imply that the FOMC is overreacting to the data rather than sticking to its game plan, and would increase the likelihood that the FOMC will eventually overtighten and lessen the possibility of achieving a soft landing.
Since World War II, there have been only seven times when the committee hiked rates by 100 basis points, and all came during the bid to overcome inflation at the end of the 1970s: November 1978, October 1979, February, September, November and December 1980, and May 1981:
After those hikes, CFRA found that the S&P 500 slipped four times over one-month, three-month, and six-month periods, posting average returns of -2.4%, -1.3% and +0.1%, respectively. Such a hike might create the impression that the Fed is “panicking,” said Steve Sosnick, chief strategist at Interactive Brokers:
While various Fed talking heads have noted that they are willing to run the risk of a slower economy in order to win their inflation fight, a 1% move could easily be interpreted as an overreaction and more likely to be recessionary.
Others, however, suggest that Jerome Powell and his colleagues will be keen to follow the example of Paul Volcker, the Fed chair responsible for the previous 100 basis-point hikes. They eventually convinced the market that he was serious about beating inflation. Some, such as Ed Yardeni, president of Yardeni Research, expect exactly this headline-grabbing move:
We expect Wednesday’s FOMC meeting to bring a 100bps hike in the fed funds rate to 3.25%-3.50% and more hawkish projections of committee members, suggesting a terminal rate this tightening cycle of 4.25%-4.50% … Fed Chair Powell seems to be channeling his 1970s predecessor Paul Volcker — who masterfully tamed high inflation amid a severe recession.
Beyond the magnitude of the hike, the second key question is the Summary of Economic Projections, best known as the infamous “dot plot.” For Ragan of D.A. Davidson, the dots are most important, because they allow some insight on when the Fed governors expect to end the tightening. Many still expect a peak at 3.75% or 4%, he says: “If it seems like they’re leaning towards higher than that, we could see some ongoing weakness in the market.”
As a reminder, June’s version of the dot plot, in which each dot represents the prediction of one FOMC member, suggested that rates would be higher at the end of 2023 than at the end of 2022 (something that the market has been betting strongly against), but it also shows that a majority don’t think the peak rate will get above 4%. That’s likely to be revised upward:
The dot plot could also be used to show that the FOMC is serious about inflicting a serious slowdown in economic growth in order to get inflation down. To quote David Mericle, economist at Goldman Sachs, the dots “are likely to show GDP growth more materially below potential this year and next than in June, a slightly larger increase in the unemployment rate in the years ahead, and a bit more inflation this year and next.” If not as spectacularly negative as the Bank of England, the Fed governors are going to prepare everyone for the worst. Best to prepare for that.
This is one for people who might have been brought up in Britain in the 1980s. Like me. I’m being self-indulgent. This is a BBC documentary making the case that the ’80s were the greatest decade for music. Enjoy. And if this isn’t nostalgia for you, you might still have fun with it.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets and Bloomberg Opinion columnist. A former chief markets commentator and editor of the Lex column at the Financial Times, he is author of “The Fearful Rise of Markets.”
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