The Fed Might Start to Act Sooner to Head Off Housing Boom and Bust. What Could Happen.

By Randall W. Forsyth

Stacks of lumber in Chicago: Tight supplies of building materials have fed into a housing market boom. / Scott Olson/Getty Images

Can we talk? 

That immortal query from comedian Joan Rivers would succinctly sum up the mouthful from the minutes of last month’s Federal Open Market Committee meeting, which has perked up the ears of market watchers.

“A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases,” reads the key sentence in the minutes, released this past week.

Classic Fed-speak, worthy of former Federal Reserve head Alan Greenspan, with qualifiers about even talking about reducing the central bank’s massive securities purchases running at a $120 billion monthly pace. 

While the onetime maestro once worried that his circumlocutions might actually be understood, Jerome Powell, the current Fed chairman, has been refreshingly forthright about the direction of policy.

In particular, he has insisted that monetary authorities weren’t even “thinking about thinking about” raising interest rates (with another “thinking about” thrown in on occasion). 

The Fed would continue to use its tools—which, importantly, include those asset purchases—to generate what it deems maximum employment, while letting inflation run above its 2% target for a time to make up for past shortfalls.

Fed watchers were surprised that a suggestion to begin a conversation about planning to reduce bond buying had come up so soon. 

They had circled late August on their calendars—when the Kansas City Fed will hold its annual policy confab in Jackson Hole, Wyo.—as the likely date for some sort of an announcement. 

And they’ve been guessing that an actual reduction in the securities purchases probably wouldn’t even start until early 2022.

The Fed arguably already could declare “mission accomplished” for its campaign to ease financial conditions after the financial markets’ near meltdown in March 2020 from the impact of the Covid-19 pandemic.

Since then, stocks have soared, with the S&P 500 index up over 85% from its meltdown low. 

In the credit markets, spreads between U.S. Treasuries and corporate bonds—both investment-grade and high-yield—have narrowed to historic tight levels. 

This indicates that investors are demanding little extra return for their added risk in holding nongovernment paper.

The same is true in the mortgage market, in no small part because of the Fed’s buying $40 billion net of agency mortgage-backed securities, along with $80 billion of Treasury notes and bonds every month. 

As a result, MBS spreads are the tightest on record—only about 20 basis points (two-tenths of a percentage point) over comparable Treasuries. 

For prospective home buyers, that means that a 30-year fixed-rate loan costs just 3% annually (excluding 0.6 of a point paid to the originator), a big factor in the red-hot housing market.

At least one central bank official has raised questions about why the U.S. central bank is pumping up already-inflated home prices, a point made here on more than one occasion.

“My own personal view is that the mortgage market probably doesn’t need as much support now,” Boston Fed President Eric Rosengren is quoted as having commented, according to a research report by J.P. Morgan economist Alex Roever, which says that the Fed official added, “And in fact, one of my financial stability concerns would be if the housing market gets overheated.”

Rosengren is a thought leader at the Fed, Roever observes. 

Before the pandemic, he raised concerns about inflated commercial real estate valuations. 

If Rosengren’s views gain traction, Roever contends, the central bank could shift more of its purchases to Treasuries from agency mortgage-backed securities, while keeping its current buying pace. 

Or it could start trimming MBS purchases before it slows its buying of Treasury paper. 

Or it could cut purchases of both but wind down the MBS buying sooner, which Roever views as most likely. 

But J.P. Morgan’s base case is that the Fed will start to reduce Treasury and MBS buying simultaneously, and ratchet them down to zero at the same time.

That said, there seems little justification to stoke housing demand at a time when the market is constrained by a lack of supply. 

New-home construction is being hampered by tight supplies of building materials and labor. 

The inventory of existing homes also is low, because homeowners are reluctant to sell when they can’t find a new abode.

The Fed might be exacerbating those problems through its securities purchases. 

It’s not as if the mortgage market needs help. 

Banks have been even bigger buyers of mortgage-backed securities, expanding their holdings of agency MBS by $532 billion annually, or about $44 billion a month, according to Joseph F. Kalish, chief global macro strategist at Ned Davis Research.

Banks have been stuffed with deposits, while they have been “starved for loan growth,” notes J.P. Morgan’s Roever. 

So they’ve been forced to put their cash to work in high-quality assets to generate some net interest income. 

Over the next year, agency MBS yield spreads could widen by 20 to 30 basis points over benchmark Treasuries, he estimates. 

Once the Fed fully withdraws from the market by halting the reinvestment of monthly interest and principal payments, an additional 20 basis points could be added to that.

Indeed, removal of the Fed’s implicit subsidy should help restore some stability to the housing market, in which starts plunged 9.8% in April to a seasonally adjusted annual rate of 1.569 million units. 

The supply challenges also are reflected in the backlog of housing units authorized but not started. 

These have risen sharply for the second straight month, reports the Nomura North America Economics team, led by Lewis Alexander.

This tightness has been seen in a slide in home builders’ stocks, according to Yardeni Research. 

The iShares U.S. Home Construction exchange-traded fund (ticker: ITB) fell 9.1% from May 10 to May 19, compared with a 1.6% drop in the S&P 500 in that span. 

That comes after the ETF’s 75.1% rise in the latest 12 months, versus a 39.7% gain in the S&P 500.

The ETF’s laggard performance reflects the surge in prices of key building materials, such as lumber and copper, which crimp builders’ margins. 

The higher material costs also have worsened affordability, despite low mortgage rates. 

In fact, respondents’ assessment of home-buying conditions in the latest University of Michigan consumer sentiment survey is at its lowest level since May 1971, the Nomura economists point out.

While some people deny the importance of soaring home costs in inflation, because of the way they’re included in the consumer-price index, even government statisticians could recognize what’s clearly evident to aspiring homeowners.

For now, lower rents have held down the CPI, despite the big jumps in home prices. 

But Jim Bianco, who heads the eponymous Bianco Research, contends that rents have been held down by the federal moratorium on evictions. 

Some tenants pay a “goose egg,” which lowers average rents.

The CPI is backward-looking. 

Moreover, the eviction moratorium is slated to end in September. 

Looking ahead, Evercore ISI’s proprietary survey of apartment companies points to an acceleration in rent increases. 

“Higher rents may be viewed as more structural than transitory,” according to a client note.

That’s not surprising, given that would-be buyers can’t find homes that are worth buying at inflated prices, amid the frenzy of people flocking to the suburbs. 

The popular narrative is that inflation has been mainly a function of soaring goods prices, especially commodities. 

But the market has started to do its job, with high prices curing high prices, notably in lumber futures, which are off 25% from their recent peaks. 

ICAP technical analyst Walter J. Zimmermann Jr. sees signs of “upside exhaustion” in rallies of other key commodities, too, including aluminum, corn, and crude oil.

But services matter much more to the U.S. economy. Homeowners’ equivalent of rent, calculated by the Bureau of Labor Statistics, accounts for about a third of the core CPI, which excludes food and energy costs.

As noted, that rent measure has been held down because of the pandemic’s effects. 

But forward-looking indicators of rent are pointing higher, which would lift key inflation measures. 

The worry for markets, then, would be if the Fed were forced to accelerate the tapering of its securities purchases, which would be a prelude to the eventual liftoff in its federal-funds rate target from the current rock-bottom 0%-0.25%.

Following the release of the FOMC minutes, the first 25-basis-point rate hike was being priced in for the first quarter of 2023, versus the second quarter of that year, as of May 10, according to NatWest Markets strategists John Briggs and Jan Nevruzi.

Long before then, however, the Federal Reserve assuredly will be talking.

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