Views From the Floor - US Housing: Creaking or Crashing?

What happens when a $40 trillion market meets a seven-sigma event? And are central banks credible?

US Housing: Creaking or Crashing?

When a seven-sigma event hits a $40 trillion market1, some nervousness is understandable. The increase in US mortgage rates this year represents a seven standard deviation move, and has evidently been taken as bad news for the country’s homebuilders. The S&P Homebuilders Select Industry Index is down year to date by a third, underperforming the broader market by around 10 percentage points, with the industry’s valuations in the trough – a price-to-earnings ratio of 7.7 and price to book of 1.9 (Figure 1).

Is this warranted? New single home sales and housing starts have both weakened recently, but from very high levels and now look roughly in line with the pre-pandemic trend (Figure 2). Moreover, supply and demand are better aligned than in previous crises, in our view: demand may falter with higher mortgage rates and broader pressures on the cost of living, but this should be mitigated by millennials continuing to enter the market at a fast pace and relatively constrained supply.

Yet perhaps the most important driver of US homebuilding stocks is simply mortgage rates. Not only are they elevated compared with their own recent past; their spread over 30-year Treasuries has also widened significantly (Figure 3). This reflects the uncertainty over interest rates this year – US mortgage customers can lock in a loan offer for around 30 days, so lenders add a premium to account for any rate volatility. The current spread between mortgages and equivalent-duration US Treasuries is at a historical high of circa 250 basis points. Assuming some stabilisation in US Treasuries, history would suggest that there is potentially 100-150 basis points of downside to mortgage rates – without Treasury yields necessarily needing to budge. If that happens – and last week we saw a first hint that it could – sentiment towards homebuilders is likely to improve.

Figure 1. US Homebuilders Now Trade at Trough Valuations

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Source: Bloomberg; as of 1 July 2022.

Figure 2. US New Single Home Sales and Housing Starts, SAAR

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Source: Bloomberg; as of 31 May 2022.

Figure 3. The Spread Between US 30-Year Mortgages and 30-Year Treasuries Has Widened

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Source: Board of Governors of the Federal Reserve System (Market Yield on US Treasury Securities at 30-Year Constant Maturity, Quoted on an Investment Basis, retrieved from FRED, Federal Reserve Bank of St. Louis) and Freddie Mac (30-Year Fixed Rate Mortgage Average in the United States, retrieved from FRED, Federal Reserve Bank of St. Louis); as of 7 July 2022.

Reserve Judgement

Is credibility an asset or a liability for a central bank? For the most part, it seems to be the former – as explicitly noted in the latest FOMC minutes. However, investors must beware savage market reactions if a central bank considered credible deviates suddenly from expectations.

For all the talk of the Federal Reserve being ‘behind the curve’ as inflation accelerated this year, US monetary policy is priced for credibility. The five-year, five-year forward inflation expectation rate – a measure of expected average inflation over the five-year period beginning in five years’ time – only hit a recent peak of 2.67% in April and has since been reined back to 2.1% (Figure 4).

Put simply, the market believes the Fed will keep inflation under control over the medium term. Of course, this timeframe elides how aggressively the Fed may need to hike rates in the near future. Yet while the front end of the yield curve looks challenging given this uncertainty, any spike in longer-dated Treasury yields amid the noise could represent an attractive allocation point – if you trust the Fed.

Figure 4. 5-Year, 5-Year Forward Inflation Expectation Rate

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Source: Federal Reserve Bank of St. Louis, retrieved from FRED; as of 7 July 2022.

Easy ECB, See?

Meanwhile, what does the market make of the European Central Bank’s credibility? Although a hike is expected at the ECB meeting on 21 July – which would be its first in more than a decade – the euro area’s main interest rate is still negative at -0.5%. With inflation rampant across the bloc (Figure 5), real yields are lower still. Even the Swiss National Bank has raised rates, with local inflation a relatively muted 3.4% in June.

The ECB has signalled that lift-off will occur this month, but it remains to be seen how far the Bank will take rates and how quickly. It’s worth remembering that the ECB has tightened policy at controversial times in the past and has adopted a ‘whatever it takes’ approach before (albeit to solve a different problem). Investors should bear this unpredictability in mind as, while it’s possible for spreads in the euro area to widen further in the short term, surprise decisions could see trends reverse quickly.

Figure 5. Harmonised Index of Consumer Prices (HICP) – monthly data, annual rate of change

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Source: Eurostat; as of 8 July 2022.

 

With contributions from: Yohann Terry (Man GLG – Portfolio Manager); Edward Hoyle (Man AHL – Head of Macro)

1. Estimated value of US housing stock, as of January 2022, as reported by Bloomberg.

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