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By HaleStewart July 29, 2014 11:36 am
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Will Housing Market Weakness Keep the Fed on the Sideline Longer?

     On Wednesday, the Federal Reserve will issue its latest interest rate policy statement for the US economy.  The general consensus is for the Fed to continue cutting its asset purchase program but keeping interest rates on hold.  But as the US economy has exhibited stronger growth characteristics (largely as a result of stronger than expected employment numbers) many analysis have moved up their estimate of the date when the Fed will start to raise interest rates.  However, in this post, I want to put forward a different theory: that the slowdown in the US housing market will in fact keep the Fed on the sidelines for some time, perhaps even longer than anticipated.

     First, housing markets are perhaps one of the best indicators of the health of the US economy.  Edward Leamer wrote an extensive article on this which is available from the NBER website.  As he notes in the abstract:

Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy.

Intuitively, this makes sense.  For the average family, a house is by far its most important actual investment.  Not only will it represent the largest cash outlay for most families, it will also consume the largest percentage of the family’s budget for an extended period of time (15-30 years, depending on the mortgage the family uses).  Therefore, the state of the housing market  is a very good indicator of the average US family’s opinion about the overall health of the US economy and its future prospects.

     And right now, there is a great deal of concern about the future as exhibited in the housing market metrics.  Let’s start with the new homes sales market, which is a better arbiter of first time home buyers:

As the chart above shows, sales cratered to their lowest level in 2011.  They rose a bit to early 2013, where they have been printing in a very tight range for the last year and a half.  But most importantly, the current level of sales is not only very low by historical levels, but it also indicates the US consumer is at best extremely cautious about his future prospects. 

     The existing home sales market is a bit better, but this market is a better indicator for second time home buyers who are “trading up:”

The existing home sale market rose consistently from mid-2011- to mid-2013, when it dropped as a result of higher interest rates.  Since early this year, the number has continued to increase with the current overall level of activity printing at levels associated with the late 1990s-early 2000s, when the economy was in better shape.  This means the existing home sales market is in better overall shape than the new home sales market.  However, the overall number is still low by recent historical measures -- even taking into account the level associated with the housing bubble of the 00s.

     There are several reasons for this decrease in sales, with the most important being the recent rise in 15 and 30 year mortgage rates:

In mid-2013, the 15 year rate rose to 3.5% while the 30 year increased to 4.5%.  Since that rise, both rates have been trending in a 30-35 basis point range.  This increase obviously hit the new home market harder, as its current stalling activity indicates.   Second, the year over year percentage change in average hourly wages is still increasing at a very low level:

As the chart above shows, the rate of increase recently printed at around 2.5%, but that number isn’t inflation adjusted, which obviously decreasing the overall rate of earnings.  Third, we have a very weak employment situation; while the unemployment rate is currently a 6.1%, there is still a tremendous amount of slack in the economy with the U6 rate printing far higher.  All of these factors -- higher interest rates, weak wage growth and employment slack -- are contributing to the overall slowdown in the housing market.

     We know the Fed is looking at the housing market.  From their latest policy announcement:

Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow.

And from Yellen's latest Congressional testimony:

The housing sector, however, has shown little recent progress. While this sector has recovered notably from its earlier trough, housing activity leveled off in the wake of last year's increase in mortgage rates, and readings this year have, overall, continued to be disappointing.

And going back to her testimony on February 11, we have this:

In contrast, the recovery in the housing sector slowed in the wake of last year's increase in mortgage rates.

     The housing market is obviously not the Fed's only concern.  However, they are clearly looking at this part of the economy.  And considering its overall importance, the current housing market weakness may keep the Fed on the sidelines longer.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer 



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